The main objective of the price chart in technical analysis is to depict the battle between bulls (buyers) and bears (sellers) over a given period of time. One of the best and most popular ways to depict the battle between bulls and bears is by using candlestick charts.
In this article we will expose you to many of the facets of candlestick charts techniques that continue to fuel its rise as one of the most popular charting techniques.
In technical analysis the goal of a chartist isn’t to see what has happened in the past, but to attempt to predict the future.
The objective is, if you can predict the future of price movement for a majority of time, you should be able to profit nicely through wise investing and trading. In this regard, Candlestick charts can help you to determine market movements.
Just by studying price action on old candlestick charts, the trader can predict a small piece of the future and use it to turn a profit.
But you have to keep in mind that past results do not always ensure future returns. Therefore, you have to keep the overall market picture into consideration while making a decision.
To be successful, traders need easy-to-read charts that allow them to make quick decisions and efficiently analyze patterns. Candlestick charts offer these benefits.
If you are not familiar with candlestick charts, we have covered the basics of candlesticks and how it is formed in one of our earlier articles. You can refer to it for your further studies. In this article let us discuss why many new and well known traders prefer to use candlestick charts for trading.
Why to use candlestick charts
There can be many reasons why traders use candlestick charts for their short or long term trading in the financial market. Here are the most important reasons why candlestick charts are so popular among professional traders;
Candlestick charts are very flexible to use in combination with other leading technical indicators or can be used alone. They are not like point and figure charts which can’t be used along with technical indicators.
In combination with other leading indicators such as support, resistance, RSI, Stochastics, MACD, moving averages etc, you can easily recognise complex pattern moves to predict the next possible move.
You can easily use candlestick charting techniques for your short and long term trades. Almost all charting softwares are providing intraday charts like the 1-minute, 2-minute, 3-minute, 5-minute, 10-minute and 15-minute and hourly charts.
You can apply it to almost all markets such as stocks, futures, options, currency and commodities, and can trade in any market around the world.
Candlestick charts are pictorial and describe traders psychology well in comparison to any other charts. With the formation of different candlestick patterns and price information, traders can easily make their trading decisions.
You can understand the traders psychology behind the formation of the candle. By comparing one candle with the previous candles, you can interpret any changes to trader’s psychology. This type of information helps traders to make buy, sell or hold decisions.
By interpreting the size, location and color of the candle, you can easily read the psychology of market participants behind the trade. For example, a large size candle suggests tremendous strength and power behind the move.
Color of the candle is also important in determining whether the bulls or bears are in control. For example, a long green candle with a large real body is considered very bullish.
A long red candle is interpreted as a very bearish candle. A daily short candle with small or no wick, considered as a day of very narrow price movement.
A strong up-trend or down-trend is visible not only because of the direction of movement in price, but also because of the color of candles.
This simple representation reveals the nature of price action that took place during the period. You can glance at a candlestick chart and quickly gain an understanding of what is going on with the price of a stock. You can easily know whether sellers or buyers are in control. Candlestick depicts the battle between the bulls (buyers) and Bears (Sellers) over a given period of time.
Series of candlesticks forms different chart patterns which can be instantly recognisable while trading in the financial market.
For example, a strong upward or downward movement can be easily recognisable because of the colors used and height of the body. Any indication of price movement helps traders with the timing of entry and exit.
Candlestick patterns such as Hammer, Shooting Star, Hanging Man, Doji, Dark Cloud Cover, Inverted Hammer, Morning star, Evening star, Engulfing and Abandoned baby helps market participants to identify potential reversals in an up-trend or down-trend.
Candlesticks have the ability to show reversal signals earlier than any other technical indicators. It’s considered as a true leading indicator of market action.
Using along with any other indicators can be very helpful in identifying moves before they become apparent. Location of the pattern formation can easily be identified whether it will be a continuation or reversal pattern.
As a leading indicator Candlesticks can help you to find followings;
- Trade setups
- market direction
- optimal entry and exit points
Candlestick chart patterns to understand price action
You can’t trade or invest effectively by using candlestick charts unless you have thorough knowledge on candlestick chart patterns.
Before getting into candlestick chart patterns, you have to understand basic candlestick construction and use. The patterns are formed with one candle or by grouping two or more candles in a certain sequence.
If components of a candlestick are considered as bone, then patterns are the heart and soul.
Different types of chart patterns can tell you what may be happening next to the security. It tells you when the prevailing trend reverses or when they continue. These types of chart patterns within the overall context of the market tells you when to get into a trade, when to get out of a trade and whether to continue the present trade or to get out.
The number of chart patterns in candlestick is more than 200. However, to understand price action using candlestick charts we require to know a few of these patterns.
The most important signals that you will most often witness are;
- Shooting star
- Morning Star
- Abandoned baby
- Bullish and Bearish Engulfing pattern
- Inside Bar or The Harami
- Spinning Tops
- Hanging Man
- Inverted Hammer
- Dark cloud cover
- Bullish piercing line
- Three inside up/down candlestick pattern
- Three outside up/down candlestick pattern
It’s very rare to get a textbook definition of pattern when the market is live, there could be minor variation to these patterns based on the market conditions. Therefore you need to be flexible while analyzing these chart patterns.
Alternative to candlestick charting
Traders can use a variety of charts. When it comes to alternative to candlestick charting, we have two main contenders;
- Line charts: It’s a line on a chart that displays security’s closing price over time. The problem of the line chart is that it does not provide important information such as open, close, high, low, price gaps, momentum changes, or distinctions in session-to-session trading range. As it does not provide any other information, attempting to formulate any trading strategy from a line chart of price action wouldn’t be a worthwhile venture.
- Bar charts: Each bar is represented by a vertical line that shows the difference between the high and the low of the period. The top is high and the bottom is low. Bar charts provide more information in comparison to line charts. It’s quickly replaced by candlestick charts as it takes greater effort to spot the directional trends and strength of momentum..
Besides Line, Bar, and candlestick charting, we have other styles representing price action, here are few of them;
- Point and figure
- Renko charts
- Heikin Ashi
Many traders use candlestick charts as it is more visually appealing and easier to interpret. You can easily compare the relationship between the open and close as well as high and low.
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.