Candlestick charts are some of the most used instruments by day traders in their assessment of price movement. The reason behind this is that their inherent laws provide the market with a visual display of what is going on during a specific timeframe. Consequently, these charts are always limited to a precise, preset timeframe and understanding them correctly depends on your ability to understand what they mean. However, in the stock market or global currency exchange market, these representations are fairly new. In 1991, Steve Nison introduced candlestick patterns to the Western world through his book entitled “Japanese Candlestick Charting Techniques”. Like the name specifies, the idea behind these graphs comes from the Japanese culture. In the 1700s, merchants and traders from this part of the world used candlesick diagrams to mark and remember the movement that occurred in the price of rice. Ever since, people have developed various patterns of candlesick tables to help them keep track of their investment and understand whether it’s going to be profitable or not.
Understanding the candlestick
Before we jump to online stock trading based on these attractive graphs, we must fully understand what the shape means in the context of a trading timeframe. The information you can obtain from a candlestick is limited to the low, high, opening and closing price fluctuation experienced by a particular security. The most common timeframe for these charts is one day, but they can be drawn for considerably longer or shorter phases as well. Candlesticks have a wide part in the middle and two vertical lines – one on top and one on the bottom, usually referred to as shadows. The purpose of this differentiation lies in the fact that the “real body” (or wide part of the candle) signals to traders in what price range the most volume of trading occurred, as well as the variation between the closing and opening price.
The body of the candlestick can also have a different color depending on the type of movement that the price was subject to. If the strike price is lower than the opening one, than you will see a black or red body. Conversely, the body is colored white or green to indicate evolution in price. As you may have guessed, the opening and closing marks switch positions, depending on the body-type. In the case of green candlesticks, the opening price is at the bottom, whereas, in the case of red ones, the opening price is at the top. Technical analysis benefits the most from these diagrams, since it gives important cues about the behavior of the buyers and sellers of a particular stock. However, the reliability of candlestick charts and patterns is extremely limited. Their reputation suffered a big blow as hedge funds went at great lengths to provide the rest of the economy with factual examples wherein the price movement is so erratic that it yields controversial patterns on these graphs.
Types of patterns and reliability
There are tens of candlestick patterns out there used by all sorts of traders. Still, not all of them may be as beneficial to your investments as you may think. Most of the times, the lightning speed execution coming from well-exercised reflexes and strategies get the lead over technical analysis, since the latter requires a certain amount of time before it’s implemented. Moreover, what works in the stock market may prove less effective in the currency exchange department, whereas none of this is possible if your online stock broker does not provide you with the necessary tools to compare various candlestick charts. A thumb rule you should follow when using candlestick patterns is that they perform best when used as indicators of price direction and movement. Once a pattern is over, its reliability decreases exponentially anywhere from 3 to 5 bars from when it occurred, requiring more effort on the part of the trader in order to determine what should be done next.
It’s not unusual for whale investors like hedge funds to use candlestick patterns with the exact goal of trapping the rest of the market. These patterns can be split into two categories – continuation and reversal. If the first indicates that a certain trend is going to last a while longer, the second may be a good sign of an upturn or downturn from the current development. With this in mind, the candlestick chart does not extend beyond the specified period of time it was made for.
Powerful candlestick patterns you can use
The doji is probably the most important of candlestick patterns, as almost all members of a currency exchange market or stock market will take their cue from it. This formation occurs when prices open and close roughly at the same level, providing for a very narrow candle body. Even though it’s never advisable to change your stock trading direction solely based on it, the doji is a signal that a balance is reached between supply and demand. The market is almost never stable in this manner and you can be 100% sure that the participants will react in one way or another – but in what way, only the following one or two candlesticks can tell. For this reason, it’s important to be on your toes when the doji occurs and take your cue from the next candlestick.
Mathematics is, by far, the best tool we can rely upon when trying to understand candlestick patterns. Consequently, we will examine some of the most powerful configurations, based on their efficiency and probability of occurrence, the first of which is the three line strike. This shows up as three red candles in a downtrend, with each consecutive bar indicating a smaller low than the previous, while closing near the intrabar limit of the next one. The fourth bar will almost always open even lower than the previous three, but it needs to close above the high of the first bar in the series, practically engulfing the previous three and successfully showing an evolution in price. Mathematically speaking, this pattern will predict rising prices 84% of the time, which more than 4 times out of 5.
Another high-efficiency candlestick pattern is the three black crows, which is similar to the previous one, with the difference that it starts at the high (or very near it) of an uptrend. For this pattern to occur, the bars need to start off with lower lows than the previous ones and close off near the intrabar low. At this point, you can be 78% certain that a broader scale downward movement in price will occur and it’s time to get out while you still can.
Having examined the provenance, fundamentals and market view of candlestick charts, successfully incorporating them in your trading strategy highly depends on how much you rely on these graphs for your stock trading decisions. Knowing the most efficient patterns is vital, as you can already assume the majority of investors will react to them, but you should never bet the entirety of your funds based on these configurations, as they can also turn out to be wrong