A candlestick is composed of three parts; the upper shadow, lower shadow and body. The body is colored green or red. Each candlestick represents a segmented period of time. The candlestick data summarizes the executed trades during that specific period of time. For example a 5-minute candle represents 5 minutes of trades data. There are four data points in every candlestick: the open, high, low and close. The open is the very first trade for the specific period and the close is the very last trade for the period. The open and close is considered the body of the candle. The high is the highest priced trade and low is the lowest price trade for that period.
The high is represents by a vertical line extending from the top of the body to the highest price called a shadow, tail or wick. The low of the candle is the lower shadow or tail, represented by a vertical line extending down from the body. If the close is higher than the open, then the body is colored green representing a net price gain. If the open is higher than the close, then the body is colored red as it represents a net price decline.
Candlestick Chart Patterns
Every candlestick tells a story of the showdown between the bulls and the bears, buyers and sellers, supply and demand, fear and greed. It is important to keep in mind that most candle patterns need a confirmation based on the context of the preceding candles and proceeding candle. Many newbies make the common mistake of spotting a single candle formation without taking the context into consideration. For example, a hammer candle represents a near-term capitulation bottom if it forms after three preceding bearish candles, whereas hammer candle that forms on ‘flat’ sideways candles is basically useless. Therefore it pays to understand the ‘story’ that each candle represents in order to attain a firm grasp on the mechanics of candlestick chart patterns. These patterns tend to repeat themselves constantly, but the market will just as often try to fake out traders in the same vein when the context is overlooked. Candlestick charts tend to represent more emotion due to the coloring of the bodies. It’s prudent to make sure they are incorporated with other indicators to achieve best results. The following are some of common candlestick reversal patterns.
Hammer Candlestick
The hammer is a bullish reversal candlestick. It is one of the most (if not the most) widely followed candlestick pattern. It is used to determine capitulation bottoms followed by a price bounce that traders use to enter long positions.
A hammer candlestick forms at the end of a downtrend and indicates a near-term price bottom. The hammer candle has a lower shadow that makes a new low in the downtrend sequence and then closes back up near or above the open. The lower shadow (also called a tail) must be at least two or more times the size of the body. This represents the longs that finally threw in the towel and stopped out as shorts start covering their positions and bargain hunters come in off the fence. A volume increase also helps to solidify the hammer. To confirm the hammer candle, it is important for the next candle to close above the low of the hammer candle and preferably above the body. A typical buy signal would be an entry above the high of the candle after the hammer with a trail stop either beneath the body low or the low of the hammer candle. It is prudent to time the entry with a momentum indicator like a MACD, stochastic or RSI.
Shooting Star Candlestick
The upper shadow (also known as a wick) should generally be twice as large as the body. This indicates the last of the frenzied buyers have entered the stock just as profit takers unload their positions followed by short-sellers pushing the price down to close the candle near or below the open. This in essence, traps the late buyers who chased the price too high. Fear is at the highest point here as the very next candle should close at or under the shooting star candle, which will set off a panic selling spree as late buyers panic to get out and curb losses. The typical short-sell signal forms when the low of the following candlestick price is broken with trail stops at the high of the body or tail of the shooting star candlestick.
Hanging Man Candlestick
A hanging man candlestick looks identical to a hammer candlestick but forms at the peak of an uptrend, rather than a bottom of a downtrend. The hanging man has a small body, lower shadow that is larger than the body (preferably twice the size or more) and a very small upper shadow. For some reason, the buyers thwarted a potential shooting star and lifted the candle to close at the upper range of the candle to maintain the bullish sentiment, often times artificially. However, the truth hits when the next candle closes under the hanging man as selling accelerates.
Hanging man candles are most effective at the peak of parabolic like price spikes composed of four or more consecutive green candles. Most bearish reversal candles will form on shooting stars and doji candlesticks. Hanging man candles are uncommon as they are a sign of a large buyer that gets trapped trying to support the momentum or an attempt the paint the tape to generate more liquidity to sell into.
A hanging man candlestick signals a potential peak of an uptrend as buyers who chased the price look down and wonder why they chased the price so high.
Short-sell triggers signal when the low of the hanging man candlestick is breached with trail stops placed above the high of the hanging man candle.
There are many candlestick patterns that will help you make an informed decision on whether to buy or short sell the instrument. These were some common candlestick patterns you would see in most of the charts. So if you guys want to know more about other candlestick patterns like doji candlestick , engulfing candlestick, morning star, etc. ; keep your eyes open for the next part !
~ Pranit Bhandari