Beginners Guide to TA: Analysis of Candlesticks

Understanding Technical Analysis

Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysts, who attempt to evaluate a security’s intrinsic value, technical analysts focus on patterns of price movements, trading signals, and various other analytical charting tools to evaluate a security’s strength or weakness. Technical analysis utilizes price movements and chart histories to uncover trends and sentiment based on revealed market psychology.

Technical analysts have developed an extensive toolbox of analysis techniques and indicators. Typically, the use of one technical indicator does not provide enough information to make a trading decision; technicians use several indicators to confirm a hypothesis before taking action. There is no broad consensus on the best method of identifying future price movements, so most technicians gradually develop their own set of trading rules based on their knowledge and experience.

What is aTechnical Analyst?

A technical analyst, also known as a chartist or market technician, is a securities researcher or trader who analyzes investments based on past market prices and technical indicators. Technicians believe that short-term price movements are the result of supply and demand forces in the market for a given security.

Thus, for technicians, the fundamentals of the security are less relevant than the current balance of buyers and sellers. Based on the careful interpretation of past trading patterns, technical analysts try to discern this balance with the aim of predicting future price movements. Technical analysis looks for price patterns and trends based on historical performance to identify signals based on market sentiment and psychology.

Technical Indicators

Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s.1 Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts helping to form its basis. In modern day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research

Technical indicators are mathematical calculations based on the price, volume, or open interest of a security or contract.

In general, technical analysts look at the following broad types of indicators:

• Price trends
• Chart patterns
• Volume and momentum indicators
• Oscillators
• Moving averages
• Support and resistance levels

Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.

1. Markets are efficient with values representing factors that influence a security’s price, but
2. Even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time

Today the field of technical analysis builds on Dow’s work. Professional analysts typically accept three general assumptions for the discipline:

1. The market discounts everything: Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology are already priced into the stock. This point of view is congruent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
2. Price moves in trends: Technical analysts expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
3. History tends to repeat itself: Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

Candlestick Pattern

In financial technical analysis, a candlestick pattern is a movement in prices shown graphically on a candlestick chart that some believe can predict a particular market movement. The recognition of the pattern is subjective and programs that are used for charting have to rely on predefined rules to match the pattern. There are 42 recognized patterns that can be split into simple and complex patterns.

Some of the earliest technical trading analysis was used to track prices of rice in the 18th century. Much of the credit for candlestick charting goes to Munehisa Homma (1724–1803), a rice merchant from Sakata, Japan who traded in the Ojima Rice market in Osaka during the Tokugawa Shogunate. According to Steve Nison, however, candlestick charting came later, probably beginning after 1850.

Formation of candlesticks

Candlesticks are graphical representations of price movements for a given period of time. They are commonly formed by the opening, high, low, and closing prices of a financial instrument

If the opening price is above the closing price then a filled (normally red or black) candlestick is drawn.

If the closing price is above the opening price, then normally a green or hollow candlestick (white with black outline) is shown.

The filled or hollow portion of the candle is known as the body or real body, and can be long, normal, or short depending on its proportion to the lines above or below it.

The lines above and below, known as shadows, tails, or wicks, represent the high and low price ranges within a specified time period. However, not all candlesticks have shadows.

• The body, which represents the open-to-close range
• The wick, or shadow, that indicates the intra-day high and low
• The colour, which reveals the direction of market movement — a green (or white) body indicates a price increase, while a red (or black) body shows a price decrease

16 MAJOR CANDLESTICK PATTERNS

A candlestick is a way of displaying information about an asset’s price movement. Candlestick charts are one of the most popular components of technical analysis, enabling traders to interpret price information quickly and from just a few price bars. Over time, individual candlesticks form patterns that traders can use to recognise major support and resistance levels. There are a great many candlestick patterns that indicate an opportunity within a market — some provide insight into the balance between buying and selling pressures, while others identify continuation patterns or market indecision. It’s important to familiarise yourself with the basics of candlestick patterns and how they can inform your decisions.

In this article, I’ll group the 16 candlesticks under 3 groups:

1. Six bullish candlestick patterns
2. Six bearish candlestick patterns
3. Four continuation candlestick patterns

Six Bullish Candlestick Patterns

Bullish patterns may form after a market downtrend, and signal a reversal of price movement. They are an indicator for traders to consider opening a long position to profit from any upward trajectory. The six bullish candlestick patterns are: Hammer, Inverse Hammer, Bullish engulfing, Piecing line, Morning star, Three white soldiers

Hammer

The hammer candlestick pattern is formed of a short body with a long lower wick, and is found at the bottom of a downward trend.

A hammer shows that although there were selling pressures during the day, ultimately a strong buying pressure drove the price back up. The colour of the body can vary, but green hammers indicate a stronger bull market than red hammers.

Inverse Hammer

A similarly bullish pattern is the inverted hammer. The only difference being that the upper wick is long, while the lower wick is short.

It indicates a buying pressure, followed by a selling pressure that was not strong enough to drive the market price down. The inverse hammer suggests that buyers will soon have control of the market.

Bullish Engulfing

The bullish engulfing pattern is formed of two candlesticks. The first candle is a short red body that is completely engulfed by a larger green candle.

Piercing Line

The piercing line is also a two-stick pattern, made up of a long red candle, followed by a long green candle. There is usually a significant gap down between the first candlestick’s closing price, and the green candlestick’s opening. It indicates a strong buying pressure.

Morning Star

The morning star candlestick pattern is considered a sign of hope in a bleak market downtrend. It is a three-stick pattern: one short-bodied candle between a long red and a long green. Traditionally, the ‘star’ will have no overlap with the longer bodies, as the market gaps both on open and close. It signals that the selling pressure of the previous trade is subsiding, and a bull market is on the horizon.

Three White Soldiers

The three white soldiers pattern occurs over three days. It consists of consecutive long green (or white) candles with small wicks, which open and close progressively higher than the previous day.

It is a very strong bullish signal that occurs after a downtrend, and shows a steady advance of buying pressure.

Six bearish candlestick patterns

Bearish candlestick patterns usually form after an uptrend, and signal a point of resistance. Heavy pessimism about the market price often causes traders to close their long positions, and open a short position to take advantage of the falling price. The six bearish candlestick patterns are:

Hanging man, Shooting star, Bearish engulfing, Evening star, Three black claws, Dark cloud cover.

Hanging man

The hanging man is the bearish equivalent of a hammer; it has the same shape but forms at the end of an uptrend. It indicates that there was a significant sell-off during the day, but that buyers were able to push the price up again. The large sell-off is often seen as an indication that the bulls are losing control of the market.

Shooting Star

The shooting star is the same shape as the inverted hammer, but is formed in an uptrend: it has a small lower body, and a long upper wick.

Usually, the market will gap slightly higher on opening and rally to an intra-day high before closing at a price just above the open — like a star falling to the ground.

Bearish Engulfing

A bearish engulfing pattern occurs at the end of an uptrend. The first candle has a small green body that is engulfed by a subsequent long red candle. It signifies a peak or slowdown of price movement, and is a sign of an impending market downturn. The lower the second candle goes, the more significant the trend is likely to be.

Evening Star

The evening star is a three-candlestick pattern that is the equivalent of the bullish morning star. It is formed of a short candle sandwiched between a long green candle and a large red candlestick.

It indicates the reversal of an uptrend, and is particularly strong when the third candlestick erases the gains of the first candle.

Three Black Crows

The three black crows candlestick pattern comprises of three consecutive long red candles with short or non-existent wicks. Each session opens at a similar price to the previous day, but selling pressures push the price lower and lower with each close. Traders interpret this pattern as the start of a bearish downtrend, as the sellers have overtaken the buyers during three successive trading days.

Dark Cloud Cover

The dark cloud cover candlestick pattern indicates a bearish reversal — a black cloud over the previous day’s optimism. It comprises two candlesticks: a red candlestick which opens above the previous green body, and closes below its midpoint. It signals that the bears have taken over the session, pushing the price sharply lower. If the wicks of the candles are short it suggests that the downtrend was extremely decisive.

Four continuation candlestick patterns

If a candlestick pattern doesn’t indicate a change in market direction, it is what is known as a continuation pattern. These can help traders to identify a period of rest in the market, when there is market indecision or neutral price movement. There are four kinds of continuation candlestick patterns: Doji, Spinning top, Falling three methods, Rising three methods.

Doji

When a market’s open and close are almost at the same price point, the candlestick resembles a cross or plus sign — traders should look out for a short to non-existent body, with wicks of varying length. This doji’s pattern conveys a struggle between buyers and sellers that results in no net gain for either side. Alone a doji is neutral signal, but it can be found in reversal patterns such as the bullish morning star and bearish evening star. Thus, doji shows the effect of buyers and sellers are the same.

Spinning Top

The spinning top candlestick pattern has a short body centred between wicks of equal length. The pattern indicates indecision in the market, resulting in no meaningful change in price: the bulls sent the price higher, while the bears pushed it low again. Spinning tops are often interpreted as a period of consolidation, or rest, following a significant uptrend or downtrend.

Falling Three Methods

Three-method formation patterns are used to predict the continuation of a current trend, be it bearish or bullish.

The bearish pattern is called the ‘falling three methods’. It is formed of a long red body, followed by three small green bodies, and another red body — the green candles are all contained within the range of the bearish bodies. It shows traders that the bulls do not have enough strength to reverse the trend.

Rising Three Methods

The opposite is true for the bullish pattern, called the ‘rising three methods’ candlestick pattern. It comprises of three short reds sandwiched within the range of two long greens. The pattern shows traders that, despite some selling pressure, buyers are retaining control of the market.

TRADING INDICATORS

• Ichimoku
• Bollinger blind
• SMA and EMA
• RSI

Other indicators exist, but I use these ones the most :)

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