Mastering and Understanding Candlesticks Patterns

Candlestick charts are further developed line charts – which the image below shows – that serve to compensate for the disadvantage of less information. Candlestick charts have their origin in 17^thcentury Japan. Today, candlestick charts are the preferred tool of analysis for traders and most investors since they provide all the required information at a glance. In this article, you will learn everything you need to master candlesticks patterns like a true professional.

The candlesticks

As the name suggests, a candlestick chart is made up of so-called (price) candlesticks. These candlesticks are made up of different components to describe the price movements of financial instruments.

Two sample candlesticks are shown below. A candlestick consists of a solid part, the body, and two thinner lines which are called candle wicks or candlestick shadows.

The candlesticks are color-coded to illustrate the direction of the price action movements. A white candlestick represents rising prices, whereas a black candlestick shows that the price fell during the period.

Figure: A rising candlestick is shown on the left and a falling candlestick is shown on the right along with the explanations of terms used for individual candlestick components.

The length of the shadows shows how much the price has moved up and down with respect to a candlestick within a specific duration. If we set our charts so that one candlestick corresponds to one day, then we can read the daily fluctuations in the financial market using the shadows of a candlestick.

The candlestick body describes the difference between the opening and closing prices for the corresponding time period.

The body of the white, rising candlestick below shows that the price opened at $10 and closed at $20 in the selected time interval, but has fluctuated between $25 and $5 in the meantime, as indicated by the shadows.

Figure: The trend of candlesticks from the opening price to the closing price is described by the candlestick body. The shadows show the entire fluctuation width.

If we line up several candlesticks, we can reproduce the progression of line charts by following the candlestick bodies as shown below. The candle shadows also show the severity of price fluctuations in each case. We, thus, get all the information that is essential for an effective price analysis at a glance. This is why candlestick charts are mostly used for technical analysis these days.

Figure: If you follow the path of the candlestick prices, you can reconstruct the line charts. Candlesticks offer more information and are the preferred medium for technical analysts.

Anyone who knows how to analyse and interpret the so-called candlestick patterns or candle formations, already understands the actions of the financial market players a little better.

Candlesticks can be divided into four elements, where each element reveals a different aspect of the current trading behavior and the prevailing market sentiment.

Intro: The strength ratio – bulls vs. bears

To understand the price and candlestick analysis, it helps if you imagine the price movements in financial markets as a battle between the buyers and the sellers. Buyers speculate that prices will increase and drive the price up through their trades and/or their buying interest. Sellers bet on falling prices and push the price down with their selling interest.

If one side is stronger than the other, the financial markets will see the following trends emerging:

• If there are more buyers than sellers, or more buying interest than selling interest, the buyers do not have anyone they can buy from. The prices then increase until the price becomes so high that the sellers once again find it attractive to get involved. At the same time, the price is eventually too high for the buyers to keep buying.
• However, if there are more sellers than buyers, prices will fall until a balance is restored and more buyers enter the market.
• The greater the imbalance between these two market players, the faster the movement of the market in one direction. However, if there is only a slight overhang, prices tend to change more slowly.
• When the buying and selling interests are in equilibrium, there is no reason for the price to change. Both parties are satisfied with the current price and there is a market balance.

It is always important to keep this in mind because any price analysis aims at comparing the strength ratio of the two sides to evaluate which market players are stronger and in which direction the price is, therefore, more likely to move.

Element 1: Size of the candlestick body

The size of the candlestick body shows the difference between the opening and closing price and it tells us a lot about the strength of buyers or sellers.

Below, the most important characteristics of the analysis of the candlestick body are listed.

• A long candlestick body, that leads to quickly rising prices, indicates more buying interest and a strong price move.
• If the size of the candlestick bodies increases over a period, then the price trend accelerates and a trend is intensified.
• When the size of the bodies shrinks, this can mean that a prevailing trend comes to an end, owing to an increasingly balanced strength ratio between the buyers and the sellers.
• Candlestick bodies that remain constant confirm a stable trend.
• If the market suddenly shifts from long rising candlesticks to long falling candlesticks, it indicates a sudden change in trend and highlights strong market forces.

Figure:Left: Long candlestick bodies during the downward and upward trend phases. Sideways phases are usually characterized by smaller bodies. Right: Rising candlesticks are stronger in the upward trend. At the peak, the ratio tilts and a sideways phase is characterized by smaller candlesticks.

Element 2: Length of candlestick shadows

The length of shadows helps in determining the volatility, i.e. the entire range of price fluctuations.

Characteristics of candlestick-shadow analysis:

• Long shadows can be a sign of uncertainty because it means that the buyers and sellers are strongly competing, but neither side has been able to gain the upper hand so far.
• Short shadows indicate a stable market with little instability.
• We can often see that the length of the candlestick shadows increases after long trend phases. Increasing fluctuation indicates that the battle between buyers and sellers is intensifying and the strength ratio is no longer as one-sided as it was during the trend.
• Healthy trends, which move quickly in one direction, usually show candlesticks with only small shadows since one side of the market players dominate the proceedings.

Element 3: Body to shadow ratio

For a better understanding of price movements and market behaviour, the first two elements must be correlated in the third element.

Important factors in this context are:

• During a strong trend, the candlestick bodies are often significantly longer than the shadows. The stronger the trend, the faster the price pushes in the trend direction. During a strong upward trend, the candlesticks usually close near the high of the candlestick body and, thus, do not leave a candlestick shadow or have only a small shadow.
• When the trend slows down, the ratio changes and the shadows become longer in comparison to the candlestick bodies.
• Sideways phases and turning points are usually characterised by candlesticks that have a long shadow and only short bodies. This means that there is a relative balance between the buyers and the sellers and there is uncertainty about the direction of the next price movement.

Figure: There are almost no shadows during the left rising phase, confirming the strong trend. Suddenly long candlestick shadows are visible in the sideways phase; these indicate uncertainty and an intensified battle between the buyers and the sellers. When candlestick shadows increase, it can foreshadow the end of a trend.

Element 4: Position of the body

As far as the position of the candlestick body is concerned, we can distinguish between two scenarios in most cases:

• If you see only one dominant shadow which sticks out on one side and the candlestick body is on the opposite side, then this scenario is referred to as rejection, a hammer or a pinbar. The third and the seventh example in figure 10 show such candlesticks. The shadow indicates that although the price has tried to move in a certain direction, the opposition of market players has strongly pushed the price in the other direction. This is an important behaviour pattern which we will analyse in detail later.
  
  
• Another typical scenario shows a candlestick with two equally long shadows on both sides and a relatively small body. The fifth candlestick in figure 10 shows such an indecision On one hand, this pattern can indicate uncertainty, but it can also highlight a balance between the market players. The buyers have tried to move the price up, while the sellers have pushed the price down. However, the price has ultimately returned to the starting point.

Figure: From left to right: The size of the candlestick body describes the strength of the price movement. The longer the body, the stronger the impulse. If the candlestick shadows are longer, there is a balance between the sellers and the buyers and the indecision increases.

Chart examples

Now that we have covered the individual elements, we can put things together and see how we can use our knowledge to dissect price charts.

Example #1

Let’s follow price in the chart below and I share what we are seeing here in the candlesticks:

• During the downtrend, the candlesticks are only red (bearish) and long with very small or no wicks >> this shows strength
• At the bottom, we see a rejection. This is not enough yet to call a reversal but on the next candle we then start seeing bullish candles

Example #2

Below we see a typical range behavior and we can see how the candles tell us what is going on:

• Price trends lower on the left with strong bearish candles and no bullish candles in between
• Then suddenly the bodies become smaller and the wicks longer, showing that the momentum is fading
• Price trades back into a previous support and it now becomes resistance and we see a small rejection candle
• At the support of the range, we see that candles are becoming smaller and have more wicks, confirming the indecision. It also makes a break of the support unlikely
• Just before the support breaks, price is only starting to make bearish candles and we can see how momentum is picking up

Example #3

In the final example, we can see a classic pattern at the end of a trend. This is also often one of the building blocks to the trading strategy which you can learn in our pro area.

• During the uptrend, the candles are very long and have very small wicks only
• Then suddenly we see two long wicks to the downside. This shows that price tried to push lower but it did not yet have enough selling pressure
• But the candles are becoming smaller and smaller after the failed sell-off attempt which indicates that the trend is running out of steam
• Then suddenly we see a strong bearish candle which confirms the new downtrend

Conclusion: No Need For Candlestick Patterns

With this article we want to show you that you do not have to remember any candlestick formation to understand price. Quite the opposite. It’s very important on your path to becoming a professional and profitable trader that you start thinking outside the box and avoid the common beginner mistakes. Learn how to understand how buyers and sellers push price, who is in control and who is losing control.