What is a Candlestick Chart?
The candlestick chart is a graphical tool used to display asset price movements. It originated in Japan in the 18th century and has been used for centuries to identify price trend patterns, providing references for assessing future asset movements. Today, cryptocurrency traders use candlestick charts to analyze historical price data and predict future price movements.
Multiple candlesticks often form specific patterns, displaying potential signals of price increases, decreases, or stagnation. Let's take a look at how these patterns reveal market sentiment to help you seize trading opportunities.
How do candlestick charts work?
Suppose you are tracking the price of an asset like stocks or cryptocurrencies over a certain period (e.g., a week, a day, or an hour). Candlestick charts can visually present this price data.
A candlestick chart consists of a candlestick body and two lines (often referred to as wicks or shadows). The candlestick body represents the price range formed by the opening and closing prices during that period, while the wicks or shadows represent the highest and lowest prices reached during that period.
If the candlestick body is green, it indicates that the price has risen during that period. If the candlestick body is red, it indicates that the price has fallen, referred to as a bearish K-line.
How to Understand Candlestick Patterns
The candlestick pattern consists of multiple candles arranged in a specific order. Candlestick patterns are diverse, and each pattern has its unique significance. Some patterns can reflect the strength of the buyers and sellers, while others may indicate a reversal, continuation, or indecision of the trend.
It is important to note that candlestick charts are not direct buy or sell signals but rather a way to observe price action and market trends, helping traders identify potential upcoming opportunities. Therefore, understanding these patterns in conjunction with market context is often more valuable.
To reduce the risk of losses, many traders refer to candlestick patterns in conjunction with other analytical methods, such as the Wyckoff method, Elliott Wave Theory, and Dow Theory. Additionally, they often employ technical analysis (TA) indicators such as trend lines, Relative Strength Index (RSI), Stochastic RSI, Ichimoku Cloud, and Parabolic SAR.
Candlestick patterns can also be used in conjunction with support and resistance levels. In trading, support levels are price levels where buying power is expected to exceed selling power, while resistance levels are where selling power is expected to exceed buying power.
Bullish Candlestick Patterns
Hammer
The hammer is a candlestick located at the bottom of a downtrend with a long lower shadow, where the length of the lower shadow is at least twice that of the candlestick body.
The hammer indicates that despite significant selling pressure, buyers (bulls) still pushed prices close to the opening level. The hammer can be either red or green, but a green hammer typically indicates a stronger bullish trend.
Inverted Hammer
The inverted hammer pattern resembles a hammer but differs from the hammer in that its long shadow is above the candlestick body rather than below it. Similar to the hammer, its upper shadow length is at least twice that of the candlestick body.
The inverted hammer typically appears at the bottom of a downtrend, indicating that the market may reverse upward. The upper shadow indicates that prices have stopped the downtrend, but sellers ultimately pushed it back close to the opening price, forming a typical inverted hammer shape.
In short, an inverted hammer may indicate that selling pressure is weakening, and the market may soon turn bullish.
Three White Soldiers
The Three White Soldiers pattern consists of three consecutive green candlesticks, with opening prices within the body of the previous candlestick and closing prices exceeding the highest point of the previous candlestick.
In this pattern, the lower shadow of the candlestick is very short, or it may even be nonexistent, usually indicating that the buying power is stronger than the selling power, pushing prices higher. Some traders also refer to the size of the candlestick and the length of the shadows. When the candlestick body is larger, it often indicates greater buying pressure.
Bullish Engulfing
A bullish engulfing pattern refers to a longer red candlestick followed closely by a shorter green candlestick, with the green candlestick completely within the body of the red candlestick.
A bullish engulfing pattern can form over two days or longer, indicating a slowdown in the bearish trend, which may soon come to an end.
Bearish Candlestick Patterns
Hanging Man
The hanging man is the bearish counterpart of the hammer. It typically appears at the end of an uptrend, with a short candlestick body and a long lower shadow.
A lower shadow indicates that there was significant selling pressure after an uptrend, but ultimately the buyers regained control and temporarily pulled the price back into the uptrend range. In this case, the buyers attempt to sustain the upward momentum, but as more sellers enter the market, the market direction becomes uncertain.
If the hanging man pattern appears after a long-term uptrend, it may be a warning signal that the bull market is about to lose momentum, indicating that the market may potentially reverse downward.
Shooting Star
Shooting Star refers to a candlestick with a long upper shadow and a very short or nonexistent lower shadow, with a short body typically close to the bottom. The shape of a shooting star is very similar to that of an inverted hammer, with the difference being that it usually forms at the end of an uptrend.
This candlestick pattern indicates that the market once reached a local high but then the sellers took control, causing prices to retreat. Some traders choose to sell or short when a shooting star appears, while others prefer to wait for the next candlestick to confirm the pattern before making a decision.
Three Black Crows
The Three Black Crows consist of three consecutive red candlesticks, with opening prices within the body of the previous candlestick, and closing prices below the lowest point of the previous candlestick.
The Three Black Crows correspond to the bearish version of the Three White Soldiers. Typically, the Three Black Crows have short upper shadows, indicating that selling pressure continues to push prices down. Traders can assess the size of the candlestick and the length of the shadows to determine whether a downtrend may continue.
Bearish Engulfing
A bearish engulfing pattern refers to a longer green candlestick followed by a shorter red candlestick, with the red candlestick completely within the body of the green candlestick.
A bearish engulfing pattern can form over two or more periods (for example, over two days on a daily chart), typically appearing at the end of an uptrend, which may suggest that buying momentum is weakening, and the market is about to reverse.
Dark Cloud Cover
The Dark Cloud Cover refers to a green candlestick followed closely by a red candlestick, where the opening price of the red candlestick is above the closing price of the previous green candlestick, but the closing price of the red candlestick is below the midpoint of the green candlestick.
This pattern is usually accompanied by high trading volume, indicating that the market may soon switch from bullish to bearish. Some traders judge the market based on the subsequent third red candlestick.
Three Consolidation Candlestick Patterns
Rising Three Methods
The Rising Three Methods candlestick pattern is commonly found in uptrends, where three shorter red candlesticks appear consecutively before the market continues to rise. Ideally, the lengths of these three candlesticks do not exceed the body of the previous candlestick.
The hallmark of an upward consolidation pattern is a long-bodied green candlestick, indicating that the market is likely to turn bullish again.
Descending Three Methods
The descending three methods is the inverse pattern of the ascending three methods, typically indicating a continuation of a downtrend.
Doji Candlestick Patterns
When the opening and closing prices are the same (or very close), a doji pattern is formed, meaning that the price fluctuates around the opening price but ultimately closes at or near the opening price. Therefore, doji nodes indicate indecision between buyers and sellers. However, the interpretation of doji patterns largely requires analysis in specific contexts.
Based on the position of the opening or closing line, the doji can be classified as a gravestone doji, long-legged doji, or dragonfly doji.
Gravestone Doji
This is a candlestick chart that indicates a bearish reversal pattern, with a long upper shadow and the opening/closing price close to the lowest point.
Long-Legged Doji
This is a K-line chart that indicates an indecision pattern, with upper and lower shadow lines, and the opening/closing price near the midpoint of the candlestick body.
Dragonfly Doji
This is a candlestick chart that indicates a bullish or bearish market (depending on the specific situation), with a long lower shadow and the opening/closing price close to the highest point.
According to the original definition of the doji, the opening and closing prices should be exactly the same. But what if the opening and closing prices are not exactly the same but very close? This situation is referred to as a 'spinning top.' However, the cryptocurrency market often fluctuates, making pure doji patterns quite rare. Therefore, spinning tops frequently alternate with dojis.
Candlestick Chart Based on Price Gaps
When the opening price of a financial asset is higher or lower than the previous closing price, a gap appears between the two candlesticks, known as a price gap.
Although many candlestick patterns contain price gaps, patterns based on such gaps are not common in the cryptocurrency market since cryptocurrency trading occurs 24/7. Nonetheless, price gaps can still appear in low liquidity markets, mainly indicating low liquidity and high bid-ask spreads, which cannot serve as viable patterns for traders.
Conclusion
Even if traders do not incorporate candlestick charts into their trading strategies, they can benefit from being familiar with candlestick charts and their patterns.
Candlestick charts can play an important role in market analysis, thoroughly reflecting the buying and selling forces that ultimately determine market direction. However, it is worth noting that they are not foolproof analytical tools. Combining them with other tools and appropriate risk management measures can help reduce potential losses.