Jun 4, 2021
Written by:
John McDowell
Trading without candlestick patterns is a lot like flying in the night with no visibility. Sure, it is doable, but it requires special training and expertise. To that end, we’ll be covering the fundamentals of candlestick charting in this tutorial. More importantly, we will discuss their significance and reveal 5 real examples of reliable candlestick patterns. Along the way, we’ll offer tips for how to practice this time-honored method of price analysis.
Also, feel free to download our Candlestick Pattern Quick Reference Guide!
After all, there are traders who trade simply with squiggly lines on a chart. Astonishingly, some don’t even look at the charts! Instead, they pay attention to the “tape” — the bids and offers flashing across their Level II trading montage like numbers in The Matrix.
No doubt, there are countless ways to make money in the stock market. In fact, there is no right or wrong way to read a chart. But unless you are just a gambler, you need some form of data to make informed decisions.
We believe the best way to do this is by understanding candlestick patterns.
For newer traders, even reading candlestick charts can seem like an insurmountable learning curve. There appears no rhyme or reason, and no end to the amount of price and volume data being thrown your way.
It’s daunting, for sure. Especially when you’re just getting started.
But be of good cheer! There is a method to the madness. The method is in the patterns. The patterns reveal probabilities. And the right probabilities create opportunities.
More importantly, the right opportunities can create profits.
This is where candlestick patterns come in handy. They help us to decipher the patterns of the market. They’re like little road signs on crowded streets. And with enough repetition, enough practice, you just might find yourself a decent chart reader.
That’s why you’re here, right? To learn to navigate the murky waters of the market?
Trust us, it is a worthwhile endeavor.
According to Investopedia.com, it is commonly believed that candlestick charts were invented by a Japanese rice futures trader from the 18th century. His name was Munehisa Honma.2
Honma traded on the Dojima Rice Exchange of Osaka, considered to be the first formal futures exchange in history.3
As the father of candlestick charting, Honma recognized the impact of human emotion on markets. Thus, he devised a system of charting that gave him an edge in understanding the ebb and flow of these emotions and their effect on rice future prices by reading candlesticks.
Honma actually wrote a trading psychology book around 1755 claiming that emotions impacted rice prices considerably.4
When all are bearish, there is cause for prices to rise.
Munehisa Honma5
In recent history, Steve Nison is widely considered the foremost expert on Japanese candlestick methods. After all, he wrote the book that catapulted candlestick charting to the forefront of modern market trading systems.
Beyond Candlesticks: New Japanese Charting Techniques Revealed, is one of his most popular books and a definitive resource for candle patterns.
Since the 90s, this method of charting has become pervasive throughout all financial markets: equities, futures, forex, and more.
In his books, Nison describes the depth of information found in a single candle, not to mention a string of candles that form patterns. It truly puts the edge in favor of a skilled chartist.
Emotions and psychology were paramount to trading in the 1700s, just as they are today. This is the foundation of why candlesticks are significant to chart readers.
How so?
Every candle reveals a battle of emotions between buyers and sellers.
As the great trading psychologist Brett Steenbarger notes, “proper training is the best source of discipline and the most effective safeguard against intrusive anxiety and impulsivity.”
With this in mind, understanding the emotional story within candlesticks is a great place to start that training.
There are three types of candlestick interpretations: bullish, bearish, and indecisive. This is painting a broad stroke, because the context of the candle formation is what really matters. But for all intents and purposes, we’ll stick with these three japanese candlestick categories.
The formation of the candle is essentially a plot of price over a period of time. For this reason, a one minute candle is a plot of the price fluctuation during a single minute of the trading day. The actual candle is just a visual record of that price action and all of the trading executions that occurred in one minute.
Similarly, a daily or weekly candle is the culmination of all the trading executions achieved during that day or that week.
The open tells us where the stock price opens at the beginning of the minute. The close reveals the last recorded price of that minute. The wicks (also known as shadows or tails) represent the highest and lowest recorded price from the open and close, using candlestick chart patterns.
According to Nison, the Japanese placed much less emphasis on the highs and lows of individual candles. For them, as it is for modern technicians, the opening and closing prices were more relevant.6
Essentially, the broader context of candles will paint the whole picture.
A bullish candle is formed when the price at the closing of the candle is higher than the open. This can be on any time frame: from a 1-minute candle to a 1-month candle. It will all be the same.
Typically these candles close with a green or white body color, though most charting platforms allow for customization these days.
Conversely, a bearish candle is assumed when the closing price is lower than the opening price. In other words, the price dropped in the amount of time it took for the candle to form.
By default, most platforms will show a red or black candle as bearish.
This is the real question we need to ask ourselves. It isn’t enough to know that the candle opened and then closed lower, or vice-versa.
As renowned trader and best-selling author Dr. Alexander Elder explains, “The main advantage of a candlestick chart is its focus on the struggle between amateurs who control openings and professionals who control closings.”7
Dr. Elder may be referring to daily candles, but his point is still important. The candle represents a struggle between buyers and sellers, bulls and bears, weak hands and strong hands.
Armed with that knowledge, let’s dig in and see what picture those little candles are trying to paint for us.
The high of each candle, whether it is the tip of the wick at the top, or if the body closes at the top, represents the maximum effort of bulls. If it is a daily candle, buyers could not push the price of the stock one cent more during that day.
Why is that important? There are two reasons:
Just as the high represents the power of the bulls, the low represents the power of the bears. The lowest price in the candle is the limit of how strong the bears were during that session.
Why is this important? Again, two reasons:
This is where the story gets interesting.
When a candle closes above its opening price, we can assume that the bears won in some form or fashion. How much it closes above the open tells us with what intensity the bulls were in control during that session.
Let’s look at few examples to better understand this:
In this chart, we see the “Three White Soldiers,” which is a candlestick pattern describing three bullish candlesticks in a row. What can we interpret from this?
It is clear to see that the candles open low and close high. Bulls were clearly in control during each session with very little energy from the bears.
Now contrast that with what we see in the next example. Ask yourself, who was in control during this session?
Apparently there is indecision as to who is in control. How do we know? Think about the story behind this “Spinning Top” candle:
The stock opens, proceeds lower as bears are in control from the open, then rips higher during the session. But after putting in a decent high, the bulls settle back and give the bears some control into the close.
Are you beginning to see how the story unfolds?
These are the stories that candles tell us on charts. Who is in control (greed), who is weak (fear), to what extent they are in control, and what areas of support and resistance are forming.
This is one of the most important aspects of interpreting candles. As Dr. Elder notes, the range between open and close “reflects the intensity of conflict between bulls and bears.” 8
In day trading, momentum is everything. On this token, the character of the candles can tell us if there is demand or if a stock is sleepy and uninteresting — whether we are about to launch, fall off a cliff, or just grind sideways.
Additionally, the nature of the candles can tell us when to enter with tight risk. Or, when to take profits into climactic candles.
In the end, it all boils down to context and the story of buyers and sellers behind the tape.
Without practice, none of this information really matters. It takes screen time and review to interpret chart candles properly. There are no free lunches in the markets.
With that being said, let’s look at some examples of how candlestick patterns can help us anticipate reversals, continuations, and indecision in the market.
The Hanging Man is a candlestick that is most effective after an extended rally in stock prices. The story behind this candle tells us that there were extensive sellers in the formation of the candle, signified by the long wick.
It is usually accompanied by heavy volume.
The Hammer is another reversal pattern that is identical to the The Hanging Man. The only difference is the context. The Hammer occurs at the end of a selloff, signifying demand or short covering, driving the price of the stock higher after a significant selloff.
Like the Hanging Man, you want to see a solid volume signature associated with these candles.
Engulfing patterns offer a great opportunity to go long while keeping risk defined to a minimum. As you can see in the example below, the prior bearish candle is completely “engulfed” by the demand on the japanese candlestick.
Another example of engulfing patterns is the Bearish Engulfing Sandwich. Here we have what appears to be a bearish reversal, but the next candle completely swallows the supply from that red candle:
The Morning Star is yet another reversal signal. It can be found at the end of an extended downtrend or during the open. It takes 3 candles to confirm the setup.
Similar to the Morning Star, the Evening Star is its bearish cousin. It forms at the top of parabolic or extended bullish runs. Much like the Morning Star, the body of the candles should not touch.
Here are three criteria for spotting the shooting star:
As with all of these formations, the goal is to provide an entry point to go long or short with a definable risk. In the example above, the proper entry would be below the body of the shooting star, with a stop at the high. For more insights, understanding candlestick analysis is crucial.
The doji and spinning top candles are typically found in a sideways consolidation patterns where price and trend are still trying to be discovered.
The “doji’s pattern conveys a struggle between buyers and sellers that results in no net gain for either side,” as noted in this great article by IG.com.
Will it continue upward? Go sideways? Or reverse?
With indecision candles, we typically need much more context to answer these questions.
The Gravestone Doji is a perfect example of this:
Note the trend is mostly sideways in this first circled example. For this reason, waiting for the reaction to these candles is usually best for risk management.
Eventually, the price falls in this particular case as the trend becomes more extended into the rally. Correspondingly, the Shooting Star that occurs just beyond the Gravestone Doji is confirmation of that falling price action.
Interpreting candlestick patterns is crucial for stock market prediction and identifying market pressure. This section explores single and multiple candlestick patterns, time frame considerations, and the importance of pattern confirmation. Traders using platforms like MetaTrader 4 often combine these patterns with indicators such as the stochastic oscillator and advanced formations like the hikkake pattern for more accurate analysis.
Single candlestick patterns focus on individual candles, providing quick insights into market sentiment for a specific financial instrument. These patterns, such as the doji or hammer candlestick, can signal potential reversals or continuations when used in conjunction with oscillator indicators and margin considerations.
Multiple candlestick patterns, like the cloud cover or three white soldiers, offer a more comprehensive view of market trends over a longer period. These patterns often provide stronger signals for traders incorporating fundamental analysis into their strategy, as they reflect sustained buying or selling pressure across multiple trading sessions.
Time frame selection plays a crucial role in forex trading, affecting the interpretation of candlestick patterns. Traders must consider the ratio between short-term and long-term charts to balance speculation with broader market trends. For instance, a hanging man pattern on a daily chart may carry more weight than one on a 5-minute chart.
Bullish patterns identified on higher time frames often provide more reliable signals for trend reversals or continuations. However, traders should remain aware that even strong patterns can fail, especially during periods of high market volatility or significant economic events. Combining multiple time frame analysis helps create a more comprehensive trading strategy, especially when looking at an asset like currency.
Pattern confirmation is crucial in candlestick chart analysis, helping traders avoid false signals and improve their decision-making process. When analyzing candle chart patterns, traders should look for additional evidence to support their interpretation, such as volume indicators or pattern recognition technical analysis tools. This multi-faceted approach enhances the reliability of candlestick signals in stocks and other financial instruments.
Successful candle trading strategies often incorporate pattern confirmation techniques to validate potential entry and exit points. For example, a bullish engulfing pattern may be confirmed by a subsequent increase in trading volume or a breakout above a key resistance level. Understanding candlesticks and their confirmation methods enables traders to develop more robust and effective trading systems across various markets.
Trading strategies using candlestick patterns enhance market analysis and decision-making. This section explores combining patterns with technical indicators, setting entry and exit points, and implementing risk management practices. Traders can use these approaches to develop effective strategies across various financial instruments and market conditions.
Combining candlestick patterns with technical indicators enhances trading strategies by providing multiple layers of confirmation. Traders often use moving averages, such as the 50-day and 200-day SMA, to identify trend direction and support/resistance levels. When a bullish candlestick pattern forms near a rising moving average, it strengthens the buy signal.
The Relative Strength Index (RSI) complements candlestick analysis by revealing overbought or oversold conditions. A bearish engulfing pattern occurring when the RSI is above 70 may indicate a stronger sell signal. Traders also use the MACD indicator to confirm trend strength and potential reversals when analyzing setups such as the hikkake pattern candlestick formation.
Setting entry and exit points using candlestick patterns requires careful analysis of support and resistance levels. Traders often enter long positions when bullish patterns form near support levels, while bearish patterns near resistance levels signal potential short entries. Exit points are typically set using trailing stop-loss orders or at predetermined profit targets based on key chart levels.
Risk management plays a crucial role in determining entry and exit points. Traders calculate position sizes based on their risk tolerance and the distance to their stop-loss levels. For example, a trader might risk 1% of their account on a trade, adjusting their position size accordingly. This approach helps maintain consistent risk exposure across different trades and market conditions.
Risk management in candlestick trading involves setting appropriate stop-loss orders based on pattern formations. Traders often place stops below the low of a bullish pattern or above the high of a bearish pattern. This approach helps limit potential losses while allowing trades room to develop.
Position sizing is another crucial aspect of risk management in candlestick trading. Traders determine their position size based on the distance to their stop-loss and their maximum risk per trade. This method ensures consistent risk exposure across different trades, regardless of the specific candlestick pattern or market conditions such as a gravestone doji.
Common pitfalls in candlestick pattern analysis can lead to costly trading errors. This section examines three key challenges: pattern isolation, market context, and volume analysis. Understanding these issues helps traders refine their strategies and make more informed decisions in various market conditions, especially in forex trading.
Pattern isolation occurs when traders focus solely on candlestick patterns without considering the broader market context. This narrow approach can lead to misinterpretation of signals and poor trading decisions. Traders should instead view candlestick patterns as part of a larger technical analysis framework, incorporating trend lines, support and resistance levels, and other indicators to validate their observations.
To overcome pattern isolation, traders can develop a systematic approach that combines multiple analysis techniques. For example, they might confirm a bullish engulfing pattern with a breakout above a key resistance level and increased trading volume. By integrating various tools and perspectives, traders can make more informed decisions and reduce the risk of false signals in their candlestick analysis.
Market context plays a crucial role in interpreting candlestick patterns accurately. Traders must consider factors such as prevailing trends, economic indicators, and news events that can impact price movements. For example, a bullish engulfing pattern may carry more weight when it appears at the end of a downtrend rather than during an uptrend.
To overcome this pitfall, traders should develop a comprehensive analysis framework that incorporates both technical and fundamental factors. This approach involves examining multiple time frames, monitoring key economic indicators, and staying informed about market-moving events. By considering the broader market context, traders can make more informed decisions and avoid misinterpreting candlestick patterns.
Volume analysis plays a crucial role in confirming candlestick patterns and market trends. Many traders overlook this aspect, focusing solely on price action. However, volume provides valuable insights into the strength of a pattern or trend, helping traders avoid false signals and make more informed decisions.
To incorporate volume analysis effectively, traders should look for volume spikes that coincide with key candlestick patterns. For instance, a bullish engulfing pattern accompanied by high volume carries more weight than one with low volume. Traders can use volume indicators like On-Balance Volume (OBV) or Volume Weighted Average Price (VWAP) to gain deeper insights into candle patterns trading market dynamics and validate their candlestick pattern interpretations.
A candlestick chart consists of four key components: open price, close price, high price, and low price. Each candlestick represents a specific time period and displays these price points through its body and wicks, providing traders with a visual representation of price movements.
Traders interpret bullish and bearish candlestick patterns by analyzing the shape, size, and position of candles on price charts. Bullish patterns suggest potential upward price movements, while bearish patterns indicate possible downward trends. Key factors include open and close prices, shadows, and overall pattern formation.
Continuation and indecision patterns in candlestick charts include doji, spinning tops, and harami. These formations suggest market uncertainty or potential trend reversals. Traders use these patterns alongside other technical indicators to make informed decisions about potential price movements in financial markets.
Traders can develop effective strategies using candlestick patterns by studying historical price data, identifying recurring patterns, and combining them with other technical indicators. Practicing pattern recognition, understanding market psychology, and backtesting strategies can help traders make informed decisions based on candlestick formations.
Common pitfalls when using candlestick patterns include overreliance on single patterns, ignoring market context, misinterpreting timeframes, and neglecting confirmation from other indicators. Traders may also struggle with pattern recognition, emotional decision-making, and failing to consider volume in their analysis.
As always, it is best to practice a strategy before putting money to work in the market. There is no better way to do this than with a simulator.
One of the best methods to train your “chart eye” to see these patterns is to simply replay the market, noting each time you see a particular candle.
As you put in deliberate practice, ask yourself the following questions:
We have a wealth of knowledge on many different candlestick patterns, so be sure to check out those lessons, too!
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