What is a Candlestick in Technical Analysis?

Fundamentals · Oct 17, 2019

Candlestick price chart in trading and technical analysis is a very common way to visualize price movements. It’s relatively easy to understand, it’s informative and this type of chart can give some additional helpful hints to a trader that a simple chart can’t provide. These charts may look a bit vague for an outsider, for someone who has never traded market securities, and often such a chart can seem confusing, but it’s not as complicated to understand as it may seem.

Illustration

In this article, we’ll explain how to read a candlestick chart and we’ll show how these charts can be helpful for an active trader.

Definition

A Candlestick, in reality, is a thing that holds candles. It was used long time ago when electric lights weren’t invented yet.

In today’s world, a candlestick in finance and trading is a type of a price chart that has a few key elements, that are not present on other and more simple types of price charts. Candlestick price chart visually looks like a real candlestick, that is why it’s called this way. In some sense, this type of chart can be called “smart” because it contains a lot of valuable information in a simple visual form.

Brief History

These strange price charts are believed to be developed in Japan (that’s why they are sometimes called - Japanese candlestick chart) in the 18th century by a man named Munehisa Homma, a rice trader. Later Westerners discovered it and Steve Nison wrote about them in his book “Japanese Candlestick Charting Techniques”. Today these charts are wildly used by real traders and you can see them in movies about stock traders very often.

Key Elements

Any candlestick chart has at least 5 units of information expressed as a simple picture:

  • The highest price for the day (upper shadow)
  • Open/Closing Price
  • Body (black, red, white or green)
  • Open/Closing Price
  • The lowest price for the day (lower shadow)

You can see how such a chart would look like on the illustration above.

How To Read and Understand a Candlestick Price Chart?

The first thing to remember is to look at candlestick’s body color, it’s either green/white or red/black.

  • If it’s green/white - the price went up during a particular period.
  • If it’s red/black - the price went down.

Another valuable information that such a chart has is the highest and the lowest price levels (wicks) yet during the day. This data would stay hidden for a trader who is looking only on lengthy simple charts (weeks, months, etc.) because such high and low spikes can be quick and temporary and the only data that is being recorded for a typical chart is only the closing price of the previous period. A candlestick price chart allows you to see extreme price levels, which is particularly helpful for active and aggressive traders.

The size of the candlestick’s body is a distance between the open and the closing prices. The size of the body allows you to see the trading range during the day. If the body is long, that means that we are seeing a large trading range, however, at the end of the day traders, who are not using this type of chart, may not even notice these important extreme price levels.

When you look at a typical candlestick chart and when you understand it, it may seem that it doesn’t actually generate that much of new and helpful information as a regular chart, but it’s definitely not true in some cases, especially in those when “a tail” is short (or when it’s too long). By tail, we mean the size of the shadow, the lowest and the highest price levels. Sometimes you may notice a lot of activity during the day, but in the end, the closing price would be not far from the opening price, however, this activity may signify a new movement that we won’t be able to see on a different type of chart. Sometimes such activity can be called volatility, although it’s not 100% correct to name it like that, and also you shouldn’t confuse it with the trading volume. It’s true that often a big gap between the highs and the lows will be accompanied by an increased trading volume, but it’s not always the case. There is a different and more complicated kind of a candlestick chart that uses the trading volume as its data.

Long candlesticks are better to be understood, as investopedia.com puts it, as a strong signs of buying or selling pressure, especially when they are close to important price levels, such as the historical ones.

A tall stick near such a level may be a sign that many market participants are trying to penetrate the price border.

Candlestick patterns

Technical analysis tends to interpreter certain price charts as figures with meaning and this applies to candlestick charts too. There are many of those patterns that were identified by market analysts but many of them are too vague, arguable and inconclusive (Bearish Harami, Bullish 3-Method Formation, Evening Doji Star, On Neckline, Three White Soldiers, Tweezer Bottoms, etc.).

We would mention just a few interesting ones here:

  • Dragonfly Doji: a tall lower shadow without a body and an upper shadow. It happens when the opening and the closing prices are at the highest level of the day. Such a pattern tells us that traders weren’t able to reach a new price level during the day, but they have tried hard. This may occur near a historical price resistance level. It may be a sign of the trend’s turn.
  • Gravestone Doji: the opposite of the Dragonfly Doji.
  • Long-Legged Doji: tall shadows in both directions without a body. This tells us that there are strong forces that are trying to move the price to both directions and those forces have equal power at the moment, so as the result the price stays where it was.

Long sticks with short shadows, as we explained earlier, signify a pressure towards a particular direction. The fact that shadows are not present may be a sign that the price is coming close to an important border, and the next step would likely be a Dragonfly Doji, a Gravestone Doji, or a bounce.

Should I Use This Type of Chart?

What type of chart to use in trading is a question of personal preferences and strategy. For an investor who prefer to follow a conservative buy-and-hold strategy and operate in long-term, a candlestick chart is not necessary to use. Investors may not find such charts as helpful as active traders.

For an active trader, a candlestick chart may be the way to go, especially for those who trade in high volume and do it fast. That is why you would often see such charts on the monitors of active traders.

These charts are suitable for trading any kind of liquid assets, such as stocks, futures, etc.

It’s really a question of the time horizon. Why would you want to know what the highest and the lowest levels during each day were if you are planning to sell assets in your portfolio after 6-12 or more months? What benefits can this information provide to you?

analytics   indicators   investing   japan   market   portfolio   technical analysis   trends

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