Candlestick Patterns: How To Read Them, And What Are Some Common Ones To Look Out For

Open your trading platform, and you’re likely to be greeted with a price chart of a popular financial instrument. Most charting platforms offer at least three options for how you can view the historical prices of an instrument on the chart. The common options are bar charts, line charts, and candlestick charts.

Among these, candlestick charts have been popular among traders who use technical analysis to read market sentiments to make predictions on future direction. Here’s a quick introduction to how to read candlestick charts and interpret them.

History Of Candlestick Charting

What is known today as candlestick charting was a technique invented by Japanese rice trader Muneshisa Homma in the 1700s. Using the insights that he gained from past prices and patterns, he was able to predict future price movements on the rice contracts traded on the Dojima Rice Exchange, which enabled him to amass a large fortune.

Over time, his trading concepts evolved into the candlestick methodology when it was introduced to the western world by Steve Nison through his book “Japanese Candlestick Charting Technique,” first published in 1991.

How To Read Candlestick Patterns 

A candlestick chart, like a bar chart, shows the opening, closing, and highs and lows of the day’s range. However, unlike the OHLC bar chart, a candlestick chart, which consists of three elements, is more visually appealing, making it easier to read the market behaviour of an asset’s price movement.

OCHL Bar Chart vs Candlestick – Source: CityIndex

First Element: Body Size Of Candle

The size of the real body of the candle, which is the difference between the opening and closing price, can be used as a gauge of the strength of the price movement. A long-body candle indicates a significant price change, while a short-body suggests a relatively smaller change.

The colour of the body can also be used to easily identify the direction of the price movement. For example, some charting platforms may use white or green to indicate bullish candles, while black or red are used for bearish candles.

Second Element: Wicks Or Shadows

Any price movement below or above the candle’s open and closing price is referred to as the wicks or shadows. It is depicted as a thin line extending from the real body.

Third Element: Candlestick Pattern Formations

The formation of multiple candlesticks forms patterns, each of which conveys different information about market sentiments depending on where they occur in a trend. They could be categorised as bullish, bearish, or neutral patterns.

Read Also: Market Order Vs Limit Order Vs Stop Order: How The Different Types Of Trading Orders Work

Common Candlestick Patterns

There are at least over 40 variations of the candlestick patterns, consisting of one, two, and three candlestick patterns. But for a start, we shall look at four of the most common candlestick patterns that can give you an edge in your trading.

#1 Doji

Doji – Source: CityIndex

A doji is a single candlestick pattern that forms when the opening and closing prices are the same, regardless of the day’s high and low range. The small real body of the candle indicates market indecision and often precedes a trend reversal.

#2 Hammer And Hanging Man

 Hammer
Inverted Hammer

Shooting Star

Hanging man – Source: CityIndex

A hammer or hanging man pattern has a small real body and a long lower or upper wick that is at least two times greater than the size of the real body of the candle.

These single candle formations are also considered reversal candlestick patterns. For example, when a hammer pattern (or an inverted hammer) forms at the end of a downtrend, it may suggest a bullish reversal, while a hanging man, also known as a shooting star, when formed at the top of an uptrend, may suggest a bearish reversal.

#3 Engulfing Patterns

Bullish Engulfing

Bearish Engulfing – Source: CityIndex

An engulfing pattern is a two-candlestick reversal pattern that occurs when the body of the first candle is “engulfed” by the body of the second candle. These patterns can be either bullish or bearish and are regarded as a strong signal of a reversal when they appear at the low of a downtrend or at the high of an uptrend.

A bullish engulfing pattern is formed when a small bearish candlestick is followed by a larger bullish candlestick that fully engulfs the previous candle. On the other hand, a bearish engulfing pattern is formed when a small bullish candlestick is followed by a larger bearish candlestick that fully engulfs the previous candle.

#4 Morning Star And Evening Star

Morning Star

Evening Star – Source: CityIndex

A morning star and an evening star pattern is a three-candlestick reversal pattern. A morning star, which is seen as a bullish reversal pattern, occurs at the low of a downtrend when a bearish candlestick is followed by a doji, then a larger real-body bullish candlestick.

The opposite is true for an evening star pattern, which is seen as a bearish reversal pattern. It occurs at the top of an uptrend when a bullish candlestick is followed by a doji and then a larger, real-body bearish candlestick.

Read Also: How Rising Interest Rates Affect Currency Pairs

Find Your Edge In The Markets

While candlestick patterns are invaluable to technical traders and investors to understand market sentiments and predict future price movements, they are not foolproof. It’s important to consider other factors and use the candlestick patterns in confluence with other strategies to increase the probability of success.

As trading and investing carry risks, you could test out these strategies on a free demo account with a reputable broker like CityIndex without risking any capital before you start trading them on live markets.

Read Also: Investing Terms 101: What Is The P/E Ratio And How To Understand It?

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