What is Candlestick Charting?

One of the popular short-term trading techniques is Candlestick Charting. Candle stick charting is a technique used to determine and forecast the price behavior of stocks. Specifically, candlesticks are used to express the market behavior towards a particular investment vehicle. Candlestick charts form patterns that describe investor reaction and emotional feelings towards a stock that make it possible to derive possible outcomes of the stock price trend. Simply put, candlesticks are a graphical representation of investor sentiment over a period of time.

How to read a Chart

Basically, candlesticks are represented in two ways, a white bar and a black one – also coded as green and red respectively. A white or green bar represents a day when the closing price is higher than the opening price. Consequently, a black or red bar represents a day when the closing price ends up being lower than the opening price. The diagrams below will better portray the concept:

A Candlestick

First things first. Let’s identify the different sections of a Candlestick. Understanding these sections is critical in understanding Candlestick Charting. Look at this Candlestick below

A Candlestick

Here is how to read this candlestick

Open - The open is the first price traded during the candlestick, and is indicated by either the top or bottom of the wide vertical line (the bottom for an upward candlestick, and the top for a downward candlestick).

High - The high is the highest price traded during the Candlestick, and is indicated by the top of the thin vertical bar (the wick of the candlestick).

Low - The low is the lowest price traded during the candlestick, and is indicated by the bottom of the thin vertical bar (the upside down wick of the candlestick).

Close - The close is the last price traded during the candlestick, and is indicated by either the top or bottom of the wide vertical line (the top for an upward candlestick, and the bottom for a downward candlestick).

Direction - The direction of the candlestick is indicated by the color of the candlestick (specifically the wide vertical line). Usually, if the candlestick is green, the candlestick is an upward candlestick, and if the candlestick is red, the candlestick is a downward candlestick, but these colors can usually be customized.

Range - The range of the candlestick is indicated by the locations of the top and bottom of the thin vertical line (the wicks). The range is calculated by subtracting the low from the high (Range = High - Low).

Top 3 Candlestick Patterns

There are hundreds, maybe even thousands, of candlestick patterns that have been identified and used by investors to make trading decisions.

I will introduce you to three of the most common ones. It is important to mention that you will need to use Candlestick indicators with other analytical tools if you want to make effective trading decisions. Bullish Engulfing formation

The Bullish Engulfing indicator is a two day pattern. The first day’s body is smaller than the subsequent candlestick, and they are both of opposite colors. If this pattern appears at the end of an uptrend, then this is a bearish trend. If the pattern appears at the end of a down trending stock, then it represents a bullish trend.

The Psychology behind this is that if you do not see much volume occurring on the 1st day of this formation compared to the 2nd day, then this increases the strength of the pattern. The 2nd day will open low and below the close of the 1st day, and then quickly rally to close above the open of the 1st day. This prompts additional buying in the coming days.

Morning Star Candlestick Pattern

The Morning Star formation is considered a three day bullish reversal pattern. The 1st day is a long bodied black first day.

The 2nd day is a short gap down, below the 1st day’s close. The 3rd day is a long white bodied candle, which closes above the midpoint of the first day.

The psychology of this formation is that the 2nd day gaps lower, but trades in a small range. The bullishness of this indecision is confirmed by the higher close of the 3rd day. As a trader you will be looking for higher prices.

Bullish Hammer Candlestick Pattern

The Bullish Hammer is another trend that signifies a reversal. First you should see a small real body at the upper trading range. This means that trading has occurred significantly below the open, but ends well above the low and closes as its high, the candlestick formed has only one tail below its body. When this formation occurs during a downtrend, it often signals a reversal.

Note that the color of the body is not important, and that the long lower shadow will be at least twice the length of the body. In addition there will be little or no upper shadow. Finally the previous trend should be bearish.

The psychology of this pattern is that the price has gone much lower than the open then closes near the opening price. This fact reduces the confidence of the bears. Ideally, a white real body Hammer with a higher open the following day could be a bullish signal for the days ahead. As with any single candlestick, confirmation is required.

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