Another type of chart used in technical analysis is the candlestick chart, so called because the main component of the chart representing prices looks like a candlestick, with a thick body, called the real body, and usually a line extending above and below it, called the upper shadow and lower shadow, respectively. The top of the upper shadow represents the high price, while the bottom of the lower shadow represents the low price. Patterns are formed both by the real body and the shadows. Candlestick patterns are most useful over short periods of time, and mostly have significance at the top of an uptrend or the bottom of a downtrend, when the patterns most often signify a reversal of the trend.
While the candlestick chart shows basically the same information as the bar chart, certain patterns are more apparent in the candlestick chart. The candlestick chart emphasizes opening and closing prices. The top and bottom of the real body represents the opening and closing prices. Whether the top represents the opening or closing price depends on the color of the real body—if it is white, then the top represents the close; black, or some other dark color, indicates that the top was the opening price. The length of the real body shows the difference between the opening and closing prices. Obviously, white real bodies indicate bullishness, while black real bodies indicate bearishness, and their pattern is easily observable in a candlestick chart.
A doji is a candlestick with no real body, because the open price was equal to the close price. This implies that the market is in a transitional phase, that a trend is ending, or that the market is indecisive. When the opening and closing price are between the high and low price, then it is referred to as a plain doji, but if the opening and closing prices are either the high or low price, then it is given a specific interpretation.
A dragonfly doji has a long lower shadow, but no upper shadow, which means that the open and close were also the high price for the day, but also that the price was a lot lower during the day but came back up. A gravestone doji results when the open and close prices equals the low of the day, but that the price did rise significantly during the course of the day—thus, it has a long upper shadow. Both the dragonfly and gravestone doji signify that a trend is ending, whether it be up or down.
Sometimes one or both of the shadows are missing, which is a good indicator of bullish or bearish sentiment, especially if the real body is long. A shaven top results when the open or close was also the high for the day. A black shaven top indicates that the opening price was the high for the day, that the price continually dropped from there: a bearish sign. A white shaven top is bullish, since the close was also the high and that prices rose throughout the day.
A shaven bottom results when the opening or closing price is also the low. A white shaven bottom results when the opening price was the low price and it went up from there, while a black shaven top results when the close is also the low, indicating bearish sentiment.
Long shadows indicate that a lot of trading took place either far above or far below the opening and closing prices, and usually indicate that a trend may be ending.
As with price bars, it is the pattern that matters most in candlestick charts. Many patterns become more apparent using candlestick charting, especially reversal patterns.
The hammer and the hanging man are characterized by a short real body and a lower shadow that is 2 to 3 times longer than the body. A candlestick of this shape that occurs at the top of an uptrend is the hanging man and one that occurs at the bottom of a downtrend is the hammer. Both signify a reversal of the preceding trend regardless of whether they are white or black.
Another reversal pattern is the harami, which means pregnant in Japanese, where a small real body follows a long real body. (Mnemonic: think of the long real body giving birth to the smaller body.) The harami pattern is similar to the inside bar pattern, but the difference is that in the harami, only the real body is within the price of the preceding real body; the shadows can extend beyond the 1st body. When the large and small bodies are a different color, then the pair is known as a spinning top. Generally, the harami indicates a trend reversal.
The opening and close of an engulfing candlestick is both higher and lower than the opening and the close of the day before. A black engulfing candlestick in an uptrend signifies that it is ending, while a white engulfing candlestick at the end of a downtrend signifies that the trend is reversing into an uptrend. The larger the difference between the 2 bars, the stronger the signal for a trend reversal.
A shooting star has a small real body but a long upper shadow and sits above a preceding uptrend, which is interpreted as a failure of the continuation of the uptrend, and that the trend is reversing. Similarly, the inverted hammer sits at the bottom of a downtrend, with a long upper shadow and little or no lower shadow and indicates the beginning of an uptrend.
Another set of patterns indicating a trend reversal are the dark cloud cover and the piercing line—neither of these indicators are as good as the preceding patterns. The dark cloud cover consists of 2 candlesticks where the 1st has a large white body and the 2nd has a large black body at the top of an uptrend. The black body opens above the upper shadow of the white body and closes within the range of the white body, signifying a reversal to a downtrend. Likewise, the piercing line is a large black body followed by a large white body at the bottom of a downtrend and is otherwise the opposite of the dark cloud cover, portending the reversal of the downtrend.
Three white soldiers is a pattern occurring at the bottom of a downtrend and marks the beginning of an uptrend, where each of the candlesticks has a long white real body, with each candlestick higher than the one before. The size of the bodies indicates the strength of the signal. Likewise, three black crows are 3 large black bodies at the top of an uptrend, with each candlestick lower than the preceding one and indicates the beginning of a downtrend.
Some patterns signify the continuation of the present trend.
A rising window is a pattern consisting of at least 3 candlesticks, where there is a upward gap between the 1st 2, and the 3rd candlestick at least level with the 2nd candlestick, and fails to fill the gap. A falling window has the opposite pattern.
Series of Patterns
A trend doesn't continue forever, and it may last only minutes or hours, depending on the time frame considered. Therefore, there will be a series of patterns that change as the price moves from the support line to the resistance line. The support line is formed by prices where increased amount of buying prevents the price from falling further; a resistance line is formed by the upper price limit where increased selling prevents the price from moving higher. The support line and the resistance line form the channel. The astute trader will have to be constantly on the lookout for these changing patterns to respond quickly enough to take advantage of them.