Tue. Oct 20th, 2020
candlesticks

The Art of Candlestick Analysis

The souped-up level of detail available for investors with a candlestick chart makes it a favorite for currency trading.

However, the tricky part of candlestick analysis is the familiarization with the nuances between similar-looking formations or what each candlestick pattern indicates.

After all, memorizing all the known patterns can be mentally taxing.

So, the goal of this article is to provide a simplified way of understanding the concept of the candles on the chart.

The anatomy of a candlestick


There are five things to look for in a candlestick: the body, the high, the low, the close, and the open.

And, each candlestick corresponds to a specific length of time: 1 minute, 5 minutes, 30 minutes, 1 hour, 4 hours, 1 day, 1 week, and 1 month at least in the Metatrader 4 app (it might be different with other charting packages).

Breaking down the candlestick:

The body of the candlestick is depicted by its rectangular frame.

BODY

The high is the highest price traded in one timeframe. For instance, the high for the EUR/USD on June 3, 2019, is 1.1264, which means that it's the highest point the EUR/USD traded before it closed to 1.1245.

The line sprouting at the top of the body of the candlestick is called the "wick," and it represents the high.

The low, on the other hand, is also represented by a wick at the bottom of the body of the candlestick.

It's the lowest point a particular asset, or in this case, a currency pair traded during a specific timeframe.

HIGH AND LOW CANDLESTICKS

The open and the close can be quite tricky for the untrained eye, but it's quite simple after looking at a couple of charts for some time.

The capability of adding colors allows investors to quickly determine where the open and close is in a candlestick.

When the closing price goes up past its opening price, a green, blue, or white candlestick appears.

On the flip side, if the closing price closed lower than the opening price, then a red or black candlestick shows up.

BULL AND BEAR CANDLE

Representation of Traders' Psychology


Now, many factors affect how an asset trades, but emotion, by far, is the most dominant. In stocks, a company's share price doesn't always trade at a valuation that's justified by what it earns or what it owns, rather stocks trade at a price that coincides with what investors are willing to pay.

Greed and fear primarily dictate the general direction of the market. An investing climate that exhibits risk-taking behavior from most of its participants can inflate the value of certain assets.

 Conversely, the opposite happens when the mood of the market shifts to fear.

CHART PATTERNS

Now, these emotions are visualized on the charts. 

Charts capture each emotionally driven spike or steep fall in prices by printing candlesticks that perfectly define the trading activity that occurred.

The battle of buyers and sellers


One way to think about candlesticks is that it's an intense battle between buyers and sellers.

Market participants slug it out, and the victors' insignia is a candlestick in their direction. When buyers win, a bullish candlestick (closing price above open) appears on the chart, and the opposite happens when sellers take over.

So, when looking at a cluster of alternating green and red candlesticks, one could tell who's winning between the buyers and sellers.

A string of three 4-hour green candlesticks, for example, may indicate a capitulation of sellers to buyers for 12 hours -- a likely bullish momentum.

What do candlesticks lack?

The only thing that a candlestick fails to capture is the volatility of trading within a specified duration.

Sure, buyers could've been in control at the end of one timeframe, but that doesn't say anything about the kind of fight the sellers fought.

candlestick volatility

This is a visualization of the trading activity in a single candlestick. Before the green candlestick on the very left reached its final form in the 4-hour candlestick (the same one on the very right), it had undergone tremendous selling pressure in the preceding hours, which didn't breach past its open.

Deciphering Other Patterns


Now, the winner of the time-bound tug-of-war between buyers and sellers is apparent by looking at the color of candlesticks, but what if it looks like the picture below.

doji

Or this:

doji 2

The pictures above are examples of candles that new traders can't directly deduce as either a bull or a bear because the body seems to be missing.

But the thing is the body is still in there, and it's just squished down to a teeny-tiny horizontal line. So, the question is, what could be inferred from those candles?

The technique to better interpret what the candlesticks are trying to tell is to recall the tug-of-war analogy.

When the competitors who yank at each end of the rope are dead even, the marker or flag of the rope stays in the middle. 

candlestick doji and bear

And, the side who can pull their opponent past the central line is the winner.

The same thing can be applied to candlesticks on the chart: an even tussle between buyers and sellers results in a candlestick's body reduced to a horizontal line, and an overwhelming victory results in larger candlestick bodies.

Bullish, Bearish, Indecision


Generally, three meanings can be assigned to candlesticks. Bullish and bearish should be pretty clear at this point.

But "indecision" springs from a buyer and seller standoff -- the inability of either buyers or sellers to impose their will.

When the market's uncertain, candlesticks with short bodies or a flat horizontal line appears on the chart -- especially if the wicks are about of equal size.

However, not all candles that push back to the opening price communicate uncertainty or indecision.

gravestone doji

The example above is called a "gravestone doji" in which the price is pushed back down to its open, but it doesn't imply indecision. A gravestone doji signals more of a momentum shift from bullish to bearish.

Other patterns

Studying charts exposes investors to different candlestick patterns and their interpretations.

Some patterns involve two or more candlesticks and are closely eyed on certain Support and Resistance levels because some formations may indicate a reversal in the market's trend or a continuation of it.

But at a bare minimum, an investor delving into technical analysis for the first time should be able to understand the fundamental meaning behind candlesticks.

Summary


1. Compared to the line and bar chart, the candlestick chart provides more detail thanks to the color that can be added to the body of the candlesticks.

2. Each candlestick on the chart represents trading activity within a given time frame.

3. Candlesticks also tell investors the winner between the buyers and sellers in that time frame.

4. Candlesticks have three primary indications: bullish, bearish, and indecision.

5. Some formations or a cluster of candles may offer a clue if a trend may reverse or continue.

Want to learn more about Candlestick Patterns?

Check out our review on  Steve Nison's Japanese Candlestick Charting Techniques as well as other Forex books for beginners.

Japanese Candlestick charting techniques

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