A Candlestick Chart
Japanese candlestick charts form the basis of the oldest form of technical analysis. They were developed in the 17th century by a Japanese rice trader named Homma and was introduced to the rest of the world in Steve Nison's book, Japanese Candlestick Charting Techniques. Candlestick charts provide the same information as OHLC bar charts, namely open price, high price, low price and close price, however, candlestick charting also provide a visual indication of market psychology, market sentiment, and potential weakness, making it a rather valuable trading tool.
Candlesticks indicate a bullish up bar, when the closing price is higher than the opening price, using a light color such as white or green, and a bearish down bar, when the closing price is lower than the opening price, using a darker color such as black or red for the real body of the candlestick. Thus, on a green candlestick, the close price will be at the top of the candlestick real body and the open price at the bottom as the close price is higher than the open price; conversely on a red bar the close price will be at the bottom of the candlestick real body and the open price at the top as the close price is lower than the open price. For both a bullish and a bearish candlestick, the high price and the low and the low price for the session will be indicated by the top and bottom of the thin vertical line above and below the real body. This vertical line is called the shadow or the wick.
The shape and color of a candlestick can change several times during its formation. Therefore the trader must wait for the candlestick to be formed completely at the end of the time-frame to analyze the candlestick, forcing the trader to wait for the bar to close.
Candlesticks and Market Psychology
The Makeup of a Typical Candlestick
Candlesticks are also good indicators of market psychology, i.e., the feelings of fear and greed experienced by the buyers and sellers, and the strength of those feelings. Thus a bullish (green) candlestick with no shadows (which is called a Marubozu) indicate strong bullishness, and the longer the Marubozu candlestick the stronger the bullishness. A bullish candlestick with a relatively long lower shadow, a relatively small real body and a short or no upper shadow indicates that the buyers were able to drive the price up from the low. This is also a strong bullish candlestick. However, a bullish candlestick with a relatively long upper shadow, a relatively small real body and a short lower shadow indicates that sellers were able to drive the price down from the high but were not able to defeat the buyers. Although this candlestick is bullish, it is weak; and the longer the upper shadow and the smaller the real body, the weaker the candlestick.
Candlestick charts also indicate potential trend reversal patterns in only one to four candlesticks with subsequent candlestick patterns proving confirmation. When using a candlestick for confirmation of a potential trade signal, it is important to take into account the relative strength or weakness of that candlestick and its location overall in the trend lines on the chart. A weak candlestick should never be taken as a confirmation of a potential trade.
The following two charts of the EUR/USD illustrate the subtle differences between a bar chart and a candlestick chart. The first is the bar chart followed by a candlestick chart. Both charts have a 15-minute time frame and cover the exact same period.
A Bar chart of the Euro/USD
A Candlestick chart of the Euro/USD
Types of Candlesticks
Candlesticks can have different shapes, depending on the size of the candlestick body and the length of the shadows on either end of the body. It is important to remember that a candlestick does not need to have shadows. When the candle closes at the high for that period there is no shadow above the candlestick as the price was not any higher. Conversely, when the candle closes at the low for that period there is no shadow at the bottom of the candlestick as the price was never lower. When the close price is the same as the open price, the candlestick will have no real body, and no color. Finally, a light colored candlestick indicates that the price rose during that period and closed above the open while a dark colored candlestick indicates that the price declined as it closed lower than where it opened. Below is a list of the different types of candlesticks, some of which are single candlestick patterns.
The Typical Candlestick
The typical candlestick has a body and a shadow above and below the open price and close price, which indicates that the high and the low of the time-frame in which the candlestick was formed was higher and lower than the open price and the close price.
When the open and close are at the high and the low, or vice versa, then the candlestick will have no shadow above or below the real body. These candlesticks are called Marubozu, which means shaven, and can be either bullish and light in color, if the Marubozu closes at the high of the period, or bullish and dark in color if it closes at the price low. A bullish Marubozu indicates strong buying pressure as the buyers did not allow the sellers to drive the price down. The length of the candlestick indicates the strength of the bullishness, especially when the Marubozu is longer than the preceding candlesticks. Conversely, a bearish Marubozu indicates strong selling pressure. A bullish Marubozu at end of a downtrend is a potential reversal signal. You should close your short position and wait for the next candlestick to enter a long position if it is also bullish. Similarly, a bearish Marubozu at end of an uptrend it is also a potential reversal signal.
The Marubozu without a shadow at either end is less common than a Marubozu that is shaven on one end but has a shadow on the other end. The shadow can form either the opening of the candlestick or at its close. When the shadow forms at the closing price it tentatively indicates weakness as the price was pushed back near the end. However, this is a weak indication and does not necessarily indicate a reversal.
When the close price and the high price are the same or very close, the candlestick will have no or little real body. These candlesticks are called Doji, which means unskillfully. Doji candlesticks have no color and are neither bullish nor bearish. They tend to indicate momentary indecision and uncertainty in the market and may be a prelude to a trend reversal but it requires confirmation from subsequent candlesticks as Doji that appear in multiple candlestick patterns tend to be clearer indications of trend reversals.
There are different types of Doji candlesticks, depending on the position of the cross bar indicating the open and close prices. When the cross bar is more or less central with an equal length shadow on either side, it's called a Rickshaw Man Doji. When the cross bar is at the bottom of the shadow, i.e., there is no lower shadow, it's called a Gravestone Doji. When the cross bar is at the top of the shadow and there is no upper shadow, it's called a Dragonfly Doji, though some call it an Inverted Gravestone.
When the candlestick has a short real body, which is not more than a third of the entire candlestick, a long lower shadow and little or no upper shadow, it is called either a Hammer or a Hanging Man, depending on whether it is at the top of an uptrend or at the bottom of a downtrend. When it appears at the top of an uptrend it is called Hanging Man and when it appears at the bottom of a downtrend it is called a Hammer. Like the Doji, Hammer and Hanging man indicates momentary indecision and uncertainty and require confirmation from the subsequent candlestick.
The Shooting Star and the Inverted Hammer are the opposite of the Hanging Man and Hammer. These candlesticks also have a short real body, which is not more than a third of the entire candlestick, but they have a long upper shadow and little or no lower shadow. It is called a Shooting Star when it appears at the top of an uptrend, or an Inverted Hammer when it appears at the bottom of a downtrend. Like the Hammer and Hanging Man, the Shooting Star and Inverted Hammer indicate momentary uncertainty and indecision and require confirmation from the subsequent candlestick.