What do Candlestick Patterns mean?

Introduction

Mr Munehisa Homma from Japan is considered to be the father of Candlestick. According to Pring, 2014 Japanese Candlestick was introduced to the western world in the 1990s. Especially when Steve Nison wrote about it in his publication Candlestick Charting Techniques.

He understood basic supply and demand dynamics, but also identified the fact that emotion played a part in the setting of price. He wanted to track the emotion of the market players, and this work became the basis of candlestick analysis. He was extremely well respected, to the point of being promoted to Samurai status. The Japanese did an extremely good job of keeping candlesticks quiet from the Western world, right up until the 1980s, when suddenly there was a large cross-pollination of banks and financial institutions around the world. This is when Westerners suddenly got wind of these mystical charts. Obviously, this was also about the time that charting in general suddenly became a lot easier, due to the widespread use of the PC.

Learning Japanese candlestick is like learning a new language. Imagine you got a book which is written in a foreign language, you look at the pages but you get nothing from what is written. The same thing when it comes to financial markets. If you don’t know how to read Japanese candlesticks, you will never be able to trade the market.

The same thing when it comes to financial markets. If you don’t know how to read Japanese candlesticks, you will never be able to trade the market.

Japanese candlesticks are the language of financial markets, if you get the skill of reading charts, you will understand what the market is telling you, and you will be able to make the right decision in the right time.

Why Candlesticks are important to your trading analysis?

Candlesticks are important to your trading analysis because it is considered as a visual representation of what is going on in the market. By looking at a candlestick, we can get valuable information about the open, high, low and the close of price, which will give us an idea about the price movement. -Candlesticks are flexible, they can be used alone or in combination with technical analysis tools such as the moving averages, and momentum oscillators, they can be used also with methods such the Dow Theory or the Eliot wave theory. I personally use candlesticks with support and resistance, trend lines, and other technical tools that you will discover in the next chapters. -The human behaviour about money is always dominated by fear; greed, and hope, candlestick analysis will help us understand these changing psychological factors by showing us how buyers and sellers interact with each other. Candlesticks provide more valuable information than bar charts, using them is a win-win situation because you can get all the trading signals that bar chart generates with the added clarity and additional signals generated by candlesticks.

What is Candlestick?

Japanese candlesticks are formed using the open, high, low and close of the chosen time frame.

Bullish Candle & Bearish Candle
Figure 2.1 - Basic Bullish Candle & Bearish Candle Characteristics

If the close is above the open, we can say that the candlestick is bullish which means that the market is rising in this period of time. Bullish candlesticks are always displayed as a white candlestick or green candle. The most trading platform uses white colour to refer to bullish candlesticks. But the colour doesn’t matter, you can use whatever colour you want. The most important is the open price and the close price. If the close is below the open, we can say that the candlestick is bearish which indicates that the market is falling in this session. Bearish candles are always displayed as black candlesticks or red candlesticks. But this is not a rule. You can find different colours used to differentiate between bullish and bearish candlesticks. The filled part of the candlestick is called the real body. The thin lines poking above and below the body are called higher shadow and lower shadow respectively. The top of the upper shadow is high. The bottom of the lower shadow is low.

Candlestick Body Sizes

Candlestick have different Body Sizes and they are explained below:

Short Vs Long Body

Figure 2.2 - Long Vs Short Candle

Long bodies refer to strong buying or selling pressure, if there is a candlestick in which the close is above the open with a long body, this indicates that buyers are stronger and they are taking control of the market during this period of time. Conversely, if there is a bearish candlestick in which the close is below the open with a long body, this means that the selling pressure controls the market during this chosen time frame. Short and small bodies indicate a little buying or selling activity.

Candlestick Shadows (Tails)

The upper and lower shadows give us important information about the trading session. Upper shadows signify the session high. Lower shadows signify the session low. Candlesticks with long shadows show that trading action occurred well past the open and close.

Figure 2.3 - Candlestick Shadow & Tail

Japanese candlesticks with short shadows indicate that most of the trading action was confined near the open and close. If a candlestick has a long upper shadow, and short lower shadow, this means that buyers flexed their muscles and bid price higher. But for one reason or another, sellers came in and drove the price back down to end the session back near its open price. If a Japanese candlestick has a long lower shadow and short upper shadow, this means that sellers flashed their washboard abs and forced price lower. But for one reason or another buyer came in and drove prices back up to end the session back near its open price.

Candlestick Patterns

When single or in combination with other candle form a particular set of the pattern at the particular place it is defined as Candlestick Patterns. Candlestick patterns are one of the most powerful trading concepts, they are simple, easy to identify, and very profitable setups, research has confirmed that candlestick patterns have a high predictive value and can produce positive results. I personally trade candlestick pattern since the year 2004; I can’t really switch to another method, because I tried thousands of strategies and trading methods with no results. I’m not going to introduce you to a holy grail, this trading system works, but be prepared to lose some trades, losing is a part of this game, if you are looking for a 100% wining system, I highly recommend you to stop trading and go look for another business. Candlestick patterns are the language of the market, imagine you are living in a foreign country, and you don’t speak the language.

How could you live if you can’t even say a word? It’s tough right??? The same thing when it comes to trading. If you know how to read candlestick patterns the right way, you will be able to understand what these patterns tell you about the market dynamics and the trader’s behaviour. This skill will help you better enter and exit the market at the right time. In other words, this will help you act differently in the market and make money following the smart guy’s footprints.

The candlestick patterns that I’m going to show you here are the most important patterns that you will find in the market, in this chapter, I’m not going to show you how to trade them, because this will be explained in details in the next chapters. What I want you to do is to focus on the anatomy of the pattern and the psychology behind its formation, because this will help you get the skill of identifying easily any pattern you find in the market and understand what it tells you to do next.

Bullish Engulfing Pattern

The bullish engulfing bar consists of two candlesticks, the first one is the small body, and the second is the engulfing candle. See the illustration below:

Figure 2.4 - Bullish Engulfing Pattern

The bullish engulfing candlestick pattern tells us that the market is no longer under control of sellers, and buyers will take control of the market. When a bullish engulfing candle forms in the context of an uptrend, it indicates a continuation signal. When a bullish engulfing candle forms at the end of a downtrend, the reversal is much more powerful as it represents a capitulation bottom. See the example below:

Figure 2.5 Bullish Engulfing Pattern Effect on Chart

The example above shows us clearly how the market changes direction after the formation of a bullish engulfing bar pattern. The smaller body that represents the selling power was covered by the second body that represents the buying power. The colour of the bodies is not important. What’s important is that the smaller one is totally engulfed by the second candlestick.

Don’t try to trade the market using this price action setup alone, because you will need other factors of confluence to decide whether the pattern is worth trading or not, I will talk about this in the next chapters. What I want you to do now is to get the skill of identifying bearish and
bullish engulfing bar on your charts. This is the most important step for the moment.


Bearish Engulfing Pattern

The bearish engulfing is one of the most important candlestick patterns. This candlestick pattern consists of two bodies. The first body is smaller than the second one, in other words, the second body engulfs the previous one. See the illustration below:

Figure 2.6 - Bearish Engulfing Pattern

This is how a bearish engulfing bar pattern looks like on your charts, this candlestick pattern gives us valuable information about bulls and bears in the market.

In case of a bearish engulfing bar, this pattern tells us that sellers are in control of the market. When this pattern occurs at the end of an uptrend, this indicates that
buyers are engulfed by sellers which signals a trend reversal. See the example below:

Figure 2.7 - Bearish Engulfing Pattern on Chart

As you can see when this price action pattern occurs in an uptrend, we can anticipate a trend reversal because buyers are not still in control of the market, and sellers are trying to push the market to go down. You can’t trade any bearish candlestick pattern you find on your chart; you will need other technical tools to confirm your entries.


Doji Candlestick Pattern

Doji is one of the most important Japanese candlestick patterns, when this candlestick forms, it tells us that the market opens and closes at the same price which means that there are equality and indecision between buyers and sellers, there is no one in control of the market. See the example below:

Figure 2.8 - Doji Candle

As you can see the opening price is the same as the closing price, this signal means that the market didn’t decide which direction will take. When this pattern occurs in an uptrend or a downtrend, it indicates that the market is likely to reverse. See another example below to learn more:

Figure 2.9 - Doji Candle on Chart

The chart above shows how the market changed direction after the formation of the Doji candlestick. The market was trending up, that means that buyers were in control of the market. The formation of the Doji candlestick indicates that buyers are unable to keep the price higher, and sellers push prices back to the opening price.
This is a clear indication that a trend reversal is likely to happen. Remember always that a Doji indicates equality and indecision in the market, you will often find it during periods of resting after big moves higher or lower. When it is found at the bottom or at the top of a trend, it is considered as a sign that a prior trend is losing its strengths. So if you are already riding that trend it’s time to take profits, it can also be used as an entry signal if it is combined with other technical analysis.


Dragonfly Doji

The Dragonfly Doji is a bullish candlestick pattern which is formed when the open high and close are the same or about the same price. What characterizes the dragonfly Doji is the long lower tail that shows the resistance of buyers and their attempt to push the market up. See the example below:

Figure 3.0 Dragonfly Doji

The illustration above shows us a perfect Dragonfly Doji. The long lower tail suggests that the forces of supply and demand are nearing a balance and that the direction of the trend may be nearing a major turning point. See the example below that indicates a bullish reversal signal created by a Dragonfly Doji.

Figure 3.1 Dragonfly Doji on Chart

In the chart above, the market was testing the previous support level that caused a strong rejection from this area. The formation of the dragonfly Doji with the long lower tail shows us that there is a high buying pressure in the area. If you can identify this candlestick pattern on your chart, it will help you visually see when support and demand are located. When it occurs in a downtrend, it is interpreted as a bullish reversal signal.
But as i always say, you can’t trade candlestick pattern alone, you will need other indicators and tools to determine high probability dragonfly Doji signals in the market.


Gravestone Doji

The Gravestone Doji is the bearish version of the dragonfly Doji, it is formed when the open and close are the same or about the same price. What differentiates the Gravestone Doji from the dragonfly Doji is the long upper tail. The formation of the long upper tail is an indication that the market is testing a supply or resistance area. See the example below:

Figure 3.2 Gravestone Doji

The image above illustrates a perfect gravestone Doji. This pattern indicates that while buyers were able to push prices well above the open. Later in the day sellers overwhelmed the market pushing the price back down. This is interpreted as a sign that bulls are losing their momentum and the market is ready for a reversal. See another illustration below:

Figure 3.3 Gravestone Doji on Chart

The chart above shows a gravestone Doji at the top of an uptrend, after a period of strong bullish activity. The formation of this candlestick pattern indicates that buyers are no longer in control of the market. For this pattern to be reliable, it must occur near a resistance level.


Morning Star

The morning star pattern is considered as a bullish reversal pattern, it often occurs at the bottom of a downtrend and it consists of three candlesticks:
-The first candlestick is bearish which indicates that sellers are still in charge of the market.
-The second candle is a small one which represents that sellers are in control, but they don’t push the market much lower and this candle can be bullish or bearish.
-The third candle is a bullish candlestick that gapped up on the open and closed above the midpoint of the body of the first day, this candlestick holds a significant trend reversal signal.

Figure 3.4 - Morning Star

The morning star pattern shows us how buyers took control of the market from sellers when this pattern occurs at the bottom of downtrend near a support level, it is interpreted as a powerful trend reversal signal. See the illustration below:

Figure 3.5 - Morning Star Pattern on Chart

The chart above helps us identify the morning star pattern and how it is significant when it is formed at the bottom of a downtrend. As you can see the pattern occurred at an obvious bearish trend. The first candle confirmed the seller’s domination and the second one produces indecision in the market, the second candle could be a Doji or any other candle.

But here, the Doji candle indicated that sellers are struggling to push the market lower. The third bullish candle indicates that buyers took control from sellers, and the market is likely to reverse. This is how professional traders analyze the market based on candlestick patterns, and this is how you will analyze financial markets if you can master the anatomy of candlestick patterns and the psychology behind their formations.


Evening Star

The evening star pattern is considered as a bearish reversal pattern that usually occurs at the top of an uptrend. The pattern consists of three candlesticks:
-The first candle is a bullish candle
-The second candle is a small candlestick, it can be bullish or bearish or it can be a Doji or any other candlestick.
-The third candle is a large bearish candle. In general, the evening star pattern is the bearish version of the morning star pattern. See the example below:

Figure 3.6 - Evening Star Pattern

The first part of an evening star is a bullish candle; this means that bulls are still pushing the market higher. Right now, everything is going all right. The formation of the smaller body shows that buyers are still in control but they are not as powerful as they were. The third bearish candle indicates that the buyer’s domination is over, and a possible bearish trend reversal is likely to happen. See another chart that illustrates how the evening star could represent a significant trend reversal signal.

Figure 3.7 - Evening Star Pattern on Chart

As you can see the market was trending up, the first candle in the pattern indicates a long move up. The second one is a short candle indicating price consolidation and indecision.

In other words, the trend that created the first long bullish candlestick is losing momentum. The final candlestick gaping lower than the previous candlestick indicating confirmation of the reversal and the beginning of a new trend down.


Hammer (Pin Bar)

The Hammer candlestick is created when the open high and close are roughly the same price; it is also characterized by a long lower shadow that indicates a sudden interest in stock from buyers and their intention to push the market higher. See the illustration below to see how it looks like:

Figure 3.8 - Hammer or Pin Bar Pattern

The Hammer is a reversal candlestick pattern when it occurs at the bottom of a downtrend. This candle forms when sellers push the market lower after the open, but they get rejected by buyers so the market closes higher than the lowest price. See another example below:

Figure 3.9 - Hammer Pattern on Chart

As you can see the market was trending down, the formation of the Hammer (Pin Bar) was a significant reversal pattern. The long shadow represents the high buying pressure from this point. Sellers was trying to push the market lower, but in that level, the buying power was more powerful than the selling pressure which results in a trend reversal. The most important to understand is the psychology behind the formation of this pattern, if you can understand how and why it was created, you will be able to predict the market or stock direction with high accuracy.


Shooting Star (Bearish Pin Bar)

The shooting formation is formed when the open low, and close are roughly the same price, this candle is characterized by a small body and a long upper shadow. It is the bearish version of the hammer. Professional technicians say that the shadow should be twice the length of the real body. See the example below:

Figure 4.0 - Shooting Star or Bearish Pin Bar

The illustration above shows us a perfect shooting star with a small body and an upper long shadow when this pattern occurs in an uptrend; it indicates a bearish reversal signal. The psychology behind the formation of this pattern is that buyers try to push the market higher, but they got rejected by selling pressure. When this candlestick forms near a resistance level. It should be taken as a high probability setup. See another example below:

Figure 4.1 - Shooting Star Pattern on Chart

The chart above shows a nice shooting star at the end of an uptrend. The formation of this pattern indicates the end of the uptrend move and the beginning of a new downtrend. This candlestick pattern can be used with support and resistance, supply and demand areas, and with technical indicators.


Harami Pattern

The Harami pattern (pregnant in Japanese) is considered as a reversal and continuation pattern, and it consists of two candlesticks. The first candle is the large candle, it is called the mother candle, followed by a smaller candle which is called the baby. For the Harami pattern to be valid, the second candle should close outside the previous one. This candlestick is considered as a bearish reversal signal when it occurs at the top of an uptrend, and it is a bullish signal when it occurs
at the bottom of a downtrend. See an example below:

Figure 4.2 - Harami Candle or Bullish Inside Candle
Figure 4.3 - Harami Candle or Bearish Inside Candle

As you see the smaller body is totally covered by the previous mother candle, don’t bother yourself with the colours, the most important is that the smaller body closes inside of the first bigger candle. The Harami candle tells us that the market is in an indecision period. In other words, the market is consolidating. So, buyers and sellers don’t know what to do, and there is no one in control of the market. When this candlestick pattern happens during an uptrend or a downtrend, it is interpreted as a continuation pattern which gives a good opportunity to join the trend. And if it is occurred at the top of an uptrend or at the bottom of a downtrend, it is considered as a trend reversal signal. Look at another example below:

Figure 4.4 - Harami Pattern on Chart

In the chart above, you can see how the trend direction changes after the Harami pattern formation, the first bearish harami pattern occurred at the bottom of a downtrend, sellers were pushing the market lower, suddenly price starts consolidating, and this indicates that the selling power is no longer in control of the market.
The bearish Harami is the opposite of the bullish, this one occurred at the top of an uptrend indicating that buyer’s domination is over and the beginning of a downtrend is possible. When this pattern is created during an uptrend or a downtrend, it indicates a continuation signal with the direction of the market.

Conclusion

  • Test results and experience have shown that whilst the candlestick technique is a valuable trading tool, using it as a standalone may not give the desired result for many traders. One must understand that candlestick patterns do not work all the time. Some patterns may fail some of the time for various reasons. One example of failure is when a bearish candle pattern signals a sell in an uptrend. This sell signal in a bullish scenario is a weak sell signal and should not be taken, as the market can soon revert back to an uptrend to reach a higher high. Conversely, a bullish candle pattern may not give the desired result after buying because the primary trend is down. A buy signal in a downtrend is considered a weak buy signal, and the market may soon revert back into a downtrend. Another reason for failure is when signals are triggered in a sideways trend. Candles do not work best in sideways trends. As such, if one applies indiscriminately, for example, a buy‐and‐hold strategy following the occurrence of a candlestick pattern, the trade may or may not show a profit over the next 5 to 10 days or in the following weeks.
  • Summarizing, the trader starts by Identifying the primary trend by asking the question: Is the trend bullish or bearish? & trade in the direction of this trend.
  • Besides applying the candlestick technique, a trader should incorporate money management strategies to produce better results.

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