The Interpretation of Candlesticks
Updated: Sep 28, 2020
In trading, every chart tells you a story. The only way you can survive and thrive in this business, is by learning how to read charts. Reading charts goes beyond the recognition of patterns. Knowing how to recognize a visual pattern is within reach of anybody, even a child.
In essence, charts represent collective behavior. There's a direct correlation with psychology.
When I started trading, everything I read about candlesticks were patterns. Too many people focus on trying to remember all these names given to different candlestick formations.
Harami, Dark Cloud Cover, Separating Line, Evening Window Star, 3 Bullish Soldier, Inverted Hammer, Shooting Star, Tweezer Tops, Hanging Man, Spinning Top, Tri-Star,...
The list is endless.
Long story short, I was going nuts. Somehow, I once came across a website, from which I really learned a lot (if the author happens to read this, THANK YOU). I realized that I was focusing on the wrong things.
By writing this article, I want to share with you everything I've learned as of today about the underlying interpretation of candlesticks. Because of the fact that I'm still reading a lot of books and various stuff, I might come back to this article and update it or even write an updated version in the future.
Let's get started by doing a throwback in the 18th century.
2. The history of Candlesticks
Honma Munehisa. A name that doesn't come up that often. But, this Japenese rice trader is considered to be THE legend of trading. Besides being one of the most successful traders in history, he is the pioneer of trading psychology as we know it today.
He knew, as everyone else, how to interpret supply and demand in the rice market. He noticed that the markets were strongly influenced by emotions so he took his trading a step further and started journaling the open, close, high and low prices. This is how the first candlestick was born.
He created the candlestick in order to have a visual representation of emotions.
Even though he was the actual inventor of the candlestick, Steve Nison, who brought the candlestick charts to the West, said that it is unlikely that Honma used candlestick charts and that they emerged a few years laters, around 1850.
3. The anatomy of Candlesticks
Prices, in any market, either go up or down. This is why, candlesticks are either green (bullish, i.e. prices go up) or red (bearish, i.e. prices go down).
Each candlestick you see on a chart, is associated to a period of time (e.g. one week, one day, four hours, one hour, fifteen minutes, etc,...). Every candlestick gives us four key information (for any given period) :
The opening price
The highest price
The lowest price
The closing price
The rectangle is called "real body". The body tells us at which price the period started and at which price the period ended.
The lines above and below the body are called "wicks" ("upper wick" and "lower wick", sometimes they are also called shadows). The wicks tell us how high and/or how low prices traveled during the period.
Let's take a look at the candlestick chart below. For instance, this is a daily chart, mearning that each candlestick represents one day of trading (in the stock market).
We can extract the four basic information out of the candlestick that I pointed out :
The opening price is : 9.61
The highest price for the day is : 9.66
The lowest price for the day is : 7.81
The closing price is : 8.04
We can say that this candlestick is bearish and that sellers were in total control of the price.
4. It's all about control
The most important concept about candlesticks is that they basically tell us who is in control of the price. Who's stronger ? Buyers or sellers ?
Not only do candlesticks let us know who is in control, but also to what degree one side or the other is in control. In other words, what's the level of commitment. In general, the wider the body is, the stronger the commitment.
The candlestick below has a small body, which means that buyers didn't have either enough conviction to bid the price up or that the number of buyers didn't overwhelm the number of sellers.
Conversely, this one shows a stronger commitment.
Keep in mind that, for every buyer there must be a seller and vice-versa. But, in any market, there's often times an imbalance between buyers and sellers.
Let's take the example above (image 4.2) a step further. It is important to understand price movement (Chapter 3 : "Understanding the nature of trading").
How does the price gets from 271.50 to 272.00 ? Well, the buyers, have to absorb all the offers from the sellers. In other words, the demand has to exceed the offer. Once all the offers have been absorbed at 272.00 prices rise up until they meet the next offer.
Now, for prices to keep rising, buyers have to keep buying at higher prices. As long as there are not enough offers to satisfy buyers and as long as buyers have the conviction that the stock is cheap, prices keep rising ("Path of least resistance").
5. Candlestick Patterns
In order to provide you with a better understanding, I'll do an in-depth explanation of some candlestick patterns. Once you understand the underlying dynamics, you will be able to interpret any candlestick, in any market, on any timeframe.
5.1 The "Hammer" or "Hanging Man"
The candlestick formation below has actually two names. It can be a "Hammer" or a "Hanging Man". In both cases it is a pattern that indicates a potential trend reversal.
Visual recognition :
No upper wick or a very small one
Long lower wick
Color doesn't matter
General interpretation :
At open, sellers took control and drove prices down. At some point, buyers stepped in thinking that prices were cheap and started getting aggressive and absorbed all the offers, which made prices rise. This is also called a "price rejection". In other words, buyers rejected the sellers attempt to drive prices down, control changed hands.
Bear in mind, that candlestick patterns alone are not enough to make a trading decision ! You have to put candlesticks into a context by analyzing past price action.
The hammer : Prices came down, meaning that sellers were in control (downtrend). At one point, the control suddenly shifts and buyers absorb all the offers and make prices rise.
Buyers are threathening sellers. They have the belief that at these prices, the stock is cheap and that prices will rise. Buyers get confident and sellers get fearful. This is an indication that the downtrend is running out of steam.
The hanging man : Prices were rising, meaning that buyers were in control (uptrend). This time, sellers are threathening buyers. Sellers took control of the price for a short period, but buyers were still stronger. Sellers are saying : "You might still be in control here, but we are coming for you." In this case, buyers are getting fearful and sellers confident. This indicates that the uptrend is running out of steam.
5.2 The Inverted Hammer or Shooting Star
The "Inverted Hammer" or "Shooting Star". In essence, like the previous patterns, they both mean the same thing, but once you put them into a context, they tell different stories.
Visual recognition :
Long upper wick
No lower wick, or a very small one
Color doesn't matter
At open, buyers get very aggressive and start absorbing all the offers, which makes prices rise. But, at one point, sellers take back control. This is also a price rejection, sellers reject higher prices.
The Inverted hammer : When this pattern forms after a downtrend, it means that buyers are threathening sellers. Sellers were in control, but the buying pressure is increasing, more buyers are coming into the market. Buyers start getting confident and sellers get fearful.
The Shooting Star : While prices are going up, this pattern shows a failed attempt to push prices further up by buyers. Selling pressure is increasing and there's less buyers coming into the market to buy. Sellers are threathening buyers. Buyers get fearful, sellers get confident.
5.3 Candlestick calculation
There's a concept I really like because it is simple (I like simple things, especially when it comes to Trading) and it enables a quick interpretation of candlestick patterns that are composed of two or more candlesticks, it's called "Candlestick calculation".
Basically, it's all about adding up candlesticks. It's very useful, because instead of remembering the names, you can just blend them and come up with a "single candlestick" that you can easily interpret (with what we covered above).
Let's take an example. There's a pattern called the "Dark Cloud Cover". It's a bearish reversal pattern, meaning that it indicates a potential reversal after an uptrend. This is how it looks like :
This is how candlestick calculation works :
You take the low and the open of the first candlestick
You take the close and the high of the last candlestick
And this is what the "Dark Cloud Cover" really means :
What we're left with is that higher prices have been rejected. Remember, this pattern is meaningful when forming after an uptrend movement. Selling pressure is increasing, sellers confidence is rising, meanwhile buyers start getting fearful.
6. What now ?
I suggest you keep practicing reading charts by bearing the notions of control and emotions in mind. To this day, I'm still practicing my candlestick reading ability. To do that, I use a random stock picker and I go through charts and apply all I know. Often times, I notice things and correlations I didn't previously knew the existence of.
By doing this exercise, I train my brain to look further than only the visual aspect. The more charts you go through, the better your understanding gets.
I hope that you enjoyed this article and learned something new. If you have any question, suggestion or idea, do not hesitate to leave a comment below. You can also send me a message through the "Contact" page.
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Thank you !
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