They are graphic elements for price representation that resemble candles, hence the name candlestick. Candlestick was developed by the Japanese in the eighteenth century to analyze the prices of rice futures contracts.
The main purpose of candles is to predict changes in the price movements of an asset in order to identify the best buy or sell opportunities.
Candles represent the variation of prices over a given period of time and are formed by a body, upper shadow and lower shadow. Commonly differentiated by color, the candle indicates the opening price, ie the asset value at time zero and the closing indicates the price of this asset after a specified period of time. The shadows, represented by the thin lines, indicate the price oscillation between the opening and closing moment of the candle. If the closing occurs above the entry price, it’s called a bullish candlestick and is usually drawn in green. The red candle shows that the closing price was lower than the opening price, also known as the bearish candle.
From the dozens of candlestick patterns, we select the most common used by traders, which are Hammers, Engulfing and Dojis.
The hammer and inverted hammer have as their main feature a shadow at least 3 times larger than the body. Represented by the figure below, it is considered a reversal pattern as it shows the changing sentiment of buyers and sellers within the life of the candle.
The entry signal is displayed at the maximum break in the case of the hammer or the minimum in the case of the inverted hammer.
Another pattern well known to Traders is the bearish and bullish Engulfing. It is a pattern represented by two candles, where the second one completely engulfs the first with a large body candle caused by a large volume of trades.
Doji is considered an indecision candle. Its main feature is the formation of a shadowy and disembodied pattern. The closing price is equal to or very close to the opening price. As a sign of indecision, the break of the high or low shows where demand for offers is strongest.
Application of Candles with Supports and Resistors
One of the most commonly used ways of candlesticks is to match the input signal with the support and resistance levels. In the example below prices test resistance and an inverted hammer is formed as a sign of reversal. The short entry at the break of the hammer’s low and immediately after the price begined the strong downward movement.
The formation of Engulfing shows the price rejection happening twice on the same support. The buyers in this example had two good entry opportunities before the bullish movement and profit on the transaction.
The Doji indecision candlestick formed on the resistance followed by a bearish engulfing showed traders a good short entry just before prices fell sharply.
Japanese candlesticks are a strong decision tool and when combined with other strategies can provide trades high probability signals. Candles can be combined with supports, resistances, Fibonacci levels and various trend indicators. However, this powerful tool, like any other strategy, will not provide 100% accuracy. Risk management and proper strategy execution are essential for success in this market.