The japanese candlestick charting technique dates back to the 1700s when bar charting and other popular forms of charting were not even discovered. Japanese traders were using this technique to trade their rice market.
Candlesticks charting became popular when Americans discovered it from Japanese traders. Traders started using it when American Analyst, Steve Nison introduced it to the the United States of America and the rest of the world.
In our last article we have covered the reasons why candlestick charts are so popular today. In this article, we will cover the basic components that create candlestick patterns and candles.
To create a candlestick, four pieces of information are combined i.e. the opening price, high, low and closing price.
The relationship between the day’s open, high, low and close determines the look of the daily candle. Similarly, if you change charting to a lower or higher time frame, then that period’s opening, high, low and closing prices will be comibned to print candlesticks.
For instance if you selected 1 hour as your trading time frame, then opening, high, low and closing price of every one hour will be combined by your charting software to print candlesticks in your chart.
The Open price
Open as mentioned in the above image is the first piece of information used to create a candlestick. It’s the price at which the stock/security opens on a given period.
For instance, if you are in daily chart, then open indicates the opening price of that stock or security for that day. This means stock or security for that day started trading at the opening price. Same concept is applicable based on the time frame you choose to analyse market data in your charting software.
If the candle is bullish, the opening price corresponds to the bottom edge of a candlestick’s candle.
In a bearish candle, the open price correspondence to the top edge of the body of the candle.
The High Price
It’s the highest price that a stock/security reaches during a given period corresponding to the top of the candlestick.
If the security opens and trades consistently lower than that the opening price through the period, there won’t be any wick and the open will be the high of that period.
The Low price
Bottom of the candlestick correspondence to the low price that the stock reaches during a period.
If after opening, the stock trades above the open price, it’s a bullish candle. In this case, the open price will also be the low of the period and there won’t be any wick at the bottom.
The Close price
It’s the last and most important piece of information used to create a complete candlestick for a period. Close price is the price at which a security finishes trading during a given period of time.
Close price will determine whether the candlestick is bullish or bearish and whether bulls/bears dominate the period.
If the closing price is higher than the opening, the candlestick is bullish and colored in green. When the closing is lower than the opening, the candlestick is bearish, colored in red.
Knowing securities’ close price relative to its opening price for a period is vital information to quickly identify who is in control. Bulls win when for a period the close settles higher than the open, and bears win when the price of a security closes lower than its open.
Based on the timeframe you select, these four pieces of data are combined to construct the individual candle. The time frame can be daily, 1-hour, 15-minute, 5-minute, 1-minute or any other time period you prefer.
Several candles are created by using these data from several periods in succession to produce a full candlestick chart.
Open, High, Low and Close price of candle or session is also referred to as OHLC. Not only candlestick chart, even bar chart is also printed on your screen based on these four information.
How a candlestick is formed – 4 simple steps
Here are the four simple steps used to draw a candlestick chart.
We will be discussing how a daily candlestick chart is drawn. Same concept is applicable to all time frames.
- The opening is marked when the market opens.
- Immediately when security started trading, the most recent traded price and the open box-up to form a rectangle, it’s called the real body of the candle. The real body is the range between the open and close of the day. If the close is higher than the open, the body is colored as green. If the close is lower than the open, the real body is colored as red.
- If the market after touching a high started trading lower, then immediately a line is drawn, called the upper wick touching the high of the day and the real body. The pick of the shadow therefore represents the high of the session.
- If the market after touching a low started trading higher, then immediately a line is drawn touching the low of the day and the real body of the candle. This line drawn below the real body is called the lower wick. The trough of the lower wick is called the low of the day.
Depending on how a security is traded in the market, price gets updated to form the candlestick, therefore, above steps might be changed. However, concepts remain the same.
You will find certain candlesticks with no upper shadow and/or lower shadow. This type of situation arises when during the trading session, price does not touch the high and/or low.
This means, if you want to see a candle for a day, then the open,high, low and close price of the stock for the day must be taken to draw the candle.
To understand the candle, you first have to know what is the body and shadow of a candle. Length of the body and shadow is the most important thing for a chartist.
The body of a candle
The box that is joined to the open and close of the session is called the body of the candle. This makes up the difference between the open and close price of the stock.
When the closing price is lower than the opening price of a day, the candle’s body turns red or bearish. Similarly, when the closing price is higher than the opening price of the day, the candle turns green or bullish.
If you are looking at a daily candle, the real body of that candle represents the range between the open and close for that day’s trading session. If the body is filled in red color, it means the close was lower than the open. If the real body is green, it means the opposite, the close was higher than the open.
How much the bulls or bears dominate the market is reflected by the length of the body or the distance between the open and the close.
If the market opens on the low and has a large body where it closes at the high of the session, that signifies that the bulls are in strong control.
In a bearish market condition, sellers enter the market on the open and dominate the session right into the close of that time period.
If the body of the candle is long, it represents a large price movement for the day.
A long bull candle that opens at the bottom and closes at the high indicates that a major trend reversal is taking place.
Similarly after a long uptrend, seeing an unusually long bearish candle at the top might indicate that a major trend reversal is occurring.
For your further studies you can refer to the following important candlestick reversal patterns;
- Three inside up/down candlestick pattern
- Three outside up/down candlestick pattern
- Bearish or bullish engulfing
- Piercing patterns
- Morning star
- Evening star
- Shooting star
- Inverted hammer
- Hanging man
The Shadows, Wicks or Tails of a candle
In the candle, you can see a line above and/or below the real body. The top place and bottom of the line represents the high and low price of the day. The complete line is known as shadows.
Many chartists refer to the shadows as wicks of the candle.
If a security opens at a certain price and then drops steadily throughout the course of the session, you won’t see any wick at the top of the candle.
If, on the other hand, the security opens at a certain price and increases in price during the session without ever dropping below the open, you won’t see any wick extending below the candle.
The wick or tail of the candle in relation to the body illustrate the market denial of a support or a resistance level. This means, shadows above the body show the rejection of higher price and lower shadows below the body show rejection of lower price.
Long wicks formed after a long downtrend, indicate that the trend has exhausted due to increase in demand and decrease in supply. Similarly, when a long wick is formed at the top after a long price advance, it indicates that demand is drying up and supply is increasing. The size of the wick in relation to a real body is important.
Candlestick charting is used because of its visual appeal and readability. You can easily know whether Sellers or buyers dominated the day and how the price is trending. Opening and closing price can also be easily known on a candlestick chart.
Small wick signifies that the stock at that point of time is less volatile.Small wick with large bodies means one group (either bulls or bears) is in control of the market for that particular time period. Small body with a large wick means it’s a Doji, which means indecision and fighting for control.
Color of the candle
In a candlestick charting software package, if the close is below the open, it will be shown in red color indicating bearishness. If the close is above the open, it will be shown in green color indicating bullishness.
You can adjust the color of the candle based on your preference. Some traders use white instead of green for a bullish candle and black instead of red for a bearish candle.
Green colored body of the candle represents bullish price action and red represents bearish price action.
Almost all charting softwares allow you to color code candlesticks however you like. Many traders use candlesticks as black and white, this means bullish candle is colored white and bearish candle is colored black. Instead of black, some traders also use red for bearish candles.
Here is how the candles will look like when you use black and white colors;
To read the psychology of the market participants, you need to look for the size, location and color of the candles in candlestick charting. Combination of a few single candles also form a pattern which signal market reversal.
Be sure you practice identifying and trading these candlestick patterns on a demo account before trading them with real money.
In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.