Mastering Candlestick Charts: Decoding Price Movements in Trading

by | Apr 17, 2024 | 0 comments

Candlestick charts are a way of representing the price changes of a security, derivative or currency. The charts are useful for their ability to give details at a glance. Below is an in-depth look into candlestick charts and how they’re used in the financial market’s analysis.

Introduction to Candlestick Charts

Although bar and point-and-figure charts were not developed until 100 years after candlestick charts were created, they still originated from Japan. Munehisa Homma discovered that while there was a link between supply, demand and price; it was also greatly influenced by emotions of traders.

Composition of Candlestick Charts

When considering the basics, each “candlestick” represents one day of trading. However, it’s made up of four main components which are the open, high, low and close (OHLC).

  • Body: This is where most of the information is placed. It shows you the range between opening and closing prices for that period on your chart. If it turns out that close is higher than open then body is often white or green: if lower than open its black or red.
  • Wicks: There are two lines attached at top and bottom of each body known as wicks/shadows/tails. These wicks show you highest and lowest prices reached during trading period – maximum & minimum prices on this chart.

Understanding Candlestick Patterns

These patterns can be made up from either a single stick or multiple sticks. They usually show continuation of ongoing trend as well as when there would be reversal.

a) Single stick patterns

These are examples of common single stick patterns;

  • Doji: Occurs when security opens & closes virtually equal & represents indecisiveness in market – could signal change in trend direction though.
  • Hammer: Small body at top end of trading range, with long wick below it. It’s a bullish reversal when happens after downtrend.
  • Inverted hammer: Also signifies reversal but has small body at lower end of trading range with long wick above.

b) Multiple Candlestick Patterns

These are examples of multiple candlestick patterns;

  • Engulfing pattern: Two candlesticks here, second candlestick’s body completely engulfs first’s. Indicating possible reversal depends on their order.
  • Harami: Opposite to engulfing pattern where first candle’s body is larger than second. Suggests possible reversal.

Analyzing Candlestick Charts

Traders use these patterns to predict prices in the future based on past patterns. The analysis can be quite complicated due to number of patterns and context within which they occur.

Why are candlestick charts of interest to traders?

The colors and lengths of bodies and wicks can give insight into the strength of a trading day’s price movements. For instance, a long white/green body indicates strong buying pressure, while a long black/red body suggests significant selling pressure.

How do patterns help decision making?

Different patterns can indicate when to enter or exit a trade. Some examples include:

  • Bullish: A ‘hammer’ or ‘bullish engulfing’ pattern could mean it’s time to enter a long position or buy a security.
  • Bearish: An ‘evening star’ or ‘bearish engulfing’ pattern might be a signal to sell or short a security in anticipation of a downturn.

What else can candlesticks tell us?

1. Sentiment:

Candlesticks can provide clues about market sentiment. For instance, if you see several consecutively long green candles, bullish sentiment is likely present, whereas multiple long red candles imply bearish sentiment.

2. Trend Reversals/Continuations:

  • Reversals: Following an uptrend, if you notice a ‘doji,’ this could be an indication that the trend has grown weak and might reverse.
  • Continuations: A trend that has shown strength with numerous ‘marubozu’ candles (wicks) is more likely to continue in that direction.

3. Support/Resistance Identifications:

By tracking the high and low points of wicks, traders can identify key support and resistance levels — which serve as targets for entry/exit points and for stop-loss orders placement.

4. Timing Entries/Exits:

  • Entry Timing: To ensure that patterns are valid before entering trades, some traders wait for confirmation candles following certain patterns (like additional green candles after bullish ones).
  • Exit Timing: When they’re holding onto a long position and notice one of these reversal patterns forming (a bearish one), it’s probably time to get out.

5. Enhancing Technical Analysis:

Traders often use candlestick charts alongside other forms of technical analysis, including trend lines, Fibonacci retracement levels and volume analysis, to confirm findings and refine decisions.

Read Also: Market Orders: Instant Transactions in the Indian Stock Market

Strategies for Trading with Candlestick Charts

Strategy 1: Trend Riding

After the appearance of a surefire trend confirmation pattern, traders can enter positions and ride the momentum. They usually set stop-loss orders just below recent lows in uptrends or above recent highs in downtrends.

Strategy 2: Reversal Trading

Some traders specialize in identifying reversals. They look for patterns like the ‘doji’ after an extended trend (indicating indecision), then enter a position when subsequent candles suggest a reversal.

Strategy 3: Breakout Trading

When a candlestick closes above resistance or below support, it signals a breakout. Traders who spot these breakouts might enter trades expecting prices to continue moving that way.

Strategy 4: Combining with Indicators

Traders frequently combine candlesticks with indicators such as moving averages. For example, buying when price action represented by candlesticks crosses over a moving average line is common practice.

Risk Management:

Candlestick charts are also commonly used for risk management strategies. For instance:

  • Setting Stop-Loss Orders: Using the low of a ‘Hammer’ or the high of a ‘Shooting Star’.
  • Profit Targets: Based on the length of the candles and their volatility.

Conclusion:

Candlestick charts are like detective work. They’ll give us all the clues we need about how people feel about a stock, and where it’s going next. But remember that even Sherlock Holmes was wrong once in a while. Don’t rely solely on these charts when you’re making decisions, but definitely use them to make better ones!

Read Also: Long-Term Investing Strategies in the Indian Market

People who know how to read these things have been saying for centuries that they can help you see the future as if it were in a crystal ball. If you want to be one of those people, take some time to study them and figure out how they work. You don’t need to become an expert, but enough knowledge will go a long way!

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