Utilizing candlestick analysis when trading is one of the simplest and most effective methods of technical analysis, regardless if trading foreign currencies or trading stocks. While there are other types of charts available including line and bar charts, candlestick charts are amongst the most popular type of charts today.
Where did Candlestick Charts come from?
Candlestick charts and candlestick analysis was first developed in Japan around the 1750s, which is why you see candlestick charts also referred to as Japanese candlestick charts. It also explains why some of the commonly recognized patterns have Japanese names such as doji or harami.
Japanese candlestick charts are believed to have been created by the very successful Japanese rice trader, Munehisa Homma. Mr. Homma traded rice futures on the Dojima Rice Exchange in Osaka, which was the largest rice exchange in Japan at the time.
Before the candlestick chart, simple line charts had been used to track closing prices of rice. Using candlesticks gave Mr. Homma a method of plotting more relevant price data while staying within a two dimensional chart.
Mr. Homma’s phenomenal success as a trader led other Japanese commodity traders to adopt this type of charting. In the 20th century, the Japanese candlestick chart was introduced to the West and now is used by many traders and in many markets.
Today, most commonly you will find the Japanese candlestick chart is traded in conjunction with using western technicals. Therefore, utilizing candlestick analysis means utilizing the benefits of candlesticks combined with the advantages of western technical analysis.
What Is A Candlestick?
A typical candlestick has a block, called the body of the candle, plus vertical lines known as shadows or wicks which stick up and down from the body. The top of the upper shadow is the highest price reached during the trading period and the bottom of the lower shadow is the lowest price reached during the trading period.
The top and bottom of the candle body mark the opening and closing prices, in either order, for the trading period tracked.
The candle body was originally unshaded (white) for a rising market where the opening price formed the bottom of the candle and the closing price was at the top of the body.
A shaded candle body indicated a declining market where the opening price marked the top of the candle body and the closing price created the bottom of the body. Today, candle charts utilize many colors, e.g. green, yellow or blue for a rising markets and most use red for declining markets.
While bar charts can also plot the open, close, high and low, the advantage of candlesticks is the level of visual clarity they deliver. Bullish or bearish periods of price movement are clearly visible on the candlestick chart.
Looking at a candlestick chart shows clearly if a market is going up, going down or going nowhere, going sideways. Candlestick charts excel in conveying a quick picture of what is going on in the market.
Has a market been rising, reached a price high and is now ready to reverse? Or has the market traded back, filled the gap and now is ready to continue with the trend? All of this is easy to see with candlestick chart analysis.
Just for the record, easy to see does not mean a candlestick formation should be traded on its own merit, alone, even though some traders trade candlestick formation by themselves.
Most frequently traders combine candlesticks along with western technical analysis to make trading decisions. They may use candlestick charts with oscillators, trend lines, moving averages, support and resistance levels, chart patterns and any other indicator available on the platform.
Japanese candlestick charts use special candle formations based on different price scenarios. For example, if price open and close or price high and low are the same, or very similar, the candlestick will look different from a normal candle and is easily recognizable.
Let’s look at two of the most common candle patterns.
A doji is a candle formation where opening and closing price for the trading period are the same or almost the same. The doji candle may look like a cross, like the letter T upside down (gravestone) or like the letter T (dragonfly doji).
The doji cross is constructed by equal open and close, by distinct price low and price high for the trading period.
The doji gravestone is constructed by equal open, low and close and by distinct price high.
The doji dragonfly is constructed by equal open, high and close and by distinct price low.
When you see a doji you can assume that there is degree of indecision in the market. And if you see the doji is at the end of a run up or down in price, it might signal a potential price reversal.
A hammer is a candle formation that looks like a … well, a hammer. The body of the hammer is small, close to the high for the period and the lower wick is long.
The hammer is found at the end of a move down and indicates a potential reversal. The stronger the move down, the stronger the potential reversal signal.
A hanging man is a comparable candle formation except it occurs at the end of a move up in price. Think of it as an upside down hammer.
Candlestick Analysis In Real Time Trading
Just like the bars on a bar chart, candlesticks can represent various time periods, ranging anywhere from 1minute to 1 month with anything in between. Candlesticks make it easy to spot emerging trends, potential breakouts or reversals.
Please remember that it’s wise to evaluate candlesticks within the context of the chart. A hammer in a sideways market doesn’t mean much. However, the same hammer carries much weight at the end of a steep price move.
Trading decisions in the live market often need to be made very fast. Candlestick analysis can help traders spot potential price movements and reversals at a glance and avoid mistakes.