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Candlesticks were believed to be used by the Japanese as far back as the mid 1700's to trade 'Rice Contracts', what was believed to be one of the earliest commodities markets. Steve Nison is credited with bringing the techniques of candlesticks to the attention of 'Western' traders through his book, 'Japanese Candlestick Techniques'. In terms of chart information, Candlestick charts give no more data than conventional bar charts, however, by reconstructing the data in a different format, certain patterns are more readily identifiable. Candlestick charting is particularly useful in short term trading and for locating the ends of trends. In this sense, new traders to Candlestick charting will probably find the biggest use for candlesticks in closing their positions, i.e. Buying or selling stock having recognised the trend has now finished. The end of a trend is known as a 'reversal pattern'. This is poor terminology as it suggests that the trend is now going to go in the reverse direction from whence it came. This is not the case. Reversal patterns really mean that the trend that was in place has now come to an end. Candlesticks can also be used to recognise 'Continuation Patterns' or patterns that suggest that the trend still currently exists and it will continue, however, the power of candlesticks really lies in their ability to locate short term reversal patterns. Like all stock chart patterns, candlestick patterns provide a picture of the market's psychology. They give an indication of what the market is thinking up until the time of the pattern formation and from this, an indication of the likely price movement as a result of this thinking.
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Before we begin examining candlestick patterns, it is important to first understand the construction of a candlestick chart. In many ways, candlestick charts are similar to conventional bar charts. They can be plotted for almost any time period (for which data is available) as well as providing information on open, high, low, closing price and volume. A candlestick differs to a conventional bar in that it has a 'body' and a 'shadow'. The body is the wide part of the candlestick (coloured black or white) and the shadow is the thin black line on the candlestick found at either end of the body. |
The following rules demonstrate how to construct a single candle for a price point:
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For example, if the data for our period was:
The candle is constructed as follows:
| Rule 1: |  |
A box has been made between the open and close prices. |
| Rule 2: | |
The open price is less than the closing price so it remains white. |
| Rule 3: |  |
The high price is higher than the top of the body so it is extended upwards with a thin line. The low price is lower than the bottom of the body so it is extended downwards with a thin line. |
Taking a second example:
The candle is constructed as follows:
| Rule 1: |  |
A box has been made between the open and close prices. |
| Rule 2: |  |
The close price is less than the open price so it is coloured black. |
| Rule 3: |  |
The high price is equal to the top of the body so nothing is done. The low price is lower than the bottom of the body so it is extended downwards with a thin line. |
Candlesticks will naturally come in various shapes and sizes. All candlestick shapes have their own name. The following section shows the different names but it is important to remember that the shapes given in the examples are near perfect shapes. In real life trading situations, each candlestick will not look exactly the same as the given examples, but will at least look similar. The closer to the 'perfect candle' the real life candle appears, the more significant its meaning.
The most common type of candle - medium size real body (compared to other candles in the chart) and reasonable size shadows (may have none at all). There is no real trading signal when this candle is identified on its own.
Like most of the single candles, their usefulness is increased greatly when they are found as part of a larger overall pattern (at least a two or three candle pattern). However, the long candles can act as an excellent breakout signal, especially if the stock is making a new high (in the case of the long white candle) or a new low (in the case of the long black candle). The psychology behind the candles is very simple. In the case of the long white candle, the market began the period at a low. With the bulls in control for nearly the entire period, the candle finished near the high. The longer the white candle, the more strength the bulls have shown and the shorter the shadows, the more control the bulls had throughout the day. Similarly, the reverse applies for the long black candle with the bears being in control.
There is not a great deal of trading signals that are generated by short candles on their own. However, their presence suggests uncertainty and could indicate a reversal in trend.
When talking of 'long' or 'short' candles, it is usually in reference to those candles surrounding it. For example, a long candle on one chart may not be a long candle on another chart because ALL of the candles on the other chart are long (or 'normal size'). As Einstein once said, "It's all relative!" The point of defining long and short candles is so that they may be identified singularly amongst other candles of differing size.
The Marubozu (or shaven candles) are similar to the long candles in that the buyers/sellers are in control. The difference with the Marubozu is that the buyers/sellers were in control for the ENTIRE period. In the case of the White Marubozu, the buyers were in control from the very first trade right up to the last trade. This is evidenced by the price of the security starting at the low of the day and finishing at the high. A similar logic applies to the Black Marubozu.
Two sub-classes of Marubozu exist - the open and the closing Marubozu. These candles are the same as the conventional Marubozu only the opening Marubozu has no shadow on the opening price side of the candle but does on the closing side and the closing Marubozu has no shadow on the closing price side of the candle but does on the opening price side. Both sub-classes are not as strong as the conventional Marubozu because the bull or bears were not in control for the entire period. However, with only a shadow at one end of the candle, they provide a stronger signal than the long white/long black candles.
The doji candles are distinguished by their very small real bodies. The ideal doji has no real body at all, i.e. the opening and closing price are equal. The shadows can be of varying length but for the conventional doji's shown, the shadow is of reasonable size and the lower shadow is roughly equal in length to the upper shadow. The interpretation of a doji is UNCERTAINTY. With the market starting at an arbitrary price, the stock then trades higher/lower. The market reverses its decision and the stock trades lower/higher, trading back through the opening price to an equal amount in the other direction. Again this direction does not continue and the market reverses again and finishes at, or very close to the opening price. There was no overall price change for the period, just some traders opening new positions and closing old ones. The market is uncertain in which direction to take the stock. That said, the trader should be cautious for a reversal in trend.
These doji's have the common factor of all having their opening price equal to the closing price but each has a different shadow in relation to the open/close price. The long legged doji (or Rickshaw man as it also known) is the same as a conventional doji only its shadows are longer. By the market taking the price to further extremes away from the opening/closing price, it just adds to the rationale that there is uncertainty present in the market. The four price doji is the opposite of the long legged doji in that it has no shadows at all. The four price doji is very rare and is usually only found in stocks that trade low volume. It derives its name from the fact that it is formed when the open, high, low and close price are equal. The four price doji also represents uncertainty and the trader should look for a change in trend.
The Gravestone doji and Dragonfly doji are slightly different in their interpretations from the other dojis. The dojis examined so far are interpreted by the trader as the market showing uncertainty and to be cautious of a change in trend. The gravestone and dragonfly also show there is uncertainty but also show in what direction the trend reversal it likely to be. For the gravestone doji, the buyers begin the day in control and push the market to the high of the day. At this point the sellers take control and push the stock back to the opening price which is also the low of the day. In other words, because the market finished at a low, the sellers were in control at the close (the most important part of the day). Therefore, if a gravestone doji is found at the top of an uptrend, it is quite likely that the uptrend is about to finish. Similarly, the same logic can be applied in reverse to the dragonfly doji. The sellers are in control at the start of trading but more importantly, the buyers are in control at the close of trading. If found in a downtrend, the dragonfly doji is a strong signal that the trend is about to finish. For the dragonfly and gravestone doji, the longer the shadows, the more uncertainty there is in the 'wrong' direction and the stronger the buyers/sellers had to be at the end of trading to return the stock to the opening price. In other words, the longer the shadows, the stronger the reversal signals.
Spinning tops are characterised by small real bodies and both upper and lower shadows that are longer than the real body. With this description there appears to be little difference between the spinning tops and the doji. The fact is that there isn't a great deal of difference. The spinning top has a larger real body than the doji but the interpretation is the same. Spinning tops represent uncertainty. The market was unable to significantly move the price in one direction or another with the overall result being unimportant. The pattern is often found at the end of trends. If found during a trend, it does not necessarily represent a strong signal that a reversal is likely to occur but it can show that the strength of the trend is weakening.
Hammers have a small real body, their lower shadow is more than two times the length of the real body, there is no (or very little) upper shadow and a hammer can only be found in a downtrend. The hammer is a bullish signal and their interpretation is not unlike that of the dragonfly doji. As the stock is trending down, the sellers are in control. When the hammer occurs, the bears begin the trading session in control but lose control at the low of the day. The bulls then take control and are indeed strong enough to return the stock up to near the opening price. The length of the shadow (having to be more than twice the length of the real body to be interpreted as a hammer) shows the strength that the bulls had and how much control the bears have lost. Confirmation of the hammer occurs if the stock begins to trend up. The smaller the real body and the longer the shadow, the more important the signal. The colour of the hammer is not all that important but a white hammer shows the bulls were slightly more in control than with a black hammer. (More important is the length of the lower shadow). Also, the signal is stronger if there is a gap between the top of the hammer and the candles immediately before and after the hammer candle. This gives the hammer a very strong similarity to a bullish 'island reversal'.
The Inverted hammer is an 'upside down' hammer. It must still have its shadow (an upper shadow, not lower) at least twice as long as the real body and the inverted hammer may only occur in a down trend. The inverted hammer signal is not as strong as the conventional hammer because the buyers are in control at the beginning of the period and the sellers are in control at the end (not ideal conditions for a bullish reversal pattern). However, the long upper shadow suggests that the market is willing to test higher prices and although the bears eventually won the trading session, traders should be cautious that there are some strong bulls present who are willing to go against the current downtrend.
The shooting star actually refers to the single, central candle in the formation. The other lines are there to show that the shooting star only occurs in an uptrend and there must also be a gap between the base of the real body of the star and the top of the real body of the candles either side of the shooting star. (Note that in bar chart analysis, for an island reversal formation to occur, it was necessary for there to be a gap in the entire range of the bars. With shooting stars, it is only necessary for there to be a gap between the real bodies). With the exception of the gap, the shooting star is very similar in both formation and interpretation to the hammer (only in reverse). A shooting star only occurs in an uptrend and the buyers remain in control at the beginning of the trading session. A long upper shadow occurs (the length must be at least twice that of the real body) which shows the bulls have strength, however, the bears finally gain control at the high but work with such force that they are able to push the stock firmly down to a price region where the trading session began. A confirmation of the reversal pattern is given if the real body of the candle in the next trading session gaps down. The smaller the real body and the longer the shadow, the more important the signal. The colour of the star is not all that important but a black star shows the bears were slightly more in control than with a white star. (Again, more important is the length of the upper shadow).
The hanging man could be considered the 'inverse shooting star'. Again the hanging man occurs during an uptrend and acts as a bearish signal warning of a downward trend. There is a requirement for a gap between the real body of the hanging man and the two candles either side of it and confirmation is only given when this second gap occurs. The hanging man is not as stronger signal as the shooting star but during the uptrend, there is a clear desire by the bears to test the market (evidenced by the long shadow which must be at least twice as long as the real body to be classed a hanging man). This shows there is uncertainty in the market. However, the bulls are in control at the end of the formation of the hanging man. This is why the trader must wait for confirmation from the downward gap in the next trading session before acting on the signal.
The previous examples were of candlesticks that occur on their own yet were still able to generate a trading signal. The following examples are of candlestick patterns that require two or more candlesticks. They are usually stronger signals than those signal candles that occur on their own.
The engulfing pattern is a two candle reversal pattern. The bearish engulfing pattern occurs in an uptrend. The first candle of the engulfing pattern is a final 'upthrust' of the bullish trend. The following day, the second candle opens higher than the close of the first day (in the pattern) and closes lower than the open of the first day. The real body of the second candle then looks as if it has 'engulfed' the real body of the first candle. It is important to remember that the shadows are irrelevant in the engulfing patterns, it is only the real bodies we are concerned with. Note that the engulfing pattern is similar to the key reversal which required the second day to open lower than the low of the first day and close higher than the high of the first day. Herein lies a difference between candlestick analysis and conventional bar analysis. In candlestick charting, the opening and closing prices (the real bodies) carry more significance than the highs and lows. However, the interpretation of a key reversal and an engulfing pattern remains the same. In the first candle, the up trend continues and the buyers are in control. At the beginning of the next trading session, the buyers are only in control for a short period of time. The sellers soon capture control and maintain control throughout the trading session, finishing the stock near its lows and less than the opening price of the previous day. The bears are now firmly in control and a change in trend is likely.
Similarly with the bullish reversal, it is found in a down trend and signals a change in trend. In the first candle, the bears are in control (as evidenced by the black candle and the down trend preceding it. The following trading session sees the bears have immediate control (it opens near the low of the trading session and less than the close of the previous trading session) but this is quickly captured by the bulls who push the stock back up past the previous days open and close the stock near the highs. The bulls are now firmly in control.
The engulfing patterns are excellent reversal patterns and as stated before, mirror the patterns of a key reversal. They are more effective when the second candle is long and has little or no shadows (Marubozu is ideal). Importance of the signal is also increased if the first candle has a very short body, showing the uncertainty in the market before the confirmation of the change in trend (Doji or spinning top is ideal).
The Piercing Pattern is a bullish pattern that forms in a down trend. It is formed when the first candle of the pattern forms a long black candle and the second candle forms a long white candle. This is similar to the engulfing pattern only it is not required that the real body of the second candle engulf the real body of the first. However, with the piercing pattern, the second candle is required to close at least half way past the midpoint of the first candle's real body if it is to be classed as a piercing pattern. Formation of a piercing pattern suggests a change in trend.
The piercing pattern is not as strong as the engulfing pattern but it works on the same principle. The first candle shows that the bears who have created the down trend are still in control of the market. At the open of the second trading session of the piercing pattern, the bears are still in control (it opens lower than the close of the previous session) but the bulls quickly capture control and push the stock up where the it finishes near the high of the trading session and higher than the midpoint of the previous sessions real body. This last criteria is the big difference between the piercing pattern and the bullish engulfing pattern. The bears are in fairly good control at the end of the second sessions trading yet they are not so much in control as to push the stock up past the open of the previous session (and this is also why the signal is not as strong).
The signal gains importance the longer the second real body becomes and the further it extends upward (without it becoming an engulfing pattern).
Dark cloud cover could be considered the bearish equivalent of the piercing pattern. It is formed when the first candle of the pattern demonstrates the bulls are continuing the up trend and a long white candle is formed. The second candle opens higher than the close of the previous session showing the bulls are still in control at the beginning of the session (the top of the real body of the second candle is higher than the top of the first) but the bears quickly capture control and the stock finishes near the lows of the session. Herein lies a key difference with the piercing pattern. Convention has it that the dark cloud cover is not required to close (or penetrate) more than half way through the real body of the first candle. To form dark cloud cover it is only necessary that the second candle penetrate somewhere within the real body of the first candle. The more it does penetrate (without it becoming an engulfing pattern) the stronger the signal is.
Like the piercing pattern, dark cloud cover is not as strong as its engulfing pattern cousin as the bears are not as forceful and commanding in the second candle.
Harami patterns could be considered the opposite of an engulfing pattern. They are formed either at the top or the bottom of a trend and suggest that a change in trend is about to occur. The bearish harami is formed during an up trend. The first candle of the pattern is a long white candle that will form the last strong move of the trend. The second candle is a smaller candle that is engulfed by the first. Although the harami's shown here have been drawn with black and white second candles (respectively) the colour of the second candle in a harami formation is not particularly important.
The rationale behind the harami is that it is able to identify uncertainty in the market immediately following a very strong move. Instead of locating uncertainty and then a price movement to the opposite direction as with the engulfing, piercing and dark cloud cover patterns, the harami patterns first locate the strong trend and then the uncertainty. In this sense it is not a strong signal and the resultant price movement is usually just a relaxing of the trend (perhaps into a sideways trend) rather than an abrupt change in direction.
The pattern carries more significance the longer the real body of the first candle (Marubozu is ideal) and the shorter the real body of the second candle (doji or spinning top is ideal). Harami patterns in which the second candle is a doji are often given the name 'Harami Cross'. As stated previously, the colour of the second candle is not particularly important but if it carries the colour opposite to that of the first candle, it is perhaps a slightly stronger signal that a reversal is about to occur.
The morning star and evening star are 'three-candle' patterns that can act as very powerful reversal patterns. The evening star is formed in an up trend beginning with a long white candle as the first candle. There is then a gap between the top of the real body of the first candle and the bottom of the real body of the second candle. The second candle may be of any colour. The third candle is a black candle that opens below the open of the second candle, it does not require a gap between its real body and the second candle. However, if a gap does occur, it becomes an even more powerful signal. The third candle is not required to be of any particular length but candlestick analysts believe the third candle should significantly penetrate into the real body of the first candle for increased effectiveness.
The psychology of the pattern is similar to that of a bearish island reversal. A long white candle signals the bulls are in control and maintaining the up trend. The gap to the star and the subsequent small body of the star suggests the bulls are beginning to lose control. Confirmation of this occurs the following day with a black candle.
The signal is stronger if there is a significant gap between the star and the first and third candles, the third candle is a long black candle (ideally Marubozu) and the real body of the star is small (ideally spinning top or doji). The colour of the second star is not important but a black star would indicate that the bears have slightly more control than if a white star had formed. If the second candle is in fact a doji, the overall pattern is often referred to as an 'evening doji star'.
The morning star is just the reverse of the evening star. It is formed during a down trend and can act as a very powerful reversal signal with the reversal often being a complete change in direction of the trend. It begins with a long black candle as the first candle. There is then a gap between the top of the real body of the first candle and the bottom of the real body of the second candle. The second candle can be of either colour, it is only important that it has a small real body showing that uncertainty has crept into the market. The third candle is a white candle that opens above the open of the second candle. There does not have to be a gap between the real bodies of the second and third candles but a particularly powerful reversal signal is given if this is indeed the case. Further strength is given to the pattern if the third candle is a long white candle (ideally Marubozu) and the star is a spinning top or doji. If the second candle is a doji, the overall pattern is often referred to as a 'morning doji star'.
In this pattern it can be seen that the bears maintain control of the downtrend in the first black candle. The gap and the subsequent small real body star shows uncertainty in the market and the final white candle shows the bulls have taken control.
Now we've seen some various candlestick patterns, it is time to lay down some firm trading rules so we can profit from the patterns when we observe them. It is important to remember that candles are predominantly used for short term trading. Part of the reason for this is that candles are used to identify reversal patterns - the end of trends. To go against a trend is always a brave thing to do from the trading perspective. Any trader wishing to trade a reversal pattern should do so with extreme caution.
A hammer will occur in a downward trend. Traders should look for a reversal to the upside. Only act on a hammer when it has occurred in a down trend, not if it forms when the stock is trading in an up trend or trading in a range.
An inverted hammer will also occur in a downward trend. Do not act on the signal if it occurs during an up trend or if the stock is trading in a range. Its signal is not as strong as the hammer. An inverted hammer more often means a softening of the trend into a sideways pattern rather than a complete reversal of trend. For this reason, it is probably best to use the inverted hammer candle as an indicator of when to take profits on a short position rather than when to use it to buy into a position. In any case, for traders who are more risk adverse, the following outlines the basic trading strategy.
A shooting star will occur in an upward trend. It should not be traded if it occurs in a downtrend or occurs whilst the stock is trading in a range. The shooting star can act as a very strong reversal signal. Ensure the gap between the star and the trading either side is of a decent size and that the shadow above the star is of a reasonable size. The shooting star is a bearish signal so the pattern should be used to take profits in stocks already held or to open new short positions.
A hanging man will also occur in an upward trend. Do not act on the signal if it occurs during an up trend or if the stock is trading in a range. Its signal is not as strong as the shooting star but traders should still look for a reversal in trend. The hanging man more often means a softening of the trend into a sideways pattern rather than a complete reversal of trend. For this reason, it is probably best to use the hanging man as an indicator of when to take profits on a short position rather than when to use it to buy into a position. In any case, for traders who are more risk adverse, the following outlines the basic trading strategy.
The piercing pattern is a 'two-candle' reversal pattern that occurs in a down trend. Do not trade on the signal if it occurs in an up trend or if it occurs whilst the stock is trading in a range. The piercing pattern is not as strong as the bullish engulfing pattern and traders should perhaps use the signal as an indicator for taking profit rather than using it to open new positions. However, the piercing pattern is often still a reliable signal for finding an immediate up trend following a downtrend.
The dark cloud cover is a 'two-candle' reversal pattern that occurs in an up trend. Do not trade on the signal if it occurs in a down trend or if it occurs whilst the stock is trading in a range. The dark cloud cover pattern is not as strong as the bearish engulfing pattern and traders should perhaps use the signal as an indicator for taking profit rather than using it to open new positions. However, the dark cloud cover pattern is often still a reliable signal for finding an immediate up trend following a downtrend. Dark cloud cover is a bearish signal so the pattern should be used to take profits in stocks already held or to open new short positions.
The bullish engulfing pattern is a 'two-candle' candlestick pattern that occurs in a down trend. Do not trade on the signal if it occurs in an up trend or if the stock is trading in a range. The bullish engulfing pattern can be a strong reversal pattern and profitable when traded correctly. Look for particularly strong patterns where the second candle is long and white (or better still, white Marubozu)
The bearish engulfing pattern is a 'two-candle' candlestick formation that occurs in an up trend. Do not trade on the signal if it occurs in a downtrend or if the stock is trading in a range. The bearish engulfing pattern can be a strong reversal pattern and profitable when traded correctly. Look for particularly strong patterns where the second candle is long and black (or better still, black Marubozu). The bearish engulfing pattern is a bearish signal so the pattern should be used to take profits in stocks already held or to open new short positions.
The morning star is a 'three-candle' candlestick pattern that is found in a down trend. Do not trade on the signal if it occurs in an up trend or if the stock is trading in a range. The morning star is possibly the most powerful of the bullish candlestick reversal patterns and can be potentially profitable when traded correctly. Look for particularly strong patterns where the second candle is a spinning top, the gap is of a reasonable size and the third candle is long and white (or better still, white Marubozu).
The evening star is a 'three-candle' candlestick pattern that is found in an up trend. Do not trade on the signal if it occurs in an downtrend or if the stock is trading in a range. The evening star is possibly the most powerful of the bearish candlestick reversal patterns and can be potentially profitable when traded correctly. Look for particularly strong patterns where the second candle is a spinning top, the gap is of a reasonable size and the third candle is long and black (or better still, black Marubozu). The evening star is a bearish signal so the pattern should be used to take profits in stocks already held or to open new short positions.