Candlestick trading is a form of technical trading, which is somewhat subjective. Though it’s pretty popular amongst traders, and many swear by its effectiveness, does popularity equate to usefulness?
Candlestick trading can be profitable when you understand the filters needed and how to read these patterns. Of course, not every candlestick chart is helpful, but when you consider the long-term trend, market volume conditions, and perform proper backtesting, candlestick trading can benefit traders.
Read on below if you’d like to know if trading with candlestick charts is profitable and what you can do to make them work best for you. I’ll also go over the basics, including what candlestick charts are and what functions those parts serve.
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
Making a Profit With Candlestick Trading
It’s possible to profit with candlestick trading, but you need to keep in mind that many trading techniques are considered subjective – what works for one trader may not work for another.
Candlesticks aren’t necessarily any more or less reliable than any other kind of chart – at least not on their own. You’ll have to add an overlay of sorts – a filter that helps you weed out what doesn’t work, so you don’t get caught up in unprofitable patterns.
In order to fully understand how they work, it’s important you know exactly what they are and what to look for when using them.
What Is a Candlestick Chart?
Candlestick charts are thought to have been created by Munehisa Homma, a rice trader, sometime in 17th century Japan. It’s said that Homma used candlesticks to predict the future of the rice market after noticing people tended to buy according to how they felt.
In trading, candlestick charts are a visual representation of a trader’s feelings and display price movements via different colors. Traders use candlesticks as a means of spotting patterns that can predict short-term prices.
How To Create a Candlestick Chart?
Candlesticks operate off a four-part data set that shows:
- Open Price – the price at which a security starts trading.
- High Price – also referred to as “today’s high,” the highest price a security is sold at within a day (or intraday).
- Low Price – a security’s lowest intraday price (today’s low).
- Close Price – the final price during the end of a day’s trading session.
Candlestick charts are called such because they look like double-ended candles – that is to say, the “candle” has a wick on either end.
With these data elements out of the way, let us get into the various components of a candlestick, and their interpretations:
The Real Body
The candle portion of the chart is called the “real body,” which charts the price differences between a day’s open and close trading prices. If it’s colored, the close price was lower than the open, and an uncolored candle means the opposite.
Of course, you don’t have to use the same colors as everybody else, but usually, down candles are colored red, and green represents up.
The Secrets of the Shadow
The two “wicks” on either end of the candle are called shadows, and they illustrate where stock prices have changed. Shadows are placed on top of or underneath the opening and closing prices.
Thus, they denote high and low ranges throughout a particular period of time (such as a minute or two) or tick period (a measurement of the smallest up or downward move a security’s price may make).
Tall Shadows vs. Short Shadows
Candlestick trading is a form of technical trading that itself is prone to interpretation. For example, various people can look at the same chart and see five different things. This method is much the same and is open to interpretation.
That said, there are specific trends that traders follow when looking at candlesticks, and there are two general groups of candlestick observers:
- Those who think tall or long shadows mean stocks will reverse or turn.
- Those who think short or low wicks suggest prices will increase.
According to some technical traders, Tall top shadows represent coming downturns or economic declines, and tall lower (underside) shadows foreshadow an economic upturn.
Bulls and Bears
Tall top wicks happen when prices move during trade and drop; this is what’s known as a “bearish signal.” Traders that feel the market is taking a downturn are called bears, and they may actively seek to gain from drops in stock prices.
While this pessimism regarding market prices typifies bears, they can – and do – react bullishly to some markets and securities.
These kinds of signals happen when prices are continually driven down by bears and are increased again by bulls. A bull is an investor that thinks securities and the general market are about to rise.
A bull will typically buy securities with the intent to make money by selling them later at higher prices. When traders take the bullish approach, they tend to put money toward investments whose value may increase even during bearish trends.
How To Make a Profit With Candlestick Trading?
Everything mentioned above are patterns that traders subjectively identify. I’m not saying they’re wrong, but they are prone to individual interpretation.
Understanding these patterns is key to making candlestick trading profitable because the more you know and understand, the better chances you have of interpreting the candlestick correctly.
Below I’ll cover a few key features that can make candlesticks work to your advantage.
Long-Term Trend
The long-term trend is pretty much how it sounds; this filter considers what market prices will look like over a long time period – often over a year or more.
Candlesticks depend on whether you’re dealing with a bullish or bearish market. For example, about 40 weeks into the trading year (the 200-day simple moving average) is when bullish patterns often work best.
Market Volume Conditions
Volume in this context means how much of a security or asset moves over a specific period – usually within a day.
If you keep a close eye on the market volume, it may provide information that tells you if a pattern is reliable.
Observing High ADX Values
The basic explanation of the ADX or average directional index is how you figure out how strongly a particular price is trending. You would measure ADX by calculating moving averages over time.
If you stay on top of high ADX values, you’ll only take signals that happen in conditions where markets and securities fluctuate wildly within a small time window.
Backtesting
Another way to ensure you’ve got a reliable pattern on your hands is to test it against ones that would have delivered in the past; this is called backtesting.
Backtesting allows you to compare and contrast different (current) candlestick patterns to ones found in historical databases to test their efficacy.
Of course, if you want to test candlestick patterns, you’ll need a trading platform that allows for these kinds of comparisons. Tradestation is one such backtesting platform, although you’ll need to learn coding to use it effectively.
Here are a few tips you should know to make backtesting effective:
- You can speed up price movements, but that’s not advisable. It’s best to test in real-time, even if it might be tedious.
- Take care not to backtest too far; one or two years is as far back as you need to go. Charts any further back won’t be relevant.
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Conclusion
Candlestick trading can be profitable, but you have to know what you’re looking at and when specific patterns aren’t going to work. Candlestick trading is subjective, but you may find that they work well for you if you know what filters to add to the charts.
Looking at the long-term trend and market volume conditions is vital, along with observing ADX values and performing detailed backtests.
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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