Candlestick charts are the first known style of chart analysis. As you look at this chart, it is made up of many red and green bars which are called candlesticks. They are called candlesticks as they resemble a candlestick with a wick coming out the top and bottom.
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The Green candlesticks represent one time period where the stock increased in value. The Red candlesticks represent a time period where the stock decreased in value. The time period that each candle represents can be anything from a minute to an hour, to a day or even a month. If we are building a chart that represents a day, we might specify that each candlestick represents a minute or five minutes. If we were trying to build a chart for a year, we might specify that each candlestick represents a day or a week.
Candles are really EASY to understand. We need to start with the OPEN PRICE of a stock, the CLOSE PRICE of a stock, the HIGHEST PRICE the stock hits during the day and the LOWEST PRICE the stock hit. All these pieces are illustrated in a candlestick.
Let’s start with a candlestick that represents a stock increasing in price for one time period. The body of these candlesticks are GREEN.
The OPEN PRICE of the stock is the top of the body.
The CLOSING PRICE of the stock is the bottom of the body.
The Body of the candlestick is green to represent the stock increasing in price for the day.
The HIGHEST PRICE for the day is the highest point of the upper wick. The upper wick is called the UPPER SHADOW.
The LOWEST PRICE for the day is represented by the lowest point of the lower wick. The lower wick is called the LOWER SHADOW.
This illustration quickly shows the action of the price during the entire day. In another class we will discuss how a single candlestick along with volume will give any investor valuable information about the future direction of the market.
Let’s now look at a candlestick that represents the stock value going down for the day. As you might guess, this candlestick is RED to identify the loss.
In the case of a red candle, the OPENING PRICE is seen as the bottom of the candle body.
The CLOSING PRICE is the top of the candle body.
The bottom of the lower wick is the LOWEST PRICE the stock hits during the day.
As you would guess, this lower wick is called the LOWER SHADOW.
The top of the upper wick represents the HIGHEST PRICE the stock reaches and just as with the green candle, the upper wick is called the UPPER SHADOW.
Sometimes you will see green candlesticks represented by hollow and black-filled candlesticks. In these cases the hollow candlesticks represent the price closing higher than the open price. The black-filled candlesticks represent the price decreasing on that day like a red candle.
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LONG VERSES SHORT BODIES
The longer the body of a candlestick, the more the pressures for the stock to increase or decrease in price verses the opening price. A short bodied candlestick represents a consolidation of price where buyers and sellers were more in agreement on what the price of the stock should be.
LONG HOLLOW or GREEN CANDLESTICKS show STRONG BUYING PRESSURE. The longer the body the farther the close was from the open and the more the price increased from the opening price. Often this represents strong BULLISH pressures but this is also dependent on VOLUME and the pattern that the prior candlesticks have created. If this long green or clear bodied candlestick occurs at the bottom of an extended period of price decline, it might show that the bulls have dug in and set a price that they feel is too low. If they defend this price and continue to buy at this price forcing the stock up in value, it is called a RESISTANCE PRICE.
LONG BLACK or RED CANDLESTICKS show STRONG SELLING PRESSURE. If the long bodied candle was RED or solid black, it might show panic where those who had held on to the stock admitted that the stock would fall or it might show that an institution was ready to dump a large block of their holdings to take profits.
LONG VERSES SHORT SHADOWS. The upper and lower wick or shadows can show very valuable information about a trading session. Upper Shadows represent the day’s high price and the Lower Shadow represents the day’s lowest price. Days with short shadows indicate that most of the trading happened near the open and close prices. Candlesticks with long shadows show that buyers and/or sellers fought loosing battles to bring the price higher or lower. When the top shadow is long, it shows that the buyers (also called the bulls) fought to take the price higher and lost as the sellers (or bears) pulled the price down again. The bottom shadow represents the sellers driving the price down and the buyers helping to pull it back up again.
Candlesticks have several standard shapes which each have their own meaning to a trader.
Marubosu – Candlesticks with long bodies and very short or no wicks are called Marubosu. This is a candlestick that shows that there was tremendous pressure to buy (green Marubosu) or sell (red Marubosu) for that trading period. The candlestick has far more significants to traders and technical analysts when put into context of a complete chart and volume information. For example, when a RED Marubosu occurring at a point of resistance (at a stock price that the stock has previously not been able to break through) would be a strong signal for a reversal. When it occurs near support (a price that the stock has previously not been able to fall below) it is also a bearish signal that the stock will continue in a bearish trend. If combined with a spike in volume, it is an even more compelling sign.
Spinning Tops – Candlesticks with a long upper shadow, long lower shadow and small real body are called spinning tops. One long shadow represents a reversal of sorts; spinning tops represent indecision. The small real body (whether hollow or filled) shows little movement from open to close, and the shadows indicate that both bulls and bears were active during the session. Even though the session opened and closed with little change, prices moved significantly higher and lower in the meantime. Neither buyers nor sellers could gain the upper hand and the result was a standoff. After a long advance or long white candlestick, a spinning top indicates weakness among the bulls and a potential change or interruption in trend. After a long decline or long black candlestick, a spinning top indicates weakness among the bears and a potential change or interruption in trend.
Long Upper or Lower Shadow – Long upper shadows warn that there may not be enough demand at higher prices to continue to propel the stock upward, at least for the short term. Although the stock or index may have formed a higher high, it has closed well off that high. This is especially evident near an overhead resistance area, and/or when a stock or market is overbought. These tails suggest that bullish traders are taking profits on long positions and bearish traders may be initiating short positions.
Long lower shadows warn that lower prices are being rejected. Even though the stock or index may have formed a lower low, it closed well off that low. This may occur near an area of support on the chart, and/or when a stock or market is oversold. These tails suggest that bearish traders are taking profits on short positions (covering) and bullish traders are entering long positions.
It is important to understand how a long shadow is formed. For example, before a long lower shadow is evident, it is first a long bearish candle (1) as illustrated in Figure 1.4. The bears are clearly in control. Then the bulls start initiating long positions, and some short covering occurs, which puts upward pressure on price. As price starts to rise, a lower shadow begins to emerge (2). The buying by bulls, and covering of short positions by bears, causes price to move higher and higher revealing more of the lower shadow. By the end of the session, what was previously a long bearish candle (1) is now a long lower shadow (3). The strong rally that occurred off the low of the session will cause concern for many bearish traders. Eager bulls have arrived and put a damper on the downward move. More bulls may jump aboard in the following trading sessions generating a rally and, subsequently, more short covering by bears to add fuel to the rally.
Doji – The Doji is a powerful candlestick formation, signifying indecision between bulls and bears. A Doji is quite often found at the bottom and top of trends and thus is considered as a sign of possible reversal of price direction, but the Doji can be viewed as a continuation pattern as well.
A Doji is formed when the opening price and the closing price are equal. A long-legged Doji, often called a “Rickshaw Man” is the same as a Doji, except the upper and lower shadows are much longer than the regular Doji formation.
The creation of the Doji pattern illustrates why the Doji represents such indecision. After the open, bulls push prices higher only for prices to be rejected and pushed lower by the bears. However, bears are unable to keep prices lower, and bulls then push prices back to the opening price.
Of course, a Doji could be formed by prices moving lower first and then higher second, nevertheless, either way, the market closes back where the day started.
In a Doji pattern, the market explores its options both upward and downward, but cannot commit either way. After a long uptrend, this indecision manifest by the Doji could be viewed as a time to exit one’s position, or at least scale back. Similarly, after a long downtrend, like the one shown above of General Electric stock, reducing one’s position size or exiting completely could be an intelligent move.
It is important to emphasize that the Doji pattern does not mean reversal, it means indecision. Doji’s are often found during periods of resting after a significant move higher or lower; the market, after resting, then continues on its way. Nevertheless, a Doji pattern is a great sign that a prior trend is losing its strength, and taking some profits might be well advised.
There are many other simple candlestick patters. These include the Dragon Fly Doji, the Gravestone Doji, hammers, hanging men, and many others. We hope you take the time to learn about all these patterns as they will have a HUGE impact on your ability to be a strong trader.