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Achieving Proficiency in Candlestick Pattern Analysis

Sebencapital

Published
11/10/23
Achieving Proficiency in Candlestick Pattern Analysis

Candlestick charts are an evolved form of line charts, as illustrated in the image below. They were developed to address the limitations of providing less information. These charts trace their roots back to 17th-century Japan. Today, candlestick charts are the preferred analytical tool for traders and most investors. They offer a comprehensive overview of essential data in a single glance. This article teaches you to master candlestick patterns like a seasoned professional.

Proficiency in Candlestick Pattern

As the name suggests, a candlestick chart comprises individual candlesticks, also known as price candlesticks. These candlesticks encompass various components that visually represent the price dynamics of financial instruments.

Displayed below, you'll find two sample candlesticks. Each candlestick comprises a solid segment called the body, accompanied by two slender lines known as candle wicks or candlestick shadows.

To simplify comprehension, candlesticks are color-coded to reflect the direction of price movements. A white candlestick signifies an increase in prices, while a black candlestick indicates a decrease in price during the specified period.

Candlestick anatomy

Image: On the left, a rising candlestick is depicted, while on the right, a falling candlestick is displayed, accompanied by explanations of the terms used to describe individual candlestick components.

The length of the candlestick shadows represents the extent to which the price has moved up and down during a specific timeframe. If we configure our charts to display one candlestick per day, we can analyze the day-to-day fluctuations in the financial market by examining the candlestick shadows.

On the other hand, the candlestick body illustrates the difference between the beginning and closing prices for the given period.

The white, rising candlestick shown below signifies that the price started at $10 and closed at $20 within the selected timeframe. However, during that time, it fluctuated between $25 and $5, as indicated by the presence of shadows.

path of price

Image: The candlestick body depicts the movement of candlesticks from the starting price to the closing price, while the shadows illustrate the full range of price fluctuations.

When we align multiple candlesticks in sequence, we can recreate the progression in line charts by tracking the candlestick bodies, as demonstrated below. The candlestick shadows also provide insights into the extent of price fluctuations in each instance. This way, we can access all the vital information required for effective price analysis at a glance. This explains why candlestick charts are predominantly employed for technical analysis in today's trading landscape.

line graph - candle graph

Image: You can reconstruct line charts by tracking the trajectory of candlestick prices. Candlesticks provide a richer source of information and are the favored tool of choice for technical analysts.

Those who grasp analyzing and interpreting the so-called candlestick patterns or candle formations gain a deeper understanding of participants' behaviors in the financial markets.

Candlesticks can be categorized into four components, with each element shedding light on distinct aspects of the current trading activity and the predominant market sentiment.

Intro: The Strength Ratio – Bulls vs. Bears

To grasp the dynamics of price and candlestick analysis, it's beneficial to envision the price movements in financial markets as a battle between two opposing forces: the buyers and the sellers.

Buyers speculate that prices will rise and, in turn, influence upward price movements through their trades and buying activities. Conversely, sellers place their bets on price declines and exert downward pressure on prices through their selling activities.

This analogy of a market battle between buyers and sellers provides valuable insight into the ebb and flow of financial markets.

When one side of the market exhibits more strength than the other, distinct trends emerge in financial markets:

  • More Buyers than Sellers: When there are more purchasers than sellers or an abundance of buying interest compared to selling interest, buyers encounter a limited supply to purchase from. As a result, prices rise until they reach a point where sellers find it enticing to participate once again. Simultaneously, these elevated prices may become unsustainable for the buyers, leading to a slowdown in buying activity.
  • More Sellers than Buyers: Conversely, if there are more sellers than buyers, prices tend to decline until a balance is restored, attracting more buyers into the market.
  • Imbalance Speeds Movement: The extent of the imbalance between these two market participants influences the speed of market movements. A significant disparity results in rapid price shifts, whereas a slight disparity leads to slower changes.
  • Equilibrium Leads to Stability: When buying and selling interests are in equilibrium, there's no driving force for price change. Both sides are content with the current price, resulting in market stability.

It's crucial always to keep these dynamics in mind because price analysis involves evaluating the relative strength of buyers and sellers to gauge the likely direction of price movement.

Element 1: Size of the Candlestick Body

The size of a candlestick body, representing the difference between its opening and closing prices, provides significant insights into the strength of buyers and sellers in the market. Let's explore the key characteristics of candlestick body analysis:

  • Long Candlestick Body - Strong Buying Interest: A lengthy candlestick body, leading to rapid price increases, indicates heightened buying interest and a robust price surge.
  • Increasing Candlestick Body Sizes - Intensified Trend: When candlestick body sizes progressively grow, it signals an acceleration in the price trend, reflecting a strengthening and intensified market momentum.
  • Shrinking Candlestick Body Sizes - Potential Trend Reversal: Conversely, diminishing candlestick body sizes suggest a potential end to a prevailing trend. This change often occurs as the strength ratio between buyers and sellers becomes more balanced.
  • Constant Candlestick Bodies - Confirming a Stable Trend: Candlestick bodies that remain relatively consistent confirm the stability of an ongoing trend. In such cases, market conditions are maintaining their current state.
  • Shift from Rising to Falling Candlesticks - Sudden Trend Change: A sudden transition from long-rising candlesticks to long-falling candlesticks signifies an abrupt change in the trend's direction. This shift highlights the presence of influential market forces that are actively reshaping market dynamics.

Understanding these characteristics of candlestick body analysis is pivotal for traders and analysts in assessing market sentiment and making informed decisions about potential price movements.

Sudden Trend Change

Figure: Left-Candlestick Body Length in Different Trend Phases

Left: In the depiction on the left, we observe long candlestick bodies during both downward and upward trend phases. Sideways or consolidating phases, on the other hand, are typically characterized by smaller candlestick bodies.

Right - Strength of Rising Candlesticks in Upward Trends

Right: On the right, we can see that rising candlesticks tend to be stronger and longer during an upward trend. However, as the trend peaks, the ratio shifts, and a sideways phase emerges, characterized by smaller candlesticks.

Understanding these patterns of candlestick body lengths is essential for traders and analysts to identify and interpret various market phases accurately.

Element 2: Length Of Candlestick Shadows

Analyzing Candlestick Shadows for Volatility

The length of candlestick shadows determines market volatility, representing the entire range of price fluctuations. Let's delve into the characteristics of candlestick-shadow analysis:

  • Long Shadows - Indicative of Uncertainty: Long shadows can signal market uncertainty, indicating strong competition between buyers and sellers, yet neither side has gained a decisive upper hand thus far.
  • Short Shadows - Reflecting Stability: Conversely, short shadows point to a stable market with minimal instability, suggesting a relatively balanced state between buyers and sellers.
  • Increased Shadow Length After Prolonged Trends: It's often observed that the length of candlestick shadows increases following extended trend phases. This growth in fluctuation signifies an intensification in the battle between buyers and sellers, with the strength ratio no longer as one-sided as during the trend.
  • Healthy Trends with Small Shadows: In healthy trends that progress swiftly in one direction, candlesticks tend to have only small shadows. This phenomenon occurs when one side of the market players dominates the proceedings.

Analyzing these patterns of candlestick shadows aids traders and analysts in assessing market volatility and understanding the dynamics between buyers and sellers.

Element 3: Body To Shadow Ratio

Correlation of Candlestick Elements for Understanding Price Movements

To gain a deeper understanding of price movements and market behavior, it's essential to establish a correlation between the first two elements and the third element. Several significant factors in this context include:

  • Strong Trend Indicators: During a robust trend, the length of candlestick bodies is often notably greater than that of the shadows. The trend's strength is reflected in how rapidly prices move in the trend's direction. In a strong upward trend, candlesticks typically conclude near the body's high, leaving no or only a minimal shadow.
  • Changing Ratios as Trends Slow Down: As the trend loses momentum, the ratio between candlestick shadows and bodies shifts. Shadows become longer compared to the candlestick bodies.
  • Sideways Phases and Turning Points: Sideways phases and market turning points are typically characterized by candlesticks with extended shadows and short bodies. This signifies a relative equilibrium between buyers and sellers, indicating uncertainty about the direction of the next price movement.

Understanding these correlations between candlestick elements is instrumental for traders and analysts in interpreting market dynamics and making informed decisions regarding potential price movements.

Candlestick Shadows in Different Market Phases

Figure: Candlestick Shadows in Different Market Phases

In the left-rising phase, there are minimal shadows, confirming the presence of a strong trend. However, the sudden appearance of long candlestick shadows during the sideways phase indicates a period of uncertainty and intensified competition between buyers and sellers. When candlestick shadows start to increase, they often serve as a potential signal of an impending end to the prevailing trend.

Element 4: Position Of The Body

Position of the Candlestick Body: Two Common Scenarios

In most cases, we can identify two common scenarios when analyzing the position of the candlestick body:

  • Rejection, Hammer, or Pinbar: This scenario is known as rejection when you observe a single dominant shadow extending prominently on one side of the candlestick, with the candlestick body on the opposite side. The third and seventh examples in Figure 10 illustrate such candlesticks. In this situation, the presence of a significant shadow indicates that despite an attempt to push the price in one direction, strong opposition from market participants has forced the price in the opposite direction. This behavioral pattern is crucial and will be examined in detail later.
  • Indecision or Balance: Another common scenario features a candlestick with two similarly long shadows on both sides and a relatively small body. The fifth candlestick in Figure 10 displays this indecision pattern. It can signify uncertainty in the market, but it can also indicate a balance between market players. Here, buyers have endeavored to drive the price higher while sellers have pushed it lower. Ultimately, the price has returned to its starting point.
BULLS VS. BEARS

Figure: Candlestick Characteristics from Left to Right

From left to right: In this sequence, we observe the significance of candlestick features:

  • Candlestick Body Size Reflects Price Movement Strength: The size of the candlestick body directly corresponds to the strength of the price movement. A longer body indicates a more forceful impulse in the price direction.
  • Longer Candlestick Shadows Signify Balance: When the candlestick shadows become longer, it indicates a balance between sellers and buyers in the market, leading to increased indecision.

Chart Examples

Now that we've discussed the individual elements let's combine them and explore how to apply this knowledge to analyze and interpret price charts effectively.

Example 1

Let's analyze the chart below and discuss what we observe in the candlesticks:

  • Downtrend Phase: In the initial downtrend phase, the candlesticks consistently appear red (bearish) and are characterized by being long with very small or nonexistent wicks. This pattern signifies significant selling pressure and market strength favoring the bears.
  • Rejection at the Bottom: As we reach the bottom of the downtrend, we notice a rejection candlestick. However, at this point, there is not sufficient evidence to label it as a complete reversal.
  • Transition to Bullish Candles: On the following candle, we start to observe the appearance of bullish (green) candles. This shift indicates a potential change in sentiment, with buyers gaining strength and challenging the previous bearish dominance.

This analysis suggests that the market is transitioning from a bearish phase to a bullish one. It's essential to continue monitoring the price action for further confirmation and signs of a reversal.

Example 2

Let's analyze the typical range behavior displayed in the chart below and observe how the candlesticks provide insights into the market dynamics:

  • Initial Downtrend: On the left side, we notice a clear downtrend characterized by strong, bearish candles with no bullish candles in between. This indicates a robust bearish momentum in the market.
  • Transition to Range: Suddenly, there's a change in behavior as the candle bodies become smaller and the wicks become longer. This shift suggests that the previous strong momentum is fading, and the market is entering a ranging phase.
  • Support Becomes Resistance: Price returns to an earlier support level, which now acts as resistance. Here, we observe a small rejection candle indicating sellers defend this level.
  • Indecision at Range Support: As the price reaches the support of the range, we see that candles are smaller and have longer wicks. This confirms market indecision and makes a support level break seem unlikely.
  • The buildup to Support Break: Just before the support eventually breaks, the price starts to form bearish candles, signaling that momentum is picking up in favor of the bears.

This analysis demonstrates how candlestick patterns can provide valuable insights into the market's transition from a downtrend to a ranging phase and, ultimately, to a breakdown of support. Monitoring these candlestick patterns can help traders make informed decisions.

Example 3

Let's examine the final example, which showcases a classic pattern at the end of a trend. This pattern often serves as one of the foundational elements in trading strategies, as taught in our professional area.

  • Uptrend Phase: We observe very long candles with very small wicks in the initial uptrend phase, indicating a strong and sustained bullish momentum.
  • Attempted Downside Move: Suddenly, two candles with long wicks point to the Downside. This suggests that the price attempted to push lower but encountered insufficient selling pressure to sustain the move.
  • Loss of Uptrend Momentum: As we progress, the candles become smaller following the failed sell-off attempt. This diminishing candle size is indicative of waning momentum in the uptrend.
  • Confirmation of Downtrend: Finally, a strong bearish candle emerges, confirming the onset of a new downtrend. This candle signifies a shift in market sentiment and a transition from bullish to bearish momentum.

This analysis highlights how candlestick patterns can provide valuable insights into the dynamics of a trend, helping traders identify potential trend reversals and plan their trading strategies accordingly.

Conclusion

This article emphasizes that you don't need to memorize specific candlestick formations to comprehend price movements. It's crucial, especially on your journey to becoming a proficient and profitable trader, to adopt a mindset that goes beyond traditional approaches and avoids common mistakes often made by beginners. Instead, focus on understanding how buyers and sellers influence price, identifying who controls the market, and recognizing when control is shifting. This perspective will significantly enhance your trading skills and decision-making abilities.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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