Technical analysis in stock trading considers a lot of numbers. The beauty of Japanese Candlestick Patterns is that they elegantly put those numbers into the context of market psychology.
Candlestick patterns use 4 stock parameters to associate technical analysis parameters with market psychology and forecast successful trades.
- Open price
- Close price
- Daily high
- Daily low
Candlestick patterns can tell a trader where an area of value lies. They then use this information to buy or sell a security.
As the old adage goes; trades be nimble, trades be quick, trades succeed with the candlestick. I may have just made that up… but as you read on to learn everything you need to trade nimbly and quickly in any market, you’ll start to see why the Japanese Candlestick method has been used for centuries.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Are Japanese Candlestick Patterns?
A candlestick pattern is a method of plotting any security’s price history. But rather than looking at just one data point, it looks at four to give an investor a better idea of how the market is behaving.
Instead of looking only at the market close price, a “candlestick” is made up of 4 pieces of technical data:
- The opening market price, meaning the price of a stock at the time the session opens.
- The closing market price. Similarly, the price of a stock when the session closes.
- The daily high, or the highest price that stock hits during the session.
- And the daily low. The lowest price it hits while the session is open.
Depending on an investor’s time horizon, the length of a session will vary. It could be 5 minutes, it could be the whole day.
Plotting candlesticks over time, instead of just price, paints a broader picture for investors. The value of candlestick charts is in their ability to tell an investor the current emotional state of the market. This is very useful information that goes beyond just the price of a security.
How To Read A Japanese Candlestick?
The ability to read a candlestick chart is the ability to put your finger on the pulse of the market’s psychology… to track the push and pull between buyers and sellers. When learning to read them, it helps to first understand how to construct one.
Construction of A Japanese Candlestick
A singular candlestick is a simple visual representation of what happened in the market on a given day or trading session. With the 4 data points above, they are simple to construct. Start with the open and close prices. These two values bound what’s called the real body of the candle. Imagine drawing a tall, skinny rectangle.
In this example, say the stock increased in value throughout the session. (close price > open price). Here, the close price would be the upper bound of your rectangle, and the open price would be the lower bound. Next, determine the color of the candlestick body.
The color indicates the overall direction of the price movement during the session. Green or white means a stock closed higher than it opened, a.k.a: it went up (bullish behavior). Red or black means it closed lower than it opened (bearish behavior).
The color of the candlestick is one important piece of information used to monitor the emotional state of a market. But before getting to that, we need to finish constructing the candlestick.
Next are the shadows. These lines on either end of the body resemble the wick of a candle, and this is where the chart gets its name. To create the shadows, you need the extreme high and low prices for the session. Draw a line from the upper bound of the body that extends to the high value, and to the same on the other end with the low value.
Simple, you’ve drawn a candlestick. Time to start making money, right? Not quite, we need to understand what the candlestick is telling us first.
Understanding Market Psychology Using Candlestick Patterns
Hope, greed, fear, despair… These are all human emotions that make people vulnerable to manipulation. What do they have to do with market prices?
Consider this. Your best friend is feeling intense anger or sadness about something, and thus they are in a vulnerable state of mind. You’re a good friend with high emotional intelligence, so you can tell something is bugging them. When they tell you what it is, you lend them an ear and support them through it, not manipulate them. In this situation, your friend is a little emotionally unstable, and you knew exactly what to do in order to help them re-center themselves.
The stock market may not be an individual human being, but that doesn’t mean it’s devoid of emotional instability. This is something Warren Buffet knows a thing or two about. These emotions either create resistance to price growth (bearish tendencies), or support for price growth (bullish tendencies)
The market is a giant conglomeration of human emotions, the difference is that there are no empathetic friends to console feelings of fear or despair.
In stock trading, consider the stock market your friend, and a candlestick chart is your emotional intelligence. When you plot each candlestick vs. time, patterns start to emerge. Such patterns are outlined in this article, and they are used to identify what the market is feeling on a psychological level, and when.
However, this is the stock market, not a support group. So instead of empathizing with it, use this emotional intelligence to take advantage of it when it’s in a vulnerable state.
The combination of psychological information and technical information provided by candlestick charts is what makes them so valuable. Probably why they’ve been used for centuries.
How Reliable Are Candlestick Patterns In Trading?
Let’s use another example. Think of your most annoying friend. Maybe one that flakes on plans all the time, or always has to one-up a story.
I’ll make an example out of the “one-upper.” You don’t know why, but this person always behaves in this way. Every time you’re with them, you know it as a fact that they will try to one-up whatever you just told them with a story of their own.
There is deeply rooted psychology at play here, to the point where you can very reliably predict your friend’s behavior.
This is what makes candlestick patterns so reliable, and it’s the foundation of why they work in trading.
Like your friends, some people have more predictable patterns of behavior than others. This is also the case for different types of candlestick patterns. Some tend to be more reliable than others. Example: Thomas Bulkowski, the author of “Encyclopedia of Candlestick Charts” claims that a proper “three-line strike” pattern within a downtrend predicts price increases with an 84% accuracy rate.
Why Candlestick Patterns Work in Trading?
As I said before, the market is not exempt from emotional influence. In fact, it’s a pretty telling reflection of the general public’s emotional state. Here’s an abstract thought, the market has its own “self-esteem”. And when placed in a certain environment, this self-esteem will dictate the market’s behavior. The chart below draws a parallel to our one-upping friend:
| Stage in Model | Human Interaction | Market Interaction |
|---|---|---|
| Identify the environment | You’re at a party with your annoying, “one-upping” friend. | The market is in an uptrend. |
| Identify the trigger | Someone tells a story. | Shooting star pattern or bearish engulfing pattern. |
| Emotional State | Your friend compulsively feels the need to boost their self-esteem by “having been there or done that.” | Seller pressure starts to overtake buyer pressure. |
| Behavior follows | Your friend immediately one-ups the story. | Bearish reversal possible, prices may decline tomorrow. |
| Enter the trade | Listen to your friend babble for a bit, and determine if their story adds any value to your life. | Check with your technical analysis to see if you’re in an area of value. If so, set a “take-profit” and a “stop-loss” for tomorrow’s trading session. |
| Exit the trade | If it does, stay and listen. If it doesn’t, walk away and get another drink. | Depending on your risk tolerance, you’ll make money when the take-profit hits, or lose money when the stop-loss hits. |
This is why candlestick patterns work in trading. They use technical analysis to let the numbers describe the market’s behavior. They provide two pieces of information that become extremely valuable when united:
- The current emotional state of the market
- The behavior that this state tends to trigger
When Candlestick Charts Don’t Work?
In isolation, a single candlestick pattern is not worth much in terms of reliability. Considering any given candlestick pattern becomes valuable when the pattern is placed in the historical context of the market.
Imagine someone tells you, “I’m angry”. Great, good information, now what? It typically doesn’t mean much on its own. So you might ask, “what happened to make you angry?”
That anger will drive behavior. Say this person tends to get into fistfights when they’re angry. They’ll typically just throw fists instead of telling you they are angry. The goal here is to avoid getting punched. To do this you need to piece together three pieces of information:
- His behavior: What he tends to do when he’s angry.
- Your behavior: How you can avoid the impact of this behavior?
- Situational Awareness: What triggers his anger.
On their own, each piece of information is useless. It’s hard to know what to do if someone’s angry when you don’t know how they act when angry. And even if you do have this knowledge, you still need to know when to implement it.
The same thing goes for the market. With these three pieces of information, you can avoid getting punched in the face (trade loss) by knowing to duck (sell) when you see the trigger of angry behavior (bearish reversal).
How To Improve The Reliability Of Candlestick Patterns?
A candlestick pattern by itself doesn’t mean much, but in the right context, it can be used to identify areas of value in the market.
Understanding the current market environment will increase the reliability of a candlestick pattern. Chart patterns, volume, and RSI divergence are all technical analysis parameters that describe the market environment. Now, instead of an angry friend’s behavior, we are tracking the moody market’s behavior. In doing so, the candlestick patterns will take on meaning as triggers of bearish or bullish behavior.
Knowing the market is in an uptrend or a downtrend will put the pattern in context and give it meaning.
- Uptrend: higher highs, higher lows
- Downtrend: lower highs, lower lows
Evaluating the candlestick chart over time will allow for patterns of support and resistance to emerge. Prices are in a constant ebb and flow between bearish resistance to growth and bullish support for growth. Observing this ebb and flow over time allows a trend to emerge.
For example, a bearish engulfing pattern in an uptrend is a sign of growth resistance. In the right context, this could indicate a drop in price over the next few trading sessions.
If in the same uptrend we see a bullish continuation pattern, chances are the prices will continue to rally.
Candlestick patterns become more reliable when charted along with support and resistance lines. These lines can be used to identify areas of value on the stock chart. It’s within these areas of value that candlestick patterns become a more reliable way to identify trade entry points (where to buy or sell).
In order to identify areas of value, it pays to be knowledgeable in reading overall chart patterns. These patterns will give candlestick patterns the context they need to be so reliable.
Candlestick Patterns and Chart Patterns
Chart patterns, like candlestick patterns, will indicate either a market continuation or a market reversal. A continuation candlestick pattern within a reversal chart pattern will not be as reliable as a continuation candlestick in a continuation chart pattern. There are tons of different market patterns, but we’ll only outline a few examples here. Particularly how they can be related to candlestick patterns.
- Head and shoulders pattern (reversal)
- Cup and Handle pattern (continuation)
- Wedge Pattern (continuation)
- Descending Triangle (continuation)
Any given chart pattern has a trade-entry point. When the market is in one of these patterns, candlesticks can be used to identify them.
Head and Shoulders Pattern
A common bearish reversal chart pattern is the head and shoulders pattern. Knowing you are in this pattern will improve the reliability of the candlestick patterns observed within. Coming off an uptrend, prices peak and begin to drop until they hit the previous market support line, aka the “neck” line. This creates the “left shoulder”.
A bullish reversal candlestick pattern here could indicate the formation of the “head,” an increase in price past the previous left shoulder resistance line. A bearish reversal candlestick pattern here can indicate the top of the head, and you may expect prices to decline back to the neckline.
Prices bump up one more time but round out near the same resistance line that the left shoulder hit, and then continue trending down.
The head and shoulders chart pattern is an area of value for those who can identify it. Witnessing a left shoulder, a head, and then a right shoulder will increase the reliability of a bearish continuation candlestick pattern at the end of the head and shoulders pattern. Depending on your trading goals and time horizon, this could be an indication for you to short or sell.
Cup And Handle Pattern
A cup and handle chart pattern is a market continuation pattern that can boost the reliability of an observed candlestick pattern. In an up-trending market, prices will hit some resistance, which may be indicated by a bearish engulfing candlestick pattern or a shooting star. They then begin to drop in a parabolic shape, rounding out near a previous market support line, and rising back up to the initial resistance line.
On a chart, this makes a “cup” shape, and its key indicator is that the shape of the curve is round. When the cup reaches the initial resistance line again, prices swing back down in a linear fashion. This makes the “handle.”
The handle will decline until it meets new support and eventually reverses. The existence of this cup-and-handle continuation pattern may increase the reliability of a bullish reversal candlestick pattern in the “handle”.
Wedge Pattern
A symmetrical triangle, or wedge, is another market continuation pattern that tends to indicate continuation in either a bearish or bullish trend. This pattern exists when a support line and a resistance line appear to be converging on one another. Again, observing this pattern is another variable you can use to increase the reliability of a candlestick pattern.
For instance, in an uptrend, a bullish continuation pattern at the tip of a wedge pattern will be more reliable than a bullish continuation pattern that’s alone in space.
Descending Triangle Pattern
A descending triangle pattern is another continuation pattern. This one is bearish in nature. When observed in a downtrend, this pattern could be a good indication to short a stock. Like the wedge, support and resistance lines are converging on each other, however, the slope of the support line is relatively flat.
The downtrend will bounce off this support line until hitting resistance. As time goes on, the price level of this resistance line decreases, so the resulting support and resistance lines make a “triangle”.
This chart pattern is another area of value, and the candlestick patterns within can indicate when to enter your trade. Typically, the entry point for a trade here is after the price breaks through the support line. A bearish continuation pattern as prices break through the support line can indicate a good entry point for a short deal.
Candlestick Patterns and Volume
Volume is another market parameter that can put candlestick patterns into context, thus improving their reliability. As we’ve already learned, the trend in which a candlestick pattern emerges is what gives it meaning.
Volume is the total amount of trades that are exchanged during a given trading period. Consider volume as the momentum of a trend. As volume increases, a trend, up or down, is generally considered healthy.
Declining volume, on the other hand, indicates uncertainty amongst buyers or sellers. Fewer people are trading at the given price, which could be a sign of resistance or support, depending on the trend.
Volume is also useful to identify the overall chart patterns above, giving you more confidence when you see the right candlestick pattern in an area of value. Consider the following example using a wedge pattern:
A strong uptrend is confirmed by high trading volume. You then think you observe a wedge continuation pattern start to form. As the shape of the wedge evolves, look for decreased volume to confirm the wedge pattern. Now that you’re confident it’s a wedge pattern, look for a bullish reversal pattern right around the support line that makes up the bottom of the wedge.
Now, this could just indicate another bounce within the wedge, but here is where volume comes in. If that bullish reversal candlestick pattern aligns with a relatively higher volume, chances are the prices will break out of the wedge and continue to rally.
So again, volume is another variable that can be used to boost a candlestick’s reliability by putting it into context.
Candlestick Pattern and Divergence/RSI
A security’s Relative Strength Index (RSI) is a technical analysis parameter that can be used to indicate when a share is overbought or oversold. RSI is a calculated index between 0 and 100. Anything between 30 and 70 is considered normal, and anything above 70 (overbought) or below 30 (oversold) is considered divergent.
The RSI is an indication of how quickly a price is growing or dropping. So, while RSI is between 30 and 70, whatever the current trend, it’s a relatively stable one. An RSI above 70 means that prices increased quickly, and vice-versa for an RSI below 30. This is what is meant by “RSI divergence.”
According to Fidelity, RSI divergence can be a signal of a market reversal.
“If underlying prices make a new high or low that isn’t confirmed by the RSI, this divergence can signal a price reversal.”
Now, here’s where RSI can boost the reliability of a candlestick pattern. If you observe a candlestick reversal pattern alongside RSI divergence, then this strengthens the candlestick’s indication of a reversal.
Types Of Candlestick Patterns
There are many different types of candlestick patterns, and we cover most of them in standalone articles. However, it is important to have an understanding of the above technical analysis parameters in order to use them reliably.
Although there are many patterns, each will indicate one of two things.
- Reversal
- Continuation
Reversal Candlestick Patterns
A reversal pattern is an indication of when a market trend will reverse. If a reversal pattern is seen in an uptrend and confirmed by other technical analysis tools, then expect prices to start falling. And if a reversal pattern is seen in a downtrend, then expect prices to start rising. Some reversal patterns include:
| Candlestick Pattern (Bearish/Bullish) | Reliability |
|---|---|
| Three Black Crows/Three White Soldiers | Strong |
| Bearish Engulfing/Bullish Engulfing | Reliable |
| Three Inside Down/Three Inside Down | Weak |
Continuation Candlestick Patterns
A continuation pattern is the opposite of a reversal pattern. These patterns can be read as an indication that the market will continue to trend in its current direction. This could be useful for setting dynamic take-profit criteria. As you approach your take-profit limit and all patterns point to trend continuation, it may be worth adjusting your exit criteria.
| Candlestick Pattern | Reliability |
|---|---|
| Concealing Baby Swallow | Strong |
| Doji Star | Reliable |
| Inverted Hammer/Hanging Man | Weak |
Indecision Candlestick Patterns
Indecision candlestick patterns indicate equal buyer and seller pressures. When placed within a given trend, they can indicate that a change to the trend is coming. Two of the most notable indecision patterns are the Spinning Top and the Doji pattern.
The Doji indicates that the security opened and closed at the same price, and the high shadow is as large as the low shadow. This indicates equal and opposite pressure from buyers and sellers. When placed within a trend, this could be a sign of impending change.
The Spinning Top looks similar to a Doji in that the body is just about in the middle of the high and low shadows. The difference is that it does have a real body. Meaning the stock opened at a slightly different price than it closed.
9 Steps To Trade Using Candlestick Patterns
Alright, you’re now a market psychologist and understand some fundamental technical analysis parameters. Now how to use this knowledge to start making money.
Identify Candlestick Pattern
First thing’s first, you need to spot and identify which candlestick patterns you are observing. You could be looking for single or multiple candle patterns. As your knowledge and experience grow, you’ll start to anticipate certain patterns depending on what the market is doing.
Determine Market Psychology
Once the candlestick pattern is identified, determine the psychology it represents. Resistance to price growth or support for price growth?
Formulate Trade Direction Hypothesis
Consider the trend that this candlestick pattern exists within. Is it an uptrend or a downtrend? Then consider where the candlestick pattern occurs in relation to support and resistance lines. Does it indicate the existence of a chart pattern? These two pieces of information will confirm the strength of the candlestick’s psychology and forecast the price direction.
Use Other Trading Tools to Confirm Trade Direction Hypothesis
Using other technical analysis tools like the ones mentioned earlier will support or disprove your trade direction hypothesis. Remember to consider:
- Overall Chart Patterns
- Trading Volume
- RSI divergence
If these all check out, then it’s time to trade.
Determine Trade Entry Point
If you’ve identified a chart pattern that you’re familiar with, then you already know where the trade entry point should be for that particular pattern. For example, a reversal at the end of a cup & handle pattern.
So, at this point, you’ll need to be on the lookout for a candlestick pattern that represents the entry point of the particular chart pattern.
Determine Stop-Loss Target
Always remember to set a stop-loss target. This number will vary based on your risk level, but exiting a trade when you know you’ve lost is just as valuable as exiting a trade that you’ve won. This is what sets technical traders apart from gamblers.
Determine Take-Profit Target
Again, this value will also vary depending on your risk level. A good rule of thumb is slightly above a previous line of resistance or below a previous line of support depending on which direction you’re trading.
Enter Trade
When the candlestick pattern that indicates your entry point emerges, enter the trade. This will either be a buy or a short. Be sure to set your stop-loss and take-profit levels at the outset.
Exit Trade
The stop-loss and take profit will automatically handle your trade exit. As the price hits your take-profit or your stop-loss limits, it’s time to sell.
Advantages and Limitations of Trading Candlestick Patterns
This article outlines the pros and cons of trading candlestick patterns. They are summed up in the table below:
| Advantages | Limitations |
|---|---|
| Elegantly blend technical analysis with market psychology on one chart | Do not work in isolation |
| Works for any type of security (stocks, bonds, cryptocurrency, futures, etc..) | Checking against other technical analysis parameters requires time and/or algorithms. |
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Conclusion
The ability to read candlestick charts has helped investors make money on trades for centuries. It is one of the oldest methods around, and when combined with modern-day technical analysis it can make for one potent trade algorithm.
Armed with the information in this article, and the cheat-sheet available to download, you’re ready to start making money trading with candlestick patterns!
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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