By: Andrey Kovalchuk
If you just came to the stock market as well as the stock brokers, perhaps for the first time, opened a trading program, and are now staring at some chart, then this material is for you. As a rule, three types of these charts are available in any trading program: a line chart, a bar chart, and a candlestick chart. Which one to choose to predict the price movement?
Candlestick patterns are individual candles of a particular kind or a combination of such candles on a candlestick chart in mid-section. Candlestick patterns are often called reversal patterns, but this is not entirely true, as they only indicate a possible change in trend.
In this connection, the choice of candlestick patterns should be approached very selectively and always wait for confirmation of a particular configuration. On the chart, such patterns can consist of one or more candles.
A candle is formed from 4 prices:
● Opening;
● Closing;
● High and low for a certain period.
If we take a minute timeframe, each candle will indicate the price movement within this minute, if an hour — within an hour, if a day — within a day.
The distance between the highest and lowest price of an asset is called the “body” of the asset. The “tail” is the end of the candle, which shows the lowest and highest price of the asset. If the high of the candle is above the low of the candle, then the color of the candle will be red; if the high of the candle is below the low of the candle, then the color of the candle will be green.
Candlestick charts are valuable for use when looking at market trends. The resulting patterns are interpreted as reversal or trend continuation patterns, and are enhancing to use. Each candlestick or combination of candlesticks is only a way of depicting the behavior of the technical buyers and sellers for the period chosen (30 min/20 sec, days/weeks, etc). We don't have to do any complex calculations on the market, since investors/traders live by people's formulas, so technical analysis is very popular among them.
Looking at the candle icon, a savvy trader can easily understand the current position of the market and identify its movement. The three white and three black crows represent an upward trend while the three white and three black ravens signify a downward trend.
Doji is a candle with no body. That is, the opening price is equal to the closing price. At the same time, the longer the Doji shadow, the stronger the model is considered. In a sideways market, the Doji is neutral and emphasizes the neutral state of the market. But during an uptrend, the Doji can become a leading reversal indicator.
The spinning top (see figure above) is characterized by a small body and long upper and lower shadows. In this case, the candle's body color does not matter.
A tombstone is a candle that does not have a lower shadow (see the figure above), that is, the minimum price for the period is equal to the opening and closing prices.
This pattern "buries" the current trend — hence its name. The appearance of a tombstone at the top of an uptrend is a sell signal (when a bearish candlestick is confirmed).
These candlestick patterns represent a candle without an upper shadow, with a small body and a lower shadow twice as large as the body. The color of the body of the candle does not matter.
The difference between the hammer and the hanging man is that the hammer appears after prices fall, while the hanging man appears after prices rise. Both figures warn of the exhaustion of the current trend and its imminent change.
The “hammer” model got its name because of its shape and the analogy with a hammer hitting an anvil. The appearance of a hammer on the chart is a hit followed by a “bounce” (upward reversal). (But if the hammer follows a sharp price drop, the market may again return to the hammer's low, thereby extending support.)
In turn, when a “hanging man” pattern appears on the chart after an uptrend, this is a signal that the market growth may be close to completion. And this signal is more substantial as the shorter the upper shadow and the smaller the candle's body. Additionally, the signal to fall is amplified if:
● A gap appears between the body of the hanged man and the next candle;
● After the hanged man, the “tombstone” model appears.
As with other candle patterns, you must wait for their confirmation when these configurations appear on the chart.
Absorption patterns only work in a market with a clear uptrend or downtrend. Their advantage lies in the fact that they give a signal that is not visible on the bar chart, resulting in them serving as a leading indicator.
These figures consist of two candlesticks (not Doji), the second of which closes (absorbs) the first one. In this case, the larger the second body (absorbing body) concerning the first one, the more significant the model.
Bullish Engulfing occurs when the market is in a downtrend and the body of the second rising candlestick engulfs the body of the first. This model shows that the bulls are taking power away from the bears and gives a signal for growth.
Bearish Engulfing occurs when the market is in an uptrend and the body of the second falling candle engulfs the body of the first. This model shows that the power is moving from the bulls to the bears and signals a downward reversal.
It is essential to understand that the behavior of individual traders adds up to the overall movement of the market, which can be “read” using candlestick charts and their basic patterns.
Consequently, your optimal investment decisions will be supported by the most compelling moments of entry or exit from a position, which will significantly improve financial results.
When analyzing candlestick patterns on a chart, it is important to consider the following points.
● The most important are candlestick patterns that appear near a strong support/resistance level.
● Japanese candlestick patterns work best on the daily time frame. With a decrease in the time interval, the degree of reliability of candlestick patterns decreases.
● On the charts, the hourly candlestick configurations do not work.
● Candlestick pattern signals should follow the direction of the main trend. The longer the trend preceding the appearance of a candlestick pattern, the more critical the signal of this pattern.
● The signal of the patterns increases with the support of the trading volume and when a gap appears (in candlestick analysis, it is called a “window”).
● Candlestick patterns always require confirmation. The signal is confirmed by forming a new candle, indicating the beginning of a trend reversal. So, if a bullish signal pattern appeared on the market, the candlestick following it should be higher.
● Confirming the candlestick pattern with other instruments, particularly technical indicators, is also desirable.
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