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Introduction to Candlestick Charts

Whether you are a bear or a bull, there is something for everybody when it comes to studying charts to inform future trading decisions.

Candlesticks are a popular charting analysis technique, and in this issue of Bullseye Insight we provide a beginner's guide to candlesticks and how they can be interpreted to guide future trading decisions.

The basics

Just like a bar chart, an individual candlestick shows the market's open, close, high and low price for a given asset on a given day.

Each candlestick has a “body" which represents the price range between the open and close of that day's trading. When the candle’s body is coloured red, it means the close was lower than the open. If the body is green, it means the close was higher than the open.

Just above and below the body are "wicks". The wicks show the high and low prices of that day's trading. If the upper wick on a red candle is short, it indicates that the open that day was near the high of the day. A short upper wick on a green body indicates that the close was near the high. The relationship between the day's open and close, high and low, determines the look of the daily candlestick.

Taken together, the body and wick of each candle provides a simple yet effective means of visualising the range of market price movements during a trading day. Taking multiple candles across consecutive trading days can also provide greater insight into the market sentiment towards an asset and allows traders to predict future price movements.

Did you know?

Candlestick charts originated in Japan over 100 years before the West developed the bar chart. In the 1700s, a Japanese man named Homma discovered that, while there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of traders. Candlesticks show that emotion by visually representing the size of price moves with different colours.

Bulls vs. Bears: shining a light on market sentiment

Candlesticks are created by movements in the market price over a period of time. Typically candlestick charts are daily - meaning each candlestick represents the price movement during one trading day. However, candlestick charts can also be monitored intra-day, for example hourly, or over longer periods. The choice of time period is completely the choice of the trader and depends on their trading or investing time horizons.

To the frustration and bemusement of many, price movements may sometimes appear random. However, to those that employ this type of technical analysis charts form patterns that can be used for short-term trading purposes. Patterns are typically categorised as either bullish or bearish.

Bullish patterns indicate that the price is likely to rise, while bearish patterns indicate that the price is likely to fall. No pattern is a guaranteed signal, as candlestick patterns represent tendencies in price movement, not guarantees.

Here are some of the most common candlestick charting patterns to get you started:

Bearish Engulfing Pattern

A bearish engulfing pattern develops in an uptrend when sellers outnumber buyers. This action is reflected by a long red body engulfing a small green real body. The pattern indicates that sellers are back in control and that the price could continue to decline.

Bullish Engulfing Pattern

An engulfing pattern on the bullish side of the market takes place when buyers outpace sellers. This is reflected in the chart by a long green body engulfing a small red body. With bulls having established some control, the price could head higher.

Bearish Evening Star

A bearish evening star is a topping pattern. It is identified by the last candle in the pattern opening below the previous day's small body.

The small body can be either red or green. The last candle closes deep into the real body of the of the candle two days prior. The pattern shows a stalling of the buyers and then the sellers taking control. More selling could develop.

Bearish Harami

A bearish harami is a small red body completely inside the previous day's body. This is not so much a pattern to act on, but it could be one to watch. The pattern shows indecision on the part of the buyers. If the price continues higher afterward, all may still be well with the uptrend, but a down candle following this pattern indicates a further slide.

Bullish Harami

The bullish harami is an upside down bearish harami. A downtrend is in play, and a small green body occurs inside the large red body of the previous day. This tells the trader that the trend is pausing. If it is followed by another up day, more upside could be on the way.

Bearish Harami Cross

A bearish harami cross occurs in an uptrend, where an up candle is followed by a doji. The doji is within the body of the prior session. The implications are the same as the bearish harami.

Bullish Harami Cross

A bullish harami cross occurs in a downtrend, where a down candle is followed by a doji.The doji is within the body of the prior session. The implications are the same as the bullish harami.

Bullish Rising Three

This pattern starts out with what is called a "long green day." Then, on the second, third and fourth trading sessions, small real bodies move the price lower, but they still stay within the price range of the long green day (day one in the pattern). The fifth and last day of the pattern is another long green day. Even though the pattern shows us that the price is falling for three straight days, a new low is not seen, and the bulls prepare for the next move up.

A slight variation of this pattern is when the second day ‘gaps up’ slightly following the first long up day. Everything else about the pattern is the same; it just looks a little different. When that variation occurs, it's called a "bullish mat hold."

Needless to say there are many more candlestick charting patterns that help guide traders in their decision-making.

No Guarantees

There are no guarantees of success when using any charting technique, but candlestick patterns have stood the test of time and continue to be popular with traders across the globe.

Understanding how to read a candlestick chart is a useful weapon to have in your armoury when navigating the maze of trading and investing.

But as with anything, overlay your common sense and apply candlestick analysis alongside your own research, other performance metrics (such as alpha), but most importantly your understanding of the investing fundamentals.

Good luck!

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