This is part three of a series on technical analysis. Click here for the series overview in part one. Click here for part two on the history of technical analysis.
One of the foundations of technical analysis is reading and interpreting candlestick charts. They were among the first chart types to be used by traders hundreds of years ago. They are still in use today, although chart technicians also use other types of charts to track prices and identify various patterns in trading.
It’s believed that candlestick charts date back to the 1700s in Japan. Rice trader Munehisa Homma is widely credited with creating them in the 18th century, although author Steve Nison said in his book Beyond Candlesticks that his research suggests Homma never actually used them. Regardless of who invented them or was the first to use them to track investments, their importance in the world of technical analysis can’t be overstated.
Perhaps the main reason candlestick charts have been in use for hundreds of years is because they provide an easy, concise way to see multiple data points in a single view. Because of this utility, they still aren’t obsolete even with all the extra tools provided by computers today. In fact, creating candlestick charts has become much easier with computers.
Components of a candlestick chart
Before you can even begin to understand these charts, it’s important to know what information they provide. Each candle is made up of a main body and upper and lower shadows, which are basically like the wick running through the center. A single chart is made up of a long series of candles, with each candle designating a particular timeframe, such as a single day or a week.
The top and bottom of the candle’s body denotes the opening or closing price. The tip of the top wick indicates the highest price of the given time period, while the tip of the bottom wick shows the lowest price of the time period. If there is no top and/ or bottom wick, then it means the opening and/ or closing price was the highest or lowest.
Usually candles which show that the price moved up during the selected timeframe are colored white or green, while candles which indicate that the price moved down during the time period are usually black or red. In addition to indicating when the price moved up or down during the selected time frame, the colors also allow traders to know whether the opening and closing prices are at the top or bottom of the candle. If the price moved up during the selected time period, then the bottom of the body denotes the opening price, while the top of the body designates the closing price. This is reversed if the price moved down during the timeframe.
How candlestick charts differ from other trading charts
In the world of technical analysis, traders use a number of different charts. Candlestick charts are similar to bar charts or box and whisker plots. Bar charts and candlestick charts display the same information in different ways. Candles have thicker bodies than bars, although some consider bar charts to look a bit cleaner than candlestick charts.
Box and whisker plots are slightly different. Although both charts show the lowest and highest prices in the bottom and top whiskers or wicks, the bodies of the bars and candles display different information. Box and whisker plots denote the 75th and 25th percentiles of the prices, while the bar inside the box marks the 50th percentile.
Some traders also use a variation on the standard candlesticks. Heikin-Ashi candlesticks differ from the standard version because the prices are weighted. They are much more complex because they assign more importance to some of the prices, and the bodies of the candles don’t necessarily line up with the actual opening and closing prices of the security being tracked. In some cases, Heikin-Ashi candles may be used along with traditional candles to identify market trends.
Heikin-Ashi candles follow different formulas in denoting prices. The closing price is calculated as the open, plus the low, plus the low, plus the close, divided by four, and it amounts to the average price of the candle. The opening price is calculated as the open of the previous candle, plus the close of the previous candle, divided by two. This gives you the midpoint of the previous candle. The high is designated as the highest of either the high, open or close, while the low is the smallest of the low, open or close. The Heikin-Ashi technique may be more helpful to experienced traders who are more adept at reading and studying candlestick charts, so beginners need not worry about this technique very much yet.
How and when are candlestick charts used?
Candlestick charts can be used to track virtually any asset, whether it’s an individual stock, gold prices, exchange-traded funds or anything else. The whole point of these charts is to identify patterns that can be used to predict future price movements. Chart technicians study the charts and predict which way a security’s price will move next based on common patterns that appear on them. These patterns only indicate probable upcoming movements, however. There are never any guarantees when it comes to predicting changes in asset prices.
Two of the easiest candlestick patterns to understand are the bearish and bullish engulfing pattern. A bearish engulfing pattern indicates that there are more sellers than buyers during the designated timeframe. This pattern appears when a larger red or black candlestick (indicating a price decline) follows a smaller green or white candlestick. The pattern got its name because the larger down candle engulfs the smaller up candle. It indicates that sellers have started to take control of the price, and it often suggests that a price reversal could be taking hold. When a bearish engulfing pattern follows a steady uptrend, it means a new downtrend could be starting.
The reverse is true of a bullish engulfing pattern, which means buyers outnumber sellers and have taken some control over the price. The pattern is indicated by a large green or white candle following a smaller red or black candle. A bullish engulfing pattern is considered a buy signal, although many chart technicians may wait for another candle or two to see if the uptrend is actually taking hold.
There are many more common patterns identified in candlestick charts, including both simple and complex patterns. Upcoming articles in this series will focus on other common candlestick patterns and interpreting charts. Many chart patterns have both bearish and bullish versions, indicating whether the market or security is generally in a downtrend or an uptrend, respectively.