What Is a Candlestick Pattern?

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What Is a Candlestick Pattern?

Candlestick Pattern Explained

Candlestick charts are a technical tool that packs data for multiple time frames into single price bars. This makes them more useful than traditional open, high, low, close (OHLC) barsor simple lines that connect the dots of closing prices. Candlesticks build patterns that may predict price directiononce completed. Proper color coding adds depth to this colorful technical tool, which dates back to 18th century Japanese rice traders.

Traditionally, candlesticks are best used on a daily basis, the idea being that each candle captures a full day’s worth of news, data, and price action. This suggests that candles are more useful to longer-term or swing traders.

Most importantly, each candle tells a story. When looking at a candle, it’s best viewed as a contest between buyers and sellers. A light candle (green or white are typical default displays) means the buyers have won the day, while a dark candle (red or black) means the sellers have dominated. But what happens between the open and the close, and the battle between buyers and sellers, is what makes candlesticks so attractive as a charting tool.

Key Takeaways

  • Candlestick patterns are technical trading indicators that have been used to forecast market movement for millennia.
  • There are hundreds of distinct candlestick patterns, each having a descriptive name and a corollary pattern between the upside and downside. For example, a “abandoned baby top” has a “abandoned baby bottom” corollary; “tweezer bottoms” have an upside corollary in “tweezer tops.”
  • To fine-tune their trading technique, traders enhance candlestick patterns with other technical indicators (e.g., entry, exit).
  • Candlesticks are not future indicators since they are based on present and historical price movements.

Understanding Basic Candlestick Charts

Let’s start with the fundamentals of candles so you can comprehend the many elements of a candlestick.

How to Read a Candlestick Pattern

A daily candlestick displays the opening, high, low, and closing (OHLC) values of a market. The rectangular real body, or simply body, is colored with a dark color (red or black) to indicate a price decrease and a light color (green or white) to indicate a rise in price. The lines above and below the body are known as wicks or tails, and they reflect the greatest high and low of the day. When the sections of a candlestick are combined, they may often signify changes in a market’s direction or show big prospective movements that must frequently be verified by the following day’s candle.

Image by Julie Bang © Investopedia 2019

Difference Between Foreign Exchange (FX) Candles and Other Markets’ Candles

Before we get into any particular candlestick patterns, it’s important to understand the distinction between FX candlesticks, stock/ETF/futures candlesticks, and all other candlesticks. Because the FX market is active 24 hours a day, the daily close from one day is normally the start of the next day. As a consequence, the price patterns in FX charts have less gaps. FX candles can only show a weekend gap if the Friday closing differs from the Monday open.

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Many candlestick patterns depend on price gaps to signify their strength, and such gaps should be noticed in all circumstances. In the case of FX candles, a little ingenuity is required to recognize a possible candlestick indication that does not quite match the typical candlestick pattern. In the chart below, for example, the bearish engulfing line’s body does not quite engulf the previous day’s body, but the upper wick does. Certain patterns may be identified with a little ingenuity, even though their creation is not textbook.

Examples of Candlestick Patterns

Several candlestick patterns are shown below that function remarkably well as indicators of price direction and probable reversals. Each predicts higher or lower costs based on the context of the surrounding price bars. In addition, they are time sensitive in two ways:

  • They can only function within the parameters of the chart being examined, whether it is intraday, daily, weekly, or monthly.
  • Their power quickly diminishes three to five bars after the pattern is finished.

Doji and Spinning Top

A doji (plural doji) is a candlestick shape in which the open and closure are identical or almost similar. A spinning top is similar to a doji, but with a much smaller body and virtually identical open and closure motions.

Both patterns indicate market hesitation, as buyers and sellers have essentially battled to a halt. However, these patterns serve as a warning that the hesitation will soon fade and a new price trend will emerge.

Here are some visual examples of doji and spinning tops:

Bullish/Bearish Engulfing Lines

An engulfing line is a strong signal of a shift in direction. A bearish engulfing line is a reversal pattern that occurs after an upswing. The crucial point is that the body of the second candle “engulfs” the body of the previous day in the opposite direction. This implies that, in the event of an uptrend, purchasers made a short effort to go higher but concluded the day considerably below the closing of the previous candle. This indicates that the uptrend has reached a halt and has started to reverse downward. Take notice of the previous two days’ candles, which revealed a double top, or tweezers top, which is a reversal pattern in and of itself.

A bullish engulfing line develops after a decline and is the corollary pattern to a bearish engulfing line. A double bottom, also known as a tweezers bottom, is a corollary pattern that indicates a downtrend is about to a close and is about to reverse upward.

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Hammer

A hammer indicates that a downward trend is coming to an end (hammering out a bottom).The extended lower tail suggests that sellers attempted to sell lower again, but were refused, and the price reversed most or all of the day’s losses. The key reading is that this is the first time purchasers have emerged in force during the current down trend, indicating a shift in directional mood. The following day, a bullish candle confirms the pattern.

Hanging Man

A hanging man pattern, which is a corollary to the bullish hammer formation, indicates a significant possible reversal downward. The candle represents the fact that, for the first time in many days, selling interest has entered the market, resulting in a lengthy tail to the downside. The purchasers retaliated, resulting in a little, black body at the top of the candle. Confirmation of a brief signal is provided by a dark candle the next day.

Abandoned Baby Top/Bottom

An abandoned baby, also known as an island reversal, is a notable pattern that indicates a large reversal in the previous directional progress. An abandoned baby top appears after an upward trend, while an abandoned baby bottom appears after a downward trend.

The pattern consists of a gap in the direction of the current trend, which leaves a candle with a little body (spinning top/or doji) all alone at the top or bottom, much like an island. Confirmation occurs on the next day’s candle, when a gap lower (abandoned baby top) indicates that the previous gap higher has been erased and selling interest has arisen as the main market force. The following day, Confirmation is marked with a long, gloomy candle.

Take Special Note of Long Tails and Small Bodies

Candlesticks with a little body, such as a doji, suggest that the buyers and sellers battled to a draw, with the close essentially identical to the open. (A candlestick of this kind might alternatively have a very tiny body, producing a spinning top.) Small bodies show market ambivalence about the current market direction.

This implies that such little bodies are commonly used as reversal indications, since the directional movement (up or down) may have peaked. Take careful notice of important hesitation candles, for either the bulls or the bears will finally triumph. This is the moment to sit back and monitor the price action, ready to act if the market displays its hand.

Long tails are another important candlestick indicator to look for, particularly when accompanied with tiny bodies. Long tails show a failed attempt by buyers or sellers to push the price in their preferred direction, only to have the price fall back to around the open. The doji pattern illustrated below represents an effort to rise higher and lower, only to end up with no change. This follows a move upward, indicating that the following move will be downward.

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Which candlestick pattern is most reliable?

Many patterns are chosen and regarded as the most dependable by certain traders. Bullish/bearish engulfing lines, long-legged doji, and bullish/bearish abandoned baby top and bottom are among the most popular. In the interim, various neutral potential reversal indications, such as doji and spinning tops, will arise, alerting you to the next directional move.

Does candlestick pattern analysis really work?

Yes, candlestick analysis may be beneficial provided the criteria are followed and confirmation is obtained, generally in the following day’s candle. Candlestick analysis is used by traders all around the globe, particularly in Asia, to determine general market direction rather than where prices will be in two to four hours. That is why daily candles, rather than shorter-term candlesticks, function best.

How do you read a candle pattern?

The easiest way to interpret a candle pattern is to determine if it is bullish, bearish, or neutral (indecision).Observing a candlestick pattern develop may be both time-consuming and aggravating. If you see a pattern and have confirmation, you have a solid foundation for a trade. Take cautious not to find patterns where none exist. Allow the market to take its course, and you will ultimately get a high-probability candlestick indication.

The Bottom Line

Candlestick analysis has been around for decades and operates in the same way that other types of technical analysis do: traders follow it. Candlesticks may be used in conjunction with other types of technical analysis, such as momentum indicators, but they are ultimately a stand-alone kind of charting analysis.

Because they record a whole day of market information and price activity, daily candlesticks are the most effective method to see a candlestick chart. If you want to employ shorter-term candles, keep in mind that their meaning is only true for a few of the time periods you select—for example, a four-hour candle pattern is only useful for a few four-hour intervals.

Individual candles (e.g., doji) and multi-candle patterns such as bullish/bearish engulfing lines, bullish/bearish abandoned infants, and bullish hammers/bearish hanging man patterns are examples of candlestick signals. Candlesticks are excellent forward-looking indicators, but confirmation by consecutive candles is sometimes required before defining a particular pattern and trading on it. Candlestick patterns, in particular, regularly emit indications of hesitation, warning traders to a probable shift in direction.

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