Invented by the Japanese rice merchants and traders to understand the movement of trends of various commodities they wanted to trade in, Candlesticks generally help traders to identify the trend of a particular instrument.
Candlesticks are used in technical analysis for trend following which is a strategy used to predict the movement of a particular instrument to gain profits.
What is a Candlestick?
A Candlestick is a type of a price chart that displays the open, high, low and close of specific security for a given time period.
The vertical rectangle of the candlestick represents the real body and can be used to identify if the closing price was higher or lower than the opening price.
Generally, green is used to represent a bullish pattern meaning the closing price of the stock was higher than the opening price and red is used to represent a bearish pattern meaning the closing price was lower than the opening price. Here is a pictorial representation of the same below:
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What is Candlestick Pattern?
It is a method for reading the price chart of an instrument to predict the next move of the instrument. For eg, to understand the trend for Reliance Industries Ltd, you will need to have a look at the price chart of Reliance Industries for a particular time frame. Below we look at a time frame of 1 Day to understand the price trend of the stock:
Now looking at this chart we can see that the trend seems to bearish ( i.e Price of the stock going down) and is dominated by red candlestick body. Hence it will be ill-advised to buy the stock at the current scenario, however short selling the stock can fetch profits.
Candlesticks also represent the Open, High, Low and Close prices of a given stock for a particular time period wherein the High is marked by the top of the upper shadow of the Candlestick, the low by the lower shadow of the Candlestick. Shadow is the technical term for the vertical line above and below the candlestick body.
There are multiple type of patterns:
• Single Candlestick Patterns
• Neutral Candlestick Patterns
• Multiple Candlestick Patterns
In this blog, we will discuss Single Candlestick Patterns.
Single Candlestick Patterns
In this section we will discuss the bearish and bullish single candlestick patterns:
1. Hammer Reversal
A hammer type pattern can form when support is found by market participants. Below is the shape of hammer candlestick.
In the example below, the price moved lower but found some support or buying volume. At this point, the bulls took control and closed the candle around its opening level.
From the hammer candlestick, we can expect a reversal in the next candlestick to be formed, showing the momentum was continuing. Traders and investors found value and the price began to trend.
In a doji candlestick, the body is usually very small with the closing price near the opening price and can have long shadows formed for the high and low prices, which were tested but fought back from by each side.
A Doji candle is the name given to patterns which signify indecision in the price action of a stock.
Usually, they form at areas where the bulls and bears commence battle and are fighting each other for direction.
This pattern signifies uncertainty, indecision, and is waiting for either the bulls or bears to take control. Often the next direction is an upwards or downwards sustained move in price as the stock breaks beyond the Doji candle.
Although the Doji candle is often not a great entry candle for a trade (due to its nature it could be broken either way by the bulls or bears), it does offer a heads up that sentiment may be changing.
3. Inverted Hammer
This candlestick pattern gets its name literally due to its resemblance with an inverted hammer.
The inverted hammer formation is just like the Shooting Star (discussed later) formation.
It is created when the open & low or close & low prices are at the same price. This is coupled with a long upper shadow which is significantly longer than the real body of the candlestick.
This formation mostly happens at the end of downtrends and is a warning of a potential reversal and generally signals an uptrend.
4. Hanging Man
The Hanging Man pattern is typically an indicator of bearish pattern and is formed when the open, high and close prices are roughly at the same price and there is a long lower shadow which is twice the length of the body.
The hanging man and hammer have the same shape. The key difference is:
• Hanging Man Candlestick is observed after an uptrend (bullish)
• Hammer Candlestick is observed after a downtrend (bearish)
This type of pattern is used by investors to decide when to enter or exit a trade.
When the high and the open are the same a bearish Hanging Man Candlestick is formed and it is considered a stronger bearish sign than when the high and close are the same forming a bullish Hanging Man.
5. Shooting Star
A Shooting Star pattern is an indicator bearish trend that usually happens at the top of uptrends. This trend basically signals the end of the upward buying trend and the beginning of selling pressure from bears.
The shooting star and inverted hammer have the same shape. The key difference is:
• Shooting Star Candlestick is observed after an uptrend (bullish)
• Inverted Hammer Candlestick is observed after a downtrend (bearish)
It can be generally spotted when the low and the close are at the same price meaning that bears had rejected the bulls and were able to push the price down significantly.
6. Gravestone Doji
A gravestone doji is an indicator bearish pattern where the open the open, low and closing prices tend to be the same and it occurs mainly at the top of uptrends indicating a reversal in the downward direction indicating that the bears will take control of the market.
7. DragonFly Doji
A Dragonfly Doji is a type of Candlestick where the open, high and close prices are roughly the same due to which it can be used to signal a potential price reversal to the upside or the downside depending on the past price action.
In most cases, the direction of price movement is decided by the next candlestick which is followed by the dragonfly doji.
The differences between the candlestick patterns are subtle and a beginner can get easily confused. If you still require further clarification, please re-read those specific topics.
In the next blog, we will discuss Multiple Candlestick Patterns.