Ok, so you open a chart on paddypowertrader to check out a price history. You’re immediately confronted by hundreds of little green and red bars. No problem you think: “Green = Up, Red = Down. They’re candlesticks. I’ve seen them many a time before.” You’re correct, but did you know that millions of trade decisions are made by simply analysing these candlesticks? Why? The main reasons are their simplicity and, of course, their profitability. Here I’m going to explain some of the most basic candlestick signals which can be applied to any stock, currency or commodity!

Hi, my name is The Galloping Zebu and this is my first piece for paddypowertrader. I’m a financial spread bettor with a passion for the markets. I’m here to make money and you’re reading this cause you want to make money too! So let’s get straight down to it.

Candlestick Construction

First things first, how do you make these cute little bars? Remarkably simple in fact, you only need four pieces of data: (1) open price, (2) high of the period, (3) low of the period and (4) close price.

The difference between the high and the low price is drawn as a vertical line, known as the shadow. Drawn on top of this is a rectanglar box, known as the body, which shows the difference between the close and the open. If the price closed higher than it opened, then the body is filled in with green. But if the price ended lower than the open, it is filled in red. This makes the candlestick easy to interpret immediately.

That’s all there is to candlesticks. Not a lot, eh?

Timeframe

One of the beautiful things about candlesticks is that they can be used in any timeframe in any chart. The patterns and signals are still the same. A day trader who’s looking to hold a trade open for half an hour might look at a 3-minute chart, which means each candlestick would show the high, open, close and low for that 3 minute period. But a trader that plans to hold the trade open for a couple of days might look at an hourly chart and his trades based on those candles.

For simplicities sake I will use days as my timeframe. But candlesticks are independent of time.

Now let’s get down to the important stuff: interpreting and making money from candlesticks.

Candlesticks in Action

A candlestick depicts the battle between the Bulls (buyers) and the Bears (sellers). I’m not talking about the two Chicago sport teams but, now that I think about it, a football analogy could be useful. Think of the low point of the candlestick as a goal for the Bears, while the high point is a score for the Bulls. Depending on where the close finishes decides who won the game.

Like a football match, there are different conclusions that can be drawn from any given candle. And, when you bring in previous candlesticks, the analysis becomes more complicated. Let’s have a look at the pattern on the right and see if we can get some insights into who is going to win the next Bulls Vs Bears match.

First thing to note is the three long green bodies on the left of the image, suggesting that the Bulls had been winning convincingly. But since then their performances have waned. Taken together, the last three candlesticks resulted in a draw. The final candlestick is known as a Doji, a long shadow with a tiny or non-existent body. A Doji is dangerous; it indicates a market is indecisive.

So what’s going to happen in the next match? Just as in a football match, we can’t be fully certain. But we can use the previous candlesticks to make an “educated guess”. In the Bulls’ changing room, they must be getting worried after three consecutive poor performances. The “dodgy Doji” in the last match may have been the last straw. Some backers may close their long positions, at a profit, which would cause selling pressure. In the Bears camp they must be getting more confident. But at the same time they haven’t shown enough recent strength to be strongly backed themselves.

If I was long and saw a chart like the one above I would probably play it safe: close the long position and wait for a better opportunity. If I was feeling in the mood for a riskier play I might even open a new short position.

Here’s what actually happened:

This time it was a case of “fortune favours the brave!” Buying momentum ran out of steam and the market subsequently fell back to its previous levels. The candlestick analysis would have sent a signal to close long positions, thus protecting profits.

Reversal Patterns

So we have looked at the “dodgy Doji”, which suggests that a market is indecisive and a trend may be about to end. Let’s have a look at some more candlestick patterns that can help identify when a market is going to turn.

The Hammer is a bullish reversal pattern that forms after a decline. There is a long shadow on the downside of a small body near the top. This suggests that the market tried to go lower, but failed and finished near its high of the day. Candlestick logic says the Bears may now lose heart in their downtrend and the Bulls could step in.

A Hanging Man occurs at the top of an uptrend. The trend starts to peter out and there is some selling pressure during the day (long downside shadow). The interpretation is that traders with long positions would now be happy to close out at a profit, which is going to cause more selling pressure.

In both cases, a safe move would be to wait for confirmation of the reversal (a further move against the previous trend) before opening a position. Of course this means that you would have lost the initial part of the reversal. The riskier play is to trade the reversal as soon as a hammer or hanging man is spotted.

Engulfing candlesticks are also reversal signals. Let’s have a look at a Bullish Engulfing pattern first. The set up for this is a long red body. The market closes near its low and it looks like the Bears are in control. On the next day, the market opens lower again. Then comes the crucial turnaround. The Bulls drive the price right up and the long green body completely engulfs the previous red body. The psychology has changed. The Bears have gone from being in control to being completely on the back foot. It takes some guts from the Bulls to go against a big move the previous day. After seeing such a reversal, more traders may jump on the Bull bandwagon.

A Bearish Engulfing pattern is the exact opposite of the bullish engulfing. It’s a signal that the Bears have seized control of a market.

Continuation Patterns

Ok, so we’ve looked at candlesticks that indicate a reversal may be coming. On the flip side are candlestick patterns that suggest a trend may continue. “The trend is your friend”, so these patterns should be your good buddies too.

Three White Soldiers is a bullish signal that consists of three consecutive green bodies, each with a higher close. Ideally, each candle should open within the previous body and the close should be near the high of the day. This signifies that there is still plenty of momentum in the up move yet. The Bulls are in full control and they are forcing the market up day after day. Could be time to jump on and ride the uptrend.

Three Black Crows is the opposite continuation pattern and is a bearish signal. The three candles have large red bodies, with very small shadows. Each candle follows the previous in an orderly downward fashion. This shows that the Bears are in control and the Bulls are hiding in the corner with their tails between their legs.

How Do I Use Candlestick Patterns

There is no one set of uses for candlesticks. Traders all around the world use them for different purposes. But I’ve been using them for a while now and I’ve found they really help my trading. Specifically:

• They quickly tell me what is going on in a market.
• They give an insight into market sentiment and trader psychology.
• Getting a feel for how the small and big market picture is looking by using candlesticks in different timeframes on the chart.
• They can give quite clear signals on when to open, when to hold and when to close a position.
• Integrate them with other technical indicators (e.g. RSI, MACD, Moving Averages) to decide on a trade.

Candlestick patterns crop up in nearly every chart that’s opened, so I wouldn’t often trade puely on candlesticks; rather they are another piece of kit in my bag. When using them I would generally try to get a feel for the ‘bigger picture’ by looking at daily and hourly charts, then zoom in on a 5 or 10 minute chart. I would then combine them with other technical indicators and keep a close eye on the upcoming economic data in paddypowertraders Weekly Wrap before deciding on a trade.

Conclusion
Wow, we’ve come a long way in one blog. If you have never used candlesticks before, hopefully you’ll have more of an appreciation now. Even if you’re an experienced user, hopefully you may have gained a couple of new insights.

There are many more candlesticks formations, which I will revisit in more detail later. Some are commonly used, such as stars and haramis. Others have truly strange names, including “Abandoned Baby” and “Stick Sandwich”.

To sum up in one proverb what is the best thing about candlesticks: “a picture is worth a thousand words!”