The concept of Japanese candlestick charting was originally developed in the 18th century and has become an important tool for many technical traders to identify short term market sentiment.
Candlesticks are made up of a “real body”, plus a “wick” and a “tail”. The real body is the solid block of colour drawn between the opening and closing prices of the candle period. The wick is a thin line stretching up to the highest price traded during the formation of the candlestick, and the tail is a thin line drawn down to the lowest low. The colour of each candle tells us whether the price closed higher (usually green) or lower (usually red) than it opened.
Candlestick patterns are visually easy to spot, and understanding how to recognise them can add an extra layer of confirmation to your trading decisions. There are dozens of recognisable candlestick patterns, but in this blog, we'll describe just six of the most popular and reliable ones that every trader should understand.
It should also be noted that a candle in a downtrend may be given a different name to an exact same shaped candle in an uptrend, so the prior price trend direction always needs be considered before identifying each candlestick pattern.
Also, while candlestick patterns help to identify short-term sentiment shifts (from bullish to bearish or vice versa), they should not be viewed in isolation when making trading decisions. It's important to confirm any potential reversal signals with additional technical tools such as support/resistance, trend lines or price patterns, or even other technical indicators such as moving averages or RSI.
Doji Candlestick Patterns
The word Doji means “the same thing” in Japanese. In this case, the opening price of the candle is the same as the closing price, resulting in a very small or non-existent candlestick body. The wick and tail may be long or short or non-existent, and this (along with the prior trend direction) will determine the exact identity of each candlestick pattern.
Doji candlestick patterns signify indecision in the market since the candlestick opened and then closed at the same price, but the long wick or tail also illustrate a burst of selling (in an uptrend) or buying (in a downtrend) suggesting a short-term directional trend may be about to reverse.
A Gravestone Doji is a bearish candlestick pattern which may generate a sell signal. It has a long wick and little or no tail and the body is a thin horizontal line (signifying the open and close of the candle at the same price). Note that this shape of candle can ONLY be called a Gravestone Doji if it is found in an uptrend.
A Dragonfly Doji is the opposite of a Gravestone Doji. It is found exclusively in downtrends, and it signifies strong buying demand (which forms the long candle tail) at a potential market bottom.
A Gravestone Doji generates a potential sell signal, while a Dragonfly Doji generates a potential buy signal.
Hammer Candlestick Patterns
The Hammer candlestick pattern is similar to a Dragonfly Doji, except that it has a small body rather than no body at all. It has little or no wick and a long tail. Hammers only occur during downtrends, and they signify a potential bullish reversal since it reflects a burst of buyers coming into the market at a low price.
Traders often use it as a buy signal, particularly when it appears near an established support level. However, confirmation from other indicators such as volume or trend lines is still required to validate the signal.
Shooting Star Candlestick Patterns
The Shooting Star candlestick pattern is the opposite of a Hammer and is similar to a Gravestone Doji. It has a small body and long wick, but little or no tail. Shooting Stars appear exclusively in uptrends and illustrate a short-term rejection of a new high price, suggesting a potential bearish reversal.
Traders can use these patterns as entry or exit sell signals, particularly when they coincide with a key resistance level.
Bullish and Bearish Engulfing Candlestick Patterns
The Bullish Engulfing and Bearish Engulfing patterns are considered two of the most powerful reversal signals. They are double candlestick patterns since they are formed by two consecutive candles rather than just one.
In a Bullish Engulfing pattern, the second candle (which must be bullish – in this case, green) completely engulfs the previous candle's body (which must be bearish, or red). Note that the wick and tail are not considered – only the candle bodies.
This indicates a significant shift from bearish to bullish sentiment from one candle to the next, and a potential buy signal is generated.
Conversely, the Bearish Engulfing pattern occurs when the second candle's body (red) fully engulfs the previous candle's body (green), suggesting a significant shift from bullish to bearish sentiment.
Traders often look for these patterns at key support or resistance levels, as they provide clear evidence of a shift in sentiment and a potential trend reversal. However, it's crucial to consider other factors such as volume and overall market conditions to confirm the validity of these signals.
In conclusion, understanding the messages given by candlestick patterns is an extremely useful addition to a trader’s toolbox. While the six candlestick patterns outlined above provide various buy and sell signals, it's important to confirm these signals with other technical tools and indicators. It is also crucial to remember that
successful trading requires a combination of technical analysis, fundamental analysis, risk management, market awareness and psychological control. Building a structured
trading strategy with fixed rules is an excellent way to eliminate emotions from your trading and keep a tight grip on your risk management.
