Being a newbie in trading or investing is not easy, especially once you need to read those scary charts. Some people use their intuition and make their investments based on it. That, of course, could work for a while, but it is most likely not a good idea to always follow your instincts without having a pinch of theory.
The matter is that trading and investing are things heavily dependent on probabilities and risk management. So, reading, let’s say, candlestick charts is essential whichever investment style you follow. Let’s find out what are candlestick charts are and how to read them.
What Is a Candlestick Chart?
A candlestick chart is a kind of financial chart that represents the price moves of an asset for a given time period. It is called like that because it’s made up of candlesticks, each represents the same amount of time. Those candlesticks can represent any period, from seconds to years.
Candlestick charts aren’t something new, as they appeared in the 18th century. It’s believed that a Japanese rice trader called Homma came up with the idea. Then a book called "Japanese Candlestick Charting Techniques" was published and brought a concept to the Western world. Traders can now identify dozens of these formations with pretty poetic names like bearish dark cloud cover, evening star, or three black crows. Above all, single bar patterns, including the doji and hammer were incorporated into many long- and short-side trading strategies.
Candlestick charts could be used to analyze any type of data, but they are often employed to analyze financial markets more accessible. If they are used correctly, they can be great tools that help traders estimate the probability of outcomes in the price movement. They can help traders and investors to form their ideas based on their careful analysis of the market.
How Do Candlestick Charts Work?
What do you need to create a candlestick? The following price points:
- Open — The first recorded trading price of the asset within that specified time period.
- High — The highest recorded trading price of the asset within that definite time period.
- Low — The lowest recorded trading price of the asset within that specified time period.
- Close — The last recorded trading price of the asset within that particular time period.
This data set is often referred to as the OHLC values. The relationship between the open, high, low, and close defines how the candlestick looks.
The gap between the open and close is called the body, while the distance between the body and the high/low is named the wick or shadow. The distance between the high and low of the candle is called the range of the candlestick.
How to Read Candlestick Charts
Many traders think candlestick charts are easier to read than the more usual bar and line charts, although they provide similar information. Candlestick charts can be skimmed, offering a simple depiction of price action.
A candlestick shows the battle between bulls and bears for a specific period. The longer the body is, the more intense the buying or selling pressure was during the measured timeline. Short wicks on the candle mean that the high (or the low) of the measured time period was near the closing price.
The color and settings may differ with various charting tools, but usually, if the body is green, it means that the asset closed higher than it opened. Red means that the price went down during the specified time, so the close was lower than the open.
Some chartists prefer to use black-and-white depiction. So instead of using green and red, the charts show movements with hollow candles and down moves with black candles.
What Candlestick Charts Don’t Tell You
Candlesticks are handy in giving you a general idea of price movement, but they may not provide all you need for a complete analysis. For example, candlesticks can’t show in detail what happened in the interval between the open and close, only the distance between the two points.
As an example, the wicks of a candlestick can tell us the high and low of the period, but they can't show us which one happened first. Meanwhile, the timeframe can be changed in most charting tools, enabling traders to zoom into lower timeframes for more details.
Candlestick charts can also involve a lot of market noise, particularly when charting lower timeframes. The candles can change fast, making them pretty difficult to interpret.
There are various ways to read these charts. The Heikin-Ashi Technique is one of them.
Heikin-Ashi can be translated from Japanese as “average bar.” These candlestick charts rely on a changed formula that uses average price data. The main goal is to level out price action and remove market noise. So, Heikin-Ashi candles can make it easier to highlight market trends, price patterns, and possible setbacks.
Traders often use Heikin-Ashi candles combined with Japanese candlesticks to escape false signals and increase the chances of finding market trends. Green Heikin-Ashi candles with no lower wicks usually indicate a substantial rise, and red candles with no upper wicks may point to a strong fall.
Heikin-Ashi candlesticks can be a powerful tool, like any other technical analysis technique, but unfortunately, they also have their limitations. Candles use averaged price data, so patterns may take longer to develop. Also, they don’t show price gaps and may hide other price data.
Reliability of Candlesticks
Their massive popularity has increased because hedge funds and their algorithms have analyzed them. Hedge fund managers use special software to catch participants seeking high-odds bullish or bearish outcomes. However, reliable patterns continue to appear, allowing for short- and long-term profit opportunities.
Still, at least five candlestick patterns work well as precursors of price direction and momentum. Each executes within the context of surrounding price bars in predicting higher or lower prices. But again, they also have some defects:
- They perform within the limitations of the chart that was reviewed intraday, daily, weekly, or monthly.
- Their potency goes down swiftly three to five bars after the pattern is completed.
Three Line Strike
The bullish three-line strike pattern carves out three black candles within a decline. There are three bars in the direction of a trend, followed by a final candle that goes back to the start point. Traders use the three-line strike as an opportunity to buy at a current trend low or sell at a high price.
Three Black Crows
Three black crows is a bearish candlestick pattern used to foresee the reversal of a current rise. Traders use it with other technical indicators, such as the relative strength index (RSI).
- The Relative Strength Index (RSI) is an indicator that evaluates the volume of recent price changes to analyze overbought or oversold conditions.
Two Black Gapping
The bearish two-black gapping continuation pattern shows up after a noteworthy top in an uptrend, with a gap down submits two black bars posting lower lows. It predicts that the fall will continue to even lower lows.
The bearish evening star pattern begins with a tall white bar that takes an uptrend to a new high. The market gaps are higher on the next bar, but fresh buyers don’t appear, producing a narrow range candlestick. A gap down on the third bar finishes the pattern, which forecasts that the fall will continue to even lower lows.
The bullish abandoned baby pattern turns up at the low of a downtrend after several black candles print lower lows. The market gaps lower on the next bar, but fresh sellers fail to appear, producing a narrow range doji candlestick with opening and closing prints at the same price. A bullish gap on the third bar finishes the pattern, which shows that the recovery will continue to even higher highs.
Golden and Death Cross
A golden cross shows a long-term bull market going forward, while a death cross indicates a long-term bear market.
The golden cross turns up when a short-term moving average crosses over a major long-term moving average to the upside and is interpreted by analysts and traders as indicating a particular ascending turn in a market. The short-term average goes up faster than the long-term one until they cross.
Here are three stages to a golden cross:
- A downtrend that ultimately ends as selling is depleted.
- The shorter moving average crosses up through the longer moving average.
- The continuing rise, hopefully, leading to higher prices.
A death cross is a downside moving average crossover indicates the death cross and is understood to show a significant downturn in a market. The death cross happens when the short-term average trends down and crosses the long-term average, going in the opposite direction of the golden cross.
Candlestick charts are one of the most fundamental tools for any trader or investor. They provide a visual representation of the price action for a given asset and offer the flexibility to analyze data in different timeframes.
An extensive study of candlestick charts and patterns, combined with an analytical mindset and enough practice, may eventually give traders an edge over the market. Still, most traders and investors agree that it’s also important to consider other methods, such as fundamental analysis.