In this article, we are going to look at 5 candlestick chart patterns, which if used properly can be your best tools available for trading.
Type of charts
If you want to trade stocks, you will have to use some kind of chart to see the past history of prices. Charts can be of many types like line charts, bar charts, and candlestick charts, etc.
The line chart is formed by joining the close prices. It has its own merit and demerit. We can not use it for a precise entry point.
Example of line chart
A bar chart is created with 4 inputs, i.e. open, high, low and close. Open is represented by a small left wick. And close is represented by the small right wick. Low and high are represented by the length of the bar.
Example of bar chart
Basics of candlesticks: How a candlestick chart is formed
Candlestick charts are one of the best solutions to technical analysts for trading, as it provides an immediate view of price movement.
To form a candlestick chart we require the same input as we require in a bar chart. But the representation is different in the candlestick chart. We require open, high, low, close as input to form 1 candlestick.
If the open price is less than close, then it is a green( or white) candle, which indicates the price has gone up during that period. If the open price is greater than the close price then it is red ( or black) candle, which indicates the price has gone down during that period.
Lets understand this with an example.
As we can see that out of these 3 chart type, the candlestick is more visually appealing and we can tell what happened during the period ( green candle means prices went up and red means price went down)
Up and down wicks represent that price has gone that much up or down during that period. If we look at the daily chart then 1 candle is formed in 1 day, capturing its open, high, low and close of that particular day. Similarly, if we are looking at the 1-hour chart then 1 candle is formed in 1 hour.
How candlesticks are formed
Let’s say a stock has opened at 100 rupees, made a high of 105 rupees, low of 95 rupees and finally closes at 103. Then as we discussed, it is going to be green(white) candle ( open < close). This is a bullish candle.
Similarly, if a stock has opened at 100 rupees, it made a high of 105 rupees, low of 95 rupees and finally closes at 97. Then as we discussed, it is going to be a red(black) candle ( open > close) This is a bearish candle.
If open and close remain almost the same, with long wicks, then this type of candle is called a Doji. It means indecision.
There are multiple variants of Doji depending on where the price opens and close. If you want to understand the psychology of any candle then look at it where it has opened and where it is closing. If it has opened at the low of the day and closes at or near the high then it’s a bullish candle and vice versa. But if the candle has opened at price made a high from there, a certain low from high and closed near the open ( a Doji ) then it means that neither buyers nor sellers were in control, which is indeed indecision.
5 candlestick patterns with their interpretation
Bullish/ Bearish Engulfing
This is one of the best bullish signals. In bullish engulfing, the current candle completely engulfs the previous candle ( we are talking about real bodies and not wicks). So the open for current candle will be lower or the same as the previous candle and close of the current candle will be high or same with the previous candle. If the current candle closes the near the days high ( i.e. with little or no wick) it is even more bullish.
Technically a buy above the bullish candle has to be done with immediate low as stop loss.
The exact opposite of this is a bearish engulfing pattern, which gives an early signal of bearishness.
Hammer/ Inverted hammer(shooting star)
Hammer ( 1st picture) is a bullish candle in nature. We can understand this by the psychology of this candle. Prices open and made a low, which is at least two times more than the real body and closes near the open. This implies that after opening there was a sell in the market but buyers come in and the market recovered well to close near the open. Here the colour of the candle is not important.
Inverted hammer ( actually a shooting star ) is exactly opposite to hammer and bearish in nature.
This is also a very strong candle. Though it appears rarely, its implications are big. A bullish marubozu is a green or white candle with no shadows. Exactly opposite is bearish marubozu candle.
Morning star / evening star
Morning star is a 3 candle bullish pattern. If a stock is in a downtrend and has made a black candle, next day it opens further down ( can be a gap down also) but the intensity of selling is reduced ( it can be a doji or a hammer) . and finally current days candle is a bullish candle which manages to close above the half of the first candle( and we are talking about real bodies). Then it’s a morning star. A buy above the high of the first candle is advisable with low of the second candle.
The exact opposite is evening star, which is a bearish pattern.
3 white solders / 3 black crows
If we get 3 consecutive white candles that make higher highs and higher lows then we have 3 white soldiers. It is also considered highly bullish in nature. The exact opposite is 3 black crows which imply bearishness.
How to practically use candlestick patterns in trading
If you want to do successful trading using candlesticks and price action then, the above-mentioned patterns are a must for you to understand. But these patterns should be traded when the market is in an established trend. In a sideways market, if we use these patterns to trade we will get lat of whipsaws.
As all of these are trend reversals candle( except marubozu) , wait for a trend to establish and then trade these signals.
If you can combine these candle patterns with some other indicator/pattern, it will be even better.
If you see the above chart there are 2 bullish engulfing patterns marked with a circle. The first one is coming in a sideways market and hence should be ignored, the second one, on the other hand, is coming after a downtrend, so it will have a higher probability of success.
Candlesticks provide an easy visual way to see the market trend. And if you understand the phycology behind the patterns then you can trade and make good money, though it is advisable to use it with some other indicator or pattern for more robust risk-reward. As candlestick patterns do not provide us the target ( though some use it as 1:2 risk to reward as target), so if we use some indicator or classical pattern or trendlines to identify the target then odds of success will be higher.
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