Understanding Candlestick Charts

Candlestick Charts 101: The Basics Every Investor Should Know

The Role of Candlestick Charts in Market Analysis

Marcus Padley | 10 July 2024 | Education Corner

Line Charts vs. Candlestick Charts

A line chart plots the closing price of a stock - this is a daily chart so it shows the closing price at the end of every day - with one data point a day. These charts can be Hourly, Weekly, Monthly, Yearly, by the second, 1 minute, 10 Minutes, 30 Minutes and so on. With one data point at the close of every time period chosen. And here is a Candlestick chart of BHP over the same period. Again, it's a daily chart. One candlestick per day. Most charting packages plot red and green candles. We use Blue and Yellow. Same same, we just prefer the colours because some Members are colour-blind and red and green don't come over well.

The Psychology of Candlestick Charts

Line charts can show you the trend but candlestick charts (theoretically) go to the psychology of the buyers and sellers. By looking at candles you can (theoretically) get a handle on what people are thinking and how consensus thinking is changing and get a lead on the changes in the dominant trend of a stock.

The Battle of Buyers and Sellers

The way that works is this. Imagine every candle is a representation of a war between buyers and sellers. From the open, close, high and low you may be able to determine which group is in the ascendancy and identify when the balance of power is changing. The concept of a War goes back to the origin of candlesticks which came out of Japan. A nation flooded with conflict. "The concept of candlestick charting was developed by Munehisa Homma, a Japanese rice trader. During routine trading, Homma discovered that the rice market was influenced by the emotions of traders, while still acknowledging the effect of demand and supply on the price of rice." Put this in the hands of fiddling academics and you can imagine how complex and over-interpreted candlestick charts can become with some rather grandiose interpretations of multi-candle patterns punctuating the subject. It’s like any technical analysis, in the end, the complexity loses sight of the wood for the trees. The simplest technical analysis (standing back and blurring your eyes to see the trend) is often the most valuable, so let’s try and keep candlesticks simple.

Recognising Trends with Candlesticks

A candlestick shows the high, low open, and close: If the close is above the open (the share price closed above the open) the candle is white (or green or blue). A white candle suggests that the buyers have won the war on the day and pushed the price higher. A series of white candles suggests a stock is in uptrend as the buyers win the war day after day. If the close is below the open the candle is black (or red or yellow). A Black candle suggests that the sellers have won the war on the day and have pushed the price lower. A series of black (yellow) candles suggest a stock is in downtrend as the sellers win the war day after day. Now back to Yellow (Black or Red equivalent) and Blue (White or Red equivalent). You can see in the example above that whilst the share price is in uptrend (the earlier blue candles) the buyers regularly win the daily battle (blue candles) and when it is in downtrend the sellers win the day most of the time (yellow candles). Now you can start to imagine how this might develop into an analysis of the psychology of the trend. What you want to see (if you are long a stock) is perpetually blue candles and you would be on the lookout for them turning yellow. When yellow candles start to creep in it is time to start thinking about taking a profit as the sellers start to dominate the buyers.

Understanding the Doji Candle

Here is a basic example where a yellow candle following a series of blue candles has indicated a change of trend. Interestingly, a yellow candle could conceivably still have a close above the previous day’s high but the sellers have won the day. On a line chart, which only indicates the close, all you would see is the share price going up and you would not respond, but using a candle chart you would notice that the sellers had won the day even though the share price was still going up and that would indicate that even though the share price was still rising the trend was coming to an end. Now you begin to realise how candlesticks are seen as a representation of all sorts of states of mind, of the buyers and sellers and you can see how the academics get carried away and start to interpret different combinations of candles as signifying different things. At its most basic level, yellow candles following a series of blue candles suggest the trend is about to change and a blue candle at the end of a series of yellow candles might suggest a stock is about to bottom.

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Types of Doji Candles

There are countless different ways to analyse and draw conclusions from candles, but let us start you with one classic candle to look out for. The Doji candle. This one is called a Doji cross, a candle where there is no body. That tells you that the close was the same as the open: The Doji candle suggests that the buyers and sellers are matched, nobody won the war today. This suggests indecision and is often interpreted as marking the top or bottom of a trend. When a Doji Cross comes after a series of blue or yellow candles it suggests that for the first time, the sellers have matched the buyers, with the implication that the next candle might see the sellers gain the upper hand for the first time. And again interestingly, you wouldn’t pick this up on a line chart, a line chart would simply show the price going sideways. Perhaps one of the most valuable pieces of information in share trading is just what the Doji candle purports to suggest, when a trend is going to change.

Caveats: The Limitations of Doji Candles

But don't think it's that simple. Now there are different types of Doji candles: If you think logically about these you can see that the Dragonfly Doji at the end of a downtrend is bullish, and the longer the tail, the more bullish it is. It means there was a big sell-off in line with the existing trend and then the buyers came in and closed it at the open. The Gravestone Doji on the flip side is a bearish candle in an uptrend, which suggests that the buyers had a bout of enthusiasm earlier in the day, but by the end of the day, the sellers had sold it all the way down from the high to the open.

Practical Application of Candlesticks in Trading

So next time you’re looking at a chart and you see a Doji candle in an uptrend or downtrend, see it as a sign of a trend change, a point to buy or sell. Caveats:

• One Doji on its own isn’t usually enough to make a decision, but it is a sign.
• Note (boringly) that Doji candles can appear in an uptrend, and then the uptrend resumes again – this is seen as a continuation Doji and is quite bullish. It means the sellers had a go and lost. Same for a Doji in a downtrend.

As you can see, there is a lot of wooliness in the interpretation, as with all technical analysis. It all seems to boil down to the fundamental flaw – The theory works unless it doesn’t.

Final Thoughts on Candlestick Analysis

I once went to an ATAA (Australian Technical Analyst Association) conference and spoke at their dinner. On my table, an argument developed about how some ATAA Members were more interested in Technical Analysis than they were in trading, with the accusation that some of them just loved theories and had never traded a share in their life. It's a good observation. When you get into Technical Analysis, and particularly Candlestick charting, you can lose sight of the goal for the theory. The theory is supposed to help you make money, so, as one of the dinner party guests pointed out, "If you're not trading, it's just a load of wank" (excuse his French). So don't get lost in the theory. If you understand the principles, it can help the average investor identify a change of psychology in a trend. I understand enough of it for it to be mildly useful or interesting, but I don't get instructed by it and anyone who slavishly sticks to it has probably lost objectivity. It's not that easy to make money. But I do love the visual representation of psychology behind it.

Further Exploration of Candlestick Patterns

Now, you are set up to delve into the very many and varied Candlestick Patterns. Good luck. There are literally hundreds of them:

• Incredible Charts is a good place to find free stuff on Charts.
• Someone asked - A lot of Members now use TradingView for charting.
• You know you can actually get qualified in Technical Analysis. Click here.