Recap: What’s a Candlestick?

Welcome to lesson four of “Back to Basics”.

In the last episode we covered an introduction to candlestick charts. Remember what a candlestick is? It’s a visual representation of price action over a set period of time.

Candlesticks are useful because they show the trading range and closing price for a specific timeframe, giving us insight into the psychology of buyers and sellers. We can see where people bought and sold in the past, and perhaps where they will again in the future.

Candlestick Pattern Names

This chart shows just a sample of the many candlestick pattern names. A Japanese gentleman named Homma realized that certain patterns recurred in the markets, so he named them based on military battle analogies.

Some names are translated from Japanese, others like “abandoned baby” are left in Japanese because the literal translations are a bit strange! But the names help us remember what each pattern indicates about the battle between buyers and sellers.

Doji – Indecision Candles

One of my favorite patterns is the doji, which looks like a cross and signals indecision in the market. The opening and closing prices are equal, telling us that neither buyers nor sellers gained an upper hand.

Dojis often lead to a continuation of the prior trend once the stalemate is resolved. If sellers get exhausted after a doji, buyers may push the price higher.

There are many varieties of dojis like long-legged, dragonfly, and gravestone. The length of the “legs” or wicks indicates how much ground each side covered during the battle before returning back to even.

Hammer – Failed Selling

The hammer is another powerful candlestick. It has a long lower wick showing sellers tried to push the price down but failed, with buyers later stepping in to push back near the open.

It indicates the bears were not able to capitalize on the selling pressure. After a hammer, we often see the bulls regain control and push prices higher.

Inverted Hammer – Failed Buying

The inverted hammer is essentially the opposite of the regular hammer. It has a long upper wick indicating that buyers tried and failed to lift the price.

If the bulls can’t sustain upward momentum after an inverted hammer, the bears may take over and drive the price down further.

Psychology Behind Candlesticks

Always think in terms of market psychology when looking at candlestick patterns. Our goal as traders is to figure out what the crowd will do next and ride along with the wave.

If you think a stock will go up but the crowd doesn’t, they won’t come along to push up the price. Candlesticks help reveal what happened in the battle between buyers and sellers, giving clues about who might win the next skirmish.

Engulfing Patterns

Engulfing patterns span two candlesticks, with the body of the second candle engulfing the previous body. This shows a powerful reversal of sentiment.

For a bullish engulfing, the second candle shows the bulls overtaking and “engulfing” the selling pressure from the first candle. This reversal often continues the uptrend.

A bearish engulfing indicates the opposite, with bears overwhelming the bullishness from the previous candle and taking control.

Gaps

Note gaps in engulfing patterns happen when the open deviates greatly from the prior close. This can occur after significant news over the weekend. If bad news hits, the next open will be below Friday’s close as bids drop.

If buyers later step in and engulf the selling gap, it’s especially bullish as they’ve overcome negative sentiment.

Harami

Some candlestick names are lost in translation from Japanese, like “harami” meaning pregnant. The harami consists of a large candle with a smaller opposite colored candle inside.

Many see this as a reversal signal but I actually trade it as a continuation pattern, assuming the existing trend will persist when the stalemate resolves. Studies back up my contrarian interpretation.

Tying It All Together

We looked at single, double, triple and quadruple candlestick patterns. Always start simple with singles, then add more as you gain experience.

Use candlesticks to analyze pullbacks and continuations in the direction of the prevailing trend. For example, look for bullish reversal candlesticks within an uptrend, or bearish reversal candlesticks within a downtrend.

Candlesticks alone don’t predict future moves, but combining patterns with other indicators can achieve 55% accuracy or more over time.

Now get out there and start spotting candlestick patterns.