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How candlestick patterns work

…and how it can affect the way you trade

Traditionally candlesticks are represented using either a red/green or a hollow/filled combination, representing data that contains open, high, low, and close values for each time period you want to display. The Tradeview MetaTrader allows for combinations that can suit any style, so we use examples in this article from that platform.

Given the enormous number and variety of candlesticks, we will give particular focus to the Doji Candlestick, highly regarded as one of the most commonly identified and most important indicators of trend reversal and continuation patterns available.

The main portion of the candlestick is called the body. The long thin lines above and below the body represent the high/low range and are called shadows or tails. The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow. If the stock closes higher than its opening price, a green/hollow candlestick is drawn with the bottom of the body representing the opening price and the top of the body representing the closing price.

If the stock closes lower than its opening price, a red/filled candlestick is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price. In this article, we will be representing candlesticks with the green/red combination for visual purposes.

Longer green candlesticks are indicators that prices advanced significantly from open to close and buyers were aggressive and show strong buying power. While long green candlesticks are generally bullish, much depends on their position within the broader technical picture. On the reverse side, longer red candlesticks indicate that prices declined significantly from the open and sellers were aggressive, showing strong selling power.

Generally speaking, the longer the body is, the more intense the buying or selling pressure. Conversely, short candlesticks indicate little price movement and represent consolidation.

Long Versus Short Shadows

The upper and lower shadows on candlesticks can provide valuable information about the trading session. Upper shadows represent the session high and lower shadows the session low. Candlesticks with short shadows indicate that most of the trading action was confined near the open and close. Candlesticks with long shadows show that prices extended well past the open and close.

Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session, and bid prices higher. However, sellers later forced prices down from their highs, and the weak close created a long upper shadow. Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower. However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow.

Doji

Candlesticks are a good visual aid to see where the pressure is coming from within a given timeframe but sometimes a very balanced candlestick can be produced and is represented by what’s known as a Doji. Doji candlesticks are important because they provide information on their own, and as components in a number of important patterns. Doji form when the open and close are virtually equal. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross, or plus sign. Alone, Doji are neutral patterns. Any bullish or bearish bias is based on preceding price action and future confirmation.

Ideally, but not necessarily, the open and close should be equal. While a Doji with an equal open and close would be considered more robust, it is more important to capture the essence of the candlestick. Doji conveys a sense of indecision or tug-of-war between buyers and sellers, neither side being able to gain control.

The relevance of a Doji depends on the preceding trend or preceding candlesticks. After an advance, or long white candlestick, a Doji signals that the buying pressure is starting to weaken. After a decline or long black candlestick, a Doji signals that selling pressure is starting to diminish, indicating that the forces of supply and demand are becoming more evenly matched and a change in trend may be near. Doji alone are not enough to mark a reversal and further confirmation may be warranted.

Limitations to Candlesticks

Candlesticks only reflect the relationship between the open and close of a particular timeframe and do not reflect the sequence of events between the open and close. The high and the low are obvious and indisputable, but candlesticks cannot tell us which came first.

Above is just one example of a common and important type of candlestick but there are hundreds of potential combinations and types of candlestick. Candlesticks still offer valuable information on the relative positions of the open, high, low, and close. However, the trading activity that forms a particular candlestick can vary. Within each candlestick, a lot of the untold story may be hidden and only further analysis may provide the data.

Tradeview Metatrader has a finished platform that allows you to use candlesticks in a way that complements a host of other indicators to suit your timeframe, data exposure, and analysis.

RORY COLLINS
Trader
rcollins@rhino-report.tradeviewforex.com

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