How to Read the Most Popular Candlestick Patterns
Key Takeaways
Candlestick charts are a popular tool used in technical analysis to identify potential buying and selling opportunities in financial markets.
The hammer, bullish harami, hanging man, shooting star, and doji are some examples of candlestick patterns that help traders identify trend reversals or confirm existing trends.
However, it’s also important to consider other factors, such as trading volume, market sentiment, and liquidity, when making trading decisions.
What Are Candlesticks?
Candlesticks are a type of charting technique used to describe the price movements of an asset. First developed in 18th-century Japan, they’ve been used to find patterns that may provide insights into asset price movements for centuries. Today, cryptocurrency traders use candlesticks to analyze historical price data and predict future price movements.
Multiple candlesticks together often form patterns that can indicate whether prices are more likely to rise, fall, or remain unchanged. Let’s take a look at how such patterns can provide insight into market sentiment and trading opportunities.
How Do Candlestick Charts Work?
Imagine you are tracking the price of an asset like a stock or a cryptocurrency over a period of time, such as a week, a day, or an hour. A candlestick chart is a way to represent this price data visually.
The candlestick has a body and two lines (often referred to as wicks or shadows). The body of the candlestick represents the range between the opening and closing prices within that period, while the wicks or shadows represent the highest and lowest prices reached during that same period.
A green body indicates that the price has increased during this period. A red body indicates a bearish candlestick, meaning that the price decreased during that period.
How to Read Candlestick Patterns
Candlestick patterns are formed by multiple candles in a specific sequence. There are numerous patterns, each with its interpretation. While some candlestick patterns provide insight into the balance between buyers and sellers, others may indicate a point of reversal, continuation, or indecision.
Keep in mind that candlestick patterns aren’t intrinsically buy or sell signals. Instead, they are a way of looking at price action and market trends to potentially identify upcoming opportunities. As such, it’s always helpful to look at patterns in context.
To reduce the risk of losses, many traders use candlestick patterns in combination with other methods of analysis, including the Wyckoff Method, the Elliott Wave Theory, and the Dow Theory. It’s also common to include technical analysis (TA) indicators, such as trend lines, the Relative Strength Index (RSI), Stochastic RSI, Ichimoku Clouds, or the Parabolic SAR.
Candlestick patterns can also be used in conjunction with support and resistance levels. In trading, support levels are price points where buying is expected to be stronger than selling, while resistance levels are price levels where selling is expected to be stronger than buying.
Bullish Candlestick Patterns
Hammer
A hammer is a candlestick with a long lower wick at the bottom of a downtrend, where the lower wick is at least twice the size of the body.
A hammer shows that despite high selling pressure, buyers (bulls) pushed the price back up near the open. A hammer can be red or green, but green hammers usually indicate a stronger bullish reaction.
Inverted hammer
This pattern is just like a hammer but with a long wick above the body instead of below. Similar to a hammer, the upper wick should be at least twice the size of the body.
An inverted hammer occurs at the bottom of a downtrend and may indicate a potential reversal to the upside. The upper wick suggests that the price has stopped its downward movement, even though the sellers eventually managed to drive it back down near the open (giving the inverted hammer its typical shape).
In short, the inverted hammer may indicate that selling pressure is slowing down and buyers may soon take control of the market.
Three white soldiers
The three white soldiers pattern consists of three consecutive green candlesticks that all open within the body of the previous candle and close above the previous candle's high.
In this pattern, the candlesticks have small or absent lower wicks. This indicates that buyers are stronger than sellers (driving the price higher). Some traders also consider the size of the candlesticks and the length of their wicks. The pattern tends to work out better when the candlestick bodies are bigger (stronger buying pressure).
Bullish harami
A bullish harami is a long red candlestick followed by a smaller green candlestick that's completely contained within the body of the previous candlestick.
The bullish harami can be formed over two or more days, and it's a pattern that indicates that the selling momentum is slowing down and may be coming to an end.
Bearish Candlestick Patterns
Hanging man
The hanging man is the bearish equivalent of a hammer. It typically forms at the end of an uptrend with a small body and a long lower wick.
The lower wick indicates that there was a significant sell-off after the uptrend, but the bulls managed to regain control and drive the price back up (temporarily). It’s a point where buyers try to keep the uptrend going while more sellers step in, creating a point of uncertainty.
The hanging man after a long uptrend can act as a warning that the bulls may soon lose momentum in the market, suggesting a potential reversal to the downside.
Shooting star
The shooting star consists of a candlestick with a long top wick, little or no bottom wick, and a small body, ideally near the bottom. The shooting star is very similar in shape to the inverted hammer, but it’s formed at the end of an uptrend.
This candlestick pattern indicates that the market reached a local high, but then the sellers took control and drove the price back down. While some traders like to sell or open short positions when a shooting star is formed, others prefer to wait for the next candlesticks to confirm the pattern.
Three black crows
The three black crows consist of three consecutive red candlesticks that open within the body of the previous candle and close below the low of the last candle.
They are the bearish equivalent of three white soldiers. Typically, these candlesticks don’t have long higher wicks, indicating that selling pressure continues to push the price lower. The size of the candlesticks and the length of the wicks can also be used to judge the chances of downtrend continuation.
Bearish harami
The bearish harami is a long green candlestick followed by a small red candlestick with a body that is completely contained within the body of the previous candlestick.
The bearish harami can unfold over two or more periods (i.e., two or more days if you are using a daily chart). This pattern typically appears at the end of an uptrend and can indicate a reversal as buyers lose momentum.
Dark cloud cover
The dark cloud cover pattern consists of a red candlestick that opens above the close of the previous green candlestick but then closes below the midpoint of that candlestick.
This pattern tends to be more relevant when accompanied by high trading volume, indicating that momentum may soon shift from bullish to bearish. Some traders prefer to wait for a third red bar to confirm the pattern.
Three Continuation Candlestick Patterns
Rising three methods
The rising three methods candlestick pattern occurs in an uptrend where three consecutive red candlesticks with small bodies are followed by the continuation of the uptrend. Ideally, the red candles should not break the area of the previous candlestick.
The continuation is confirmed by a green candle with a large body, indicating that the bulls are back in control of the trend.
Falling three methods
The falling three methods are the inverse of the three rising methods. It indicates the continuation of a downtrend.
Doji candlestick pattern
A doji forms when the open and close are the same (or very similar). The price may move above and below the opening price but will eventually close at or near it. As such, a doji can indicate a point of indecision between buying and selling forces. However, the interpretation of a doji is highly contextual.
Depending on where the open and close line falls, a doji can be described as a gravestone, long-legged, or dragonfly doji.
Gravestone Doji
This is a bearish reversal candlestick with a long upper wick and the open and close near the low.
Long-legged Doji
Indecisive candlestick with top and bottom wicks and the open and close near the midpoint.
Dragonfly Doji
Either a bullish or bearish candlestick, depending on the context, with a long lower wick and the open/close near the high.
According to the original definition of the doji, the open and close should be the same. What if the open and close aren't the same but are very close to each other? That's called a spinning top. However, since cryptocurrency markets can be very volatile, an exact doji is quite rare, so the spinning top is often used interchangeably with the term doji.
Candlestick Patterns Based on Price Gaps
A price gap occurs when a financial asset opens above or below its previous closing price, creating a gap between the two candlesticks.
While many candlestick patterns include price gaps, patterns based on gaps aren’t prevalent in the crypto markets because they are open 24/7. Price gaps can also occur in illiquid markets, but aren’t useful as actionable patterns because they mainly indicate low liquidity and high bid-ask spreads.
How to Use Candlestick Patterns in Crypto Trading
Traders should keep the following tips in mind when using candlestick patterns in crypto trading:
1. Understand the basics
Crypto traders should have a solid understanding of the basics of candlestick patterns before using them to make trading decisions. This includes understanding how to read candlestick charts and the various patterns they can form. Don’t take risks if you aren’t familiar with the basics.
2. Combine various indicators
While candlestick patterns can provide valuable insights, they should be used with other technical indicators to form more well-rounded projections. Some examples of indicators that can be used in combination with candlestick patterns include moving averages, RSI, and MACD.
3. Use multiple timeframes
Crypto traders should analyze candlestick patterns across multiple timeframes to gain a broader understanding of market sentiment. For example, if a trader is analyzing a daily chart, they should also look at the hourly and 15-minute charts to see how the patterns play out in different timeframes.
4. Practice risk management
Using candlestick patterns carries risks like any trading strategy. Traders should always practice risk management techniques, such as setting stop-loss orders, to protect their capital. It's also important to avoid overtrading and only enter trades with a favorable risk-reward ratio.
Closing Thoughts
Every trader can benefit from being familiar with candlesticks and what their patterns indicate, even if they don't incorporate them into their trading strategy.
While they can be useful in analyzing the markets, it's important to remember that they aren’t infallible. They’re helpful indicators that convey the buying and selling forces that ultimately drive the markets. However, they should still be used along with other tools and proper risk management to reduce potential losses.
Further Reading
7 Common Mistakes in Technical Analysis (TA)
5 Exit Strategies for Traders
12 Terms Every Crypto Trader Should Know
What Is the RSI Indicator?
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