A Beginner’s Guide to Candlestick Patterns

The Candlestick chart (also known as the Japanese candlestick chart) is a type of financial chart that describes price movements for security, derivative, or currency. The pattern is thought to have originated from a Japanese rice merchant named Munehisa Homma in the 18th century. The pattern was later introduced to the United States by Steve Nison in his book Japanese Candlestick Charting Techniques.

A Candlestick’s performance varies depending on the type. An analysis done by Thomas Bulkowski, who built performance rankings for candlestick patterns in his book, Encyclopedia of Candlestick Charts, supports this fact. So let’s take a detailed look at candlestick for easy understanding.

Understanding a Candlestick Pattern

Candlesticks show the impact of investors’ sentiments on security prices. Technical analysts use the graph to determine when to enter and exit trades. The graph is based on a technique developed in Japan for tracking rice prices. These charts are ideal for trading liquid financial assets such as stocks, financial exchange, and futures.

Candlesticks use their wider parts to display a security’s high, low, open, and closing prices for a specific period. This wider part is known as the “real body.” The real body indicates white/green if the stock closed higher and black/red if it closed lower. Long white/green candlesticks indicate significant buying pressure meaning the price is bullish.

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However, the charts must be looked at in terms of the market structure instead of individuality. For example, a long white candle has tremendous significance if it forms at a high price support level. On the other side, long black/red candlesticks indicate intense selling pressure meaning the price is bearish.

Therefore a common bullish reversal pattern known as a hammer forms when the price moves substantially lower after the opening and then rallies to close near the high. This equivalent bearish candlestick is also called a hanging man.

Bullish reversal patterns

Bullish reversal patterns must form within a downtrend. Otherwise, it is not bullish but a continuous pattern. Mostly, bullish reversal patterns are accompanied by bullish confirmation. The user must observe the bullish confirmations within three days. Additionally, bullish reversal patterns are confirmed through traditional technical analysis such as trend lines, momentum, oscillators, and volume indicators for buying pressure reaffirmation.

Bearish Engulfing Pattern

This pattern can occur anywhere, but it is more important if it occurs after a price advance. For example, a bearish engulfing pattern is seen at the end of some upward price moves. This pattern is more reliable when it follows a clean move higher.

A candlestick has lines at both ends known as shadows. Shadows show an entire range of price action for the day ranging from low to high. The upper shadows indicate the stock’s highest price for the day, while the lowest shadow shows the day’s lowest price.

Traders use candlestick signals for all trading periods, including daily, hourly, and even minute-long cycles of the trading day.

Best Way to Learn How to Read Candlestick Patterns

The best way one can learn how to read candlestick patterns is through practice. Practicing involves entering and exiting trades from the signals they give. One can develop the skills through a risk-free environment by opening a demo account. After learning through the demo account, one can open a live account and begin trading.

Although candlesticks are excellent at predicting patterns, they are not entirely reliable. Therefore, the user should use the patterns alongside other forms of technical analysis for overall trend confirmation. Let’s look at some of the candlesticks that perform exemplary well.

1. Three-line strike

This bullish reversal pattern carves out three black candles within a downtrend, followed by a final candle that pulls back to the start point. Traders use the three-line strike as an opportunity to buy at the recent low trend or sell at the recent high trend. This reversal predicts higher prices with an 83% accuracy rate, according to Bulkowski.

2. Two Black Gapping

The two black gapping acts as a bearish pattern presenting a two black gapping continuation that appears after a notable top in an uptrend. A gap appears, yielding two black bars posting lower lows. This gap predicts that the decline will continue to even lower lows. This pattern predicts lower prices with a 68% accuracy rate, according to Bulkowski.

3. Three-Black Crows

This bearish three-black crows reversal pattern starts at the high of an uptrend. Three black bars post lower lows that close near intrabar lows. Three black crows predict the decline will continue to even lower lows. The decline may trigger a broader-scale downtrend. According to Bulkowski, the Three Black Crows predicts lower prices with a 78% accuracy rate.

4. Evening Star

Technical analysts use this candlestick to predict future price reversals to the downside. Although the candlestick is rare, it is considered by the trader to be the most reliable technical indicator. This candlestick predicts higher prices with a 49.73% accuracy rate, according to Bulkowski.

Conclusion

Although candlesticks capture market players’ attention, many reversal and continuation signals emitted by candlesticks don’t work reliably in the modern electronic environment. However, statistics by Thomas Bulkowski show great accuracy for a limited selection of these patterns.

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Having gained insight from the above information on candlestick patterns to use and invest in an asset requires a brokerage account. However, choosing a brokerage account requires research and time. Therefore, before choosing a brokerage account that suits one’s needs, it is advisable to look for a list of the best online brokers for an investment.