Introduction to Technical Analysis

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Candlesticks 101: How to read a Candlestick charts

4.6

In the previous chapter, you were briefly introduced to candlestick charts, which form the crux of technical analysis. Since candlesticks are extensively used by traders for technical analysis, in this chapter, we’ll be delving even deeper into these charts.

Bullish and bearish candles

You remember the basic structure of a candlestick, don’t you? Let’s use that to understand the different types of candlesticks. We’ll take up some theoretical values for the opening, lowest, highest, and the closing price of a stock and try to draw a candlestick for this data.

Opening price = Rs. 120

Lowest price = Rs. 100

Highest price = Rs. 160

Closing price = Rs. 150

The candlestick for the given data would look like this.

The candle is represented in green because the closing price of the stock is more than its opening price. This is also known as a bullish candle.

Now, let’s also take up a case where the closing price is lower than the opening price.

Opening price = Rs. 150

Lowest price = Rs. 100

Highest price = Rs. 160

Closing price = Rs. 120

Based on the given data, the candlestick would look something like this.

The body is represented in red, indicating that it is a bearish candle.

Here’s a fun fact for you. Most charting platforms and services give you the option to change the colours of the charts to represent these two types of candlesticks. You could change the colour from green to white to indicate bullishness, and from red to black to indicate bearishness.

Now that you’ve gotten a grip on candlesticks, we’ll move on to candlestick patterns and try to understand them.

What are candlestick patterns?

The patterns generated by candlesticks are merely price movements of a particular stock, which are then used as indicators or signals for trading in the said stock. Candlestick patterns have the ability to predict future price movements using the historical price and the volume data of a stock. Here’s a closer look at the different candlestick patterns that you’re likely to encounter during technical analysis.

Patterns based on the size of the candlestick body

As we discussed before, the body of a candlestick represents the opening and the closing price of a stock. The longer the body of the candlestick, the larger the movement of prices.

• A long bullish candlestick body indicates that the prices are rising quickly, which again is an indication of increasing buying interest (demand) for the stock.
• On the contrary, a long bearish candlestick body indicates that the prices are falling quickly, which means that the selling interest (supply) is growing.
• If the size of a candlestick body gradually increases over a period of time, it may be an indicator of the formation of a trend. The trend can either be bullish or bearish, based on the movement of the candlesticks
• The bullish or bearish trend is said to come to an end when the size of the candlestick body shrinks over a period of time.

Here’s an example of a trend formation on the candlestick charts, where the height of the body gradually increases.

And here’s an example of a candlestick chart where the height of the body gradually decreases.

When the size of the candlesticks remain consistently small over a period, the prices tend to generally be stable because the buyers and sellers of the stock are evenly matched.

If the patterns shift from long bearish candlesticks to long bullish candlesticks within a short period of time, it may be construed as an indicator of an abrupt reversal in the trend.

Patterns based on the length of the candlestick shadows

As we’ve already seen in the previous chapter, the candlestick shadows represent the price range of a particular stock.

• When the upper and lower shadows of a candlestick are significantly longer, it signifies uncertainty in the market. It essentially means that the buyers and sellers are strongly competing against each other, with neither side being able to dominate the other.
• Similarly, shorter upper and lower shadows of a candlestick are indicators of stability. This means that both the buyers and the sellers are in balance with each other.
• The length of the shadows are almost always short in the event of a prevailing trend (whether bullish or bearish). Since a trend is essentially one side gaining the upper hand against the other, there’s no uncertainty in price movement of a share.

Here’s a relevant example.

Also, at the end of a prevailing trend, you can see the length of the shadows increase. This increase indicates that the buyers and sellers are battling it out for control and that there’s uncertainty in the price movement of the stock.

Patterns based on the body-to-shadow ratio

In the event of a strong bullish or a bearish trend, the body of a candlestick is often longer than its shadows. This is primarily because during a strong trend, the stock prices tend to either close near its highs or its lows, depending on the trend. Due to this, the candlestick is left with either a small shadow or in some cases, no shadow at all.

Here’s an example of one such market phase.

On the other hand, when the trend weakens, the shadows tend to get longer than the body of a candlestick.

Also, when a stock is trading sideways or when it is facing a trend reversal, the candlestick is usually characterised by short bodies and very long shadows. This effectively means that there is uncertainty in the market and that the buyers and sellers have reached a balance.

Wrapping up

These are the basic patterns that you’ll see. But when you get a bit deeper into the subject of candlestick charts, you’ll notice that many patterns often tend to repeat over time. These patterns can be formed by a single candlestick or by multiple candlesticks. In the upcoming chapters, we’ll see some of these popular patterns and what they mean for traders.

A quick recap

• A bullish candle is represented in green because the closing price of the stock is more than its opening price.
• A bearish candle is represented in red because the opening price of the stock is more than its closing price.
• Most charting platforms and services give you the option to change the colours of the charts. You could change the colour from green to white to indicate bullishness, and from red to black to indicate bearishness.
• The patterns generated by candlesticks are merely price movements of a particular stock, which are then used as indicators or signals for trading in the said stock.
• The longer the body of the candlestick, the larger the movement of prices.
• When the upper and lower shadows of a candlestick are significantly longer, it signifies uncertainty in the market.
• In the event of a strong bullish or a bearish trend, the body of a candlestick is often longer than its shadows.
• Also, when a stock is trading sideways or when it is facing a trend reversal, the candlestick is usually characterised by short bodies and very long shadows.