Candlestick Charting Explained

We have already touched briefly upon the Basics of How How to Read Stock Charts. In this article we will review many powerful candlestick patterns. It is a topic that has filled many good books. To simplify things a bit, we are going to ask one important question as we review a few of these patterns, “Who won the battle, the bulls or the bears?”

First, let’s review the basic terminology of the candlestick. The thick part of the candle is called the body. It represents the range between the opening and close of that bar’s time period. It is considered to be the most important part of the candle by the Japanese. Many traders set up their charts so the candles are red if the close is lower than the open, and green when the close is higher than the open. It is a matter of personal preference. Backgrounds are typically set to either black or white.

The thin lines above and below the body are shadows. Other terms commonly used in the west are wicks and tails. The upper shadow represents the high of the range within the time period of the candle. The lower shadow represents the low end of that range. Japanese chartists regard this portion of the candle to be least important.

One battle, or one candle, does not win the war or change the trend, but it does have the potential of tipping the balance. Usually it takes a combination of candles to tip the balance between the bulls and the bears. Let’s review a some of these patterns now.

Hammer

Many single candled patterns can be either bullish or bearish, depending on the context in which they are found. The Hammer is one of those patterns. Hammer is the name given to the bullish version of this pattern. The bottom shadow portion should be at least twice as long as the body and is typically found after an extended multi bar decline. The close can be either higher of lower than the open. The upper shadow should be short to non existent. The long tail represents buyers stepping into the market and pushing the line of scrimmage into the upper 10 to 20% of the range. This is very bullish, many times it kicks off a trend reversal.

Hanging Man

This single candled pattern is identical to the Hammer, except that it can be found within an extended move up. It gives the appearance of a bullish continuation of the trend until it’s long tail is violated, tipping the scales in favor of the bears. It can be very bearish since the bulls who were once confident, are proven wrong, must exit, possibly even joining the shorts.

Evening & Morning Doji Stars

These are three bar patterns with dojis in the middle. Dojis are candles that have opens and closes at the same price. They have the appearance of a cross. Dojis can have long shadows, short shadows, or a long and a short shadow. Star patterns typically have dojis with equal short shadows. Dojis that occur after an extended trend or multi bar move can be a powerful indication of a trend reversal. They represent a stall in the momentum of the previous move. With evening stars, the doji typically gaps above the real body of the first bar and is followed by a gap down. The third candle’s real body must close deap into the range of the first candle’s body. Morning stars are the mirror image, indicating the probable end to a downtrend.

Shooting Star

This is a bearish single bar pattern that hints that a trend or extended move may end, a mirror image of the Hammer. They may also be effective near the top of trading ranges. It has a small body with little or no shadow at the bottom and an upper shadow that is at least twice as long as the body. A bullish or bearish close is not important. The ideal shooting star gaps away from the prior candle’s body. This pattern works well for climax plays where the market has run up for five or more days in a row. The long topping tale hints that sellers have gained control.

Inverted Hammer

This is a mirror image of the Hanging Man and looks like a shooting star. It is bullish because it occurs after an extended move or trend down. It gives the appearance of a continuation of the move down until the long upper shadow is violated and the bears must cover there positions.

Dark Cloud Cover

This is a bearish two bar pattern used to find potential tops after a prolonged uptrend or extended move. The first candle in this pair should have a strong bullish body. The price of the second bar should open above the shadow of the first bar and close near the low of its range and at least 50% into the body of the first bar. The psychology behind this patten is that the bulls have been in control for an extended period and were still very confident at the close of the first bar. They felt even more euphoric when it gapped up on the open. Once prices crapped out and sold down to the lows of the day, nearly wiping out the previous day’s gains, they are beginning to have doubts.

Piercing Pattern

This is the bullish version of the Dark Cloud Cover. After an extended move down, additional bears are drawn in by the gap below the first bar’s shadow low, but are soon feeling pain after the second bar. Few sellers are left to force prices down from here. Short must either take profits or cut their losses. In order for this pattern to be bullish, it must penetrate at least 50% into the body of the previous down bar, more is better.

Bullish and Bearish Engulfing Patterns

This two bar pattern that can be found within a trend. The body of the last bar must engulf the body of the preceding bar. The shadows are not important. The body of the second candle must reverse by closing in the opposite direction. Higher volume on the reversal bar is a plus. Engulfing patterns can be used to enter a trending market after a retracement or mark the beginning of a trend reversal. Because these patterns don’t include the shadow, they offer you an earlier entry than western analysts who wait for the high of the previous candle to be violated.

We have only touched upon the art and science of candlestick analysis here. For a much more in depth coverage of this topic, Steve Nisson’s books are a must read. Learn the thought process behind each pattern. Put yourself in the shoes of both the bulls and the bears to understand how they feel.