Candlestick charts are a Japanese invention. They are simple to construct using the same information as a normal Western (open, high, low, close,) bar chart. Instead of using a single line however, the range is split, using a rectangle to represent the area between the high and the low.
The rectangle or candle is left blank or a specific colour like green for an up day and filled or a different colour like red for a down day. The rectangle is called the body or the real body and the single lines at the top or the bottom, if they exist, are called shadows, wicks or tails.
As can be seen by the above diagram candlestick charts actually provide a quick, easy to interpret picture of the days action. Candlestick charting is best applied to daily charts, they can also be applied to weekly or month charts. A shorter time frame is not really recommended.
Length of the body
The length of the body gives some indication as to the strength of a move within a session. A relatively long body will indicate a more aggressive move than a shorter body. This is both relative to the recent activity and the tails, which comprise the total range on the day.
The above diagram has three examples of bullish candlesticks. The first is the weakest, despite having an identical range to other two. It is weakest because the body is narrow relative to the total range and also to the other two candlesticks.
A small body and long tails, whether higher, lower or at both ends of the candle can be referred to as a Spinning Top and represents a degree of indecision, uncertainty in the market, a definite question over direction. If it occurs during a trend it may be signalling the end of a trend. If it occurs during a sideways market it could be signalling the start of a trend.
The centre candlestick is there as a reference to the norm. It is, for reference sake, a normal balanced, candlestick, reflecting a directional market, in this case up.
The last candlestick is quite unique and has its own name, Marubozu. It indicates, in this case, a strong up day. A filled body would indicate a strong day down. The lack of a tail either above or below suggests the dominant directional activity was prevalent during the whole session and therefore should continue into the next session. Of course this information should be seen in context. There will always be other information that should be taken into account, which might support or suppress that particular view.
Just as the body of the candlestick provides us with some information the tails also provide us with invaluable information about the activity that occurred during the session.
The mere presence of a tail suggests the opposite activity to its location. A higher tail reveals the presence of sellers and selling activity. A lower tail exposes the fact that buyers may be present. The length of the tail, relative to the body and the total range, gives some indication of the strength of the particular activity being reflected. A longer tail is more definitive than a short tail. A tail, high or low, signals that a move to the extreme for the day (high or low) has been countered by the opposite activity. The directional probe has been rejected.
The combinations of one long tail and one short tail or both short tails or both long tails have there own outcomes. If we use the logic that a tail represents the opposite activity to the direction of the probe and the length provides the degree of that activity, we can approximate a net result for the session.
Another layer of complexity can be added when the shadows for the session are examined with respect to the previous session. If the new candlestick is higher than the previous candlestick, the lower shadow would indicate greater strength than if it were a down day and below the range of the previous session.
In this case, where the current day is above the previous session the upper shadow, should be seen as normal activity with less strength than if it were occurring below the previous sessions range.
The chart above is a typical sample of market activity prepared using candlesticks. You will notice that during the trending section each new body tends to lie wholly outside and, in the case of this bull market trend, above the previous candlestick body. Also worth noting is the length of the bodies at the beginning of the trend, at the end of October. They are quite large when compared to the average body length over the whole sample.
Single Bar Formations
A hammer formation is a bullish formation that generally occurs at the end of a declining price trend. It is identified by its small real body at the higher side of the range. It can be either filled or open, a down day or an up day. The bottom tail should be at least twice the size of the real body and the upper tail should only be small, if it exists at all.
It's the length of the tail relative to the body that creates the signal. The tail could be viewed as a sign of rejection of lower prices and therefore a possible reversal of the trend. Taken alone it's not really a definitive signal and therefore it's a good idea to seek confirmation with some sort of an up day signal, the following day. The stronger the up day signal, the better. Volume can also be used to ascertain the probability of a turn around, in this case and increase in volume.
A hanging man formation is exactly the same as the hammer formation, except that it occurs at the end of an up trend. Once again the real body lies at the top of the range with the lower tail at least twice as long as the body. The upper tail should be short if it can be found at all. The colour of the body is not important, but just like the hammer formation, it is best to seek confirmation of a trend reversal with a follow-up signal the next day.
In this case a probe against the trend appears to have been rejected. It's hard to imagine how the same formation, could generate opposite signals.
It's not just the location at the end of a trend that creates or generates the signal. It's the indecision of the market and a potential corresponding change that is being signalled by this formation, in both of the above cases.
The close proximity of the open and closing prices relative to the range, which in both cases is extreme on the downside, reflect a market that is relatively undecided about direction. If this occurs at the end of a trend, up or down, it would then stand to reason that a potential change is being signalled.
An inverted hammer formation is as the name implies an upside down hammer formation. The formation has a real body at the lower end of the range, although the colour of the body is not important.
An inverted hammer is determined by a long tail on the high side, which should be at least twice as long as the body and a very small, if any, tail on the lower side.
Ideally an inverted hammer will occur at the end of a down trend or the lower side of a congestion phase. It’s a bullish signal. There’s probably going to be a gap between this real body and the previous body, although it’s not a pre-requisite. Nevertheless if a gap does exist the larger it is the stronger the buy signal.
There are a few star formations and the star position is, as one would expect, above the recent activity. It could be at the end of an uptrend or above a recent congestion phase. It’s easy to see how this one was named.
A shooting star is a bearish signal, which has an upper tail, just like an inverted hammer, twice as long as the real body and a very short lower tail. Sometimes the lower tail doesn’t exist at all, as in the example below.
The colour of the body is not important it can be either filled or open, an up day or a down day. It is generally preceded by an up day with a long body. There is usually also a gap between the previous day’s body and the body of the star.
If the star occurs above a recent congestion phase the body of the star should be above all or most of the bodies found during that congestion.
Once again both the Inverted hammer and the shooting star represent potential turning points in the market. They signal a change from what has been whether that is a change in trend or a change in phase, from trend to congestion or congestion to trend.
Both formations they reflect indecision in the market because of the close proximity of the open and closing prices. That would also suggests a degree of balance a consensus between the buyers and sellers that the old recent activity may not continue.
The long upper tail suggests a probe higher during the session couldn’t continue. If that activity occurs at the end of an uptrend it tends to suggest rejection of higher prices and exhaustion of the move. At the end of a down trend it’s more the first test against the trend that creates a kink in its armour.
This formation is a bearish signal, the result of two consecutive price bars where the real body of the second bar completely engulfs the real body of the first bar.
There are two other requirements before it can be labelled as an engulfing bearish formation. The first is that the formation must occur in a clear uptrend and the second that the first bar is an up bar or candle and the second bar is a down bar. An up bar is one where the close is higher than the open, which appears as a hatched or filled real body in the diagram. A down bar is where the close is lower than the open resulting in a non-hatched real body.
This formation occurs at the end of a down trend. In fact it requires a down trend to exist. Like the bearish version of the signal it is made up of two candles. The second candle’s real body should completely engulf the real body of the first candle. In addition the first candle should be a down candle followed by an up candle for the second bar in the formation.
This formation occurs at the end of an up trend and signals a reversal, it’s a bearish signal.
There are two candles required to make the formation and the first real body should be clear strong, relatively long. The second candle should be a down candle. The higher side of the real body should be higher than the previous real body and the lower side of the real body should be at least half way down into the previous real body.
A Doji forms when the opening price is the same or very close to the closing price. They usually have a relatively tight range from high to low, but there are obvious variations.
There’s no definitive buy or sell signal to be gleaned from this formation by itself, rather the market is telling us that it is at balance. It can reveal more information when taken in reference to the preceding candles. If it occurs at the end of a trend we could say that it is a sign of weakness for that trend. It might also occur at the end of a congestion phase.
Five different types of Doji are shown above. The first is a common symmetrical Doji and the next two are also Doji formations, even though they may be biased. The last two have specific names, the gravestone and the dragonfly respectively.
All these Doji reflect the same state of the market and that is one of balance or indecision as a result of the opening and closing price being equal or within one tick of each other. There is something to be suggested from the length of the shadows. A long upper shadow or any upper shadow reveals the presence of buyers. The subsequent price move higher appears to have attracted sellers as a result. One could say, the stronger group were, the buyers as they initiated the move higher while the sellers are merely responding to higher prices.
Conversely a lower shadow suggests the sellers were initially active and once they had dried up or as a reaction to some other force the buyers actually won out on the session after the close regained all the losses on the day. They were also the last group to be active. One could say “the market went out bid.”
The lack of a shadow, as in the case of the Gravestone and Dragonfly Doji, help to reinforce the thinking outlined above. In the case of a trending market it could hint at a possible reversal. In a sideways market it could suggests a new move, probably in the direction in which there is no shadow.
To draw such a conclusion more information would probably be required and therefore it would be a good idea to look at where the Doji occurs in relation to the recent activity. The market could be in a trend phase or congestion phase. It might follow an up candle or a down candle. The strength of the previous candle, as measured by the length of the real body, will also hold some significance as to how we read the Doji signal.
In the above diagram the unfilled white candle is an up day followed by a Doji. The Doji is in a star position, which would require confirmation with a lower session in the following trading session. After a strong up day, such as one signaled by a long white candle, the Doji is signaling a balance between buyers and sellers. It signals a potential change in direction just as much as it signals the start of a new phase of the up trend, if a trend exists.
This next diagram Fig 79 shows a down session followed by a Doji, but this time the Doji is engulfed by the previous candle. Once again to gain any real insight confirmation will be required in the following session. All that we can say by the presence of this Doji is that the market has paused and found some sort of price equilibrium, a balance between buyers and sellers.
A double Doji is, as its name implies, two Doji formations in succession. One would imagine they are not all that common, but they are more common than one would think. Like the single Doji they are a stronger sign, in fact almost confirmation, that the market has found balance and therefore at a state of indecision.
Harami means pregnant in Japanese and refers to the shape of the formation, which is a two candle formation. Harami occurs when the real body of the second candle is completely engulfed by real body of the first candle. The direction or colour of the second candle is not important, but the size of the real body of both candles is indicative to the strength of the signal. The first candle should have a rather large real body. The smaller the real body in the second candle the stronger the signal. The second real body is usually a different colour to the first candle, but doesn’t have to be.
Even though it’s not a requirement it is preferable for the shadows of the second candle to be engulfed, if not by the real body of the first candle at least engulfed by the previous range, high to low.
The signal issued by a Harami is a change in trend.
The final two candles expose the Harami bearish formation. It’s bearish because it occurs at the end of an uptrend. This formation happens only after a clear up trend.
The isolated Harami formation above is a bullish formation and therefore it should occur at the end of a down trend. In fact, it requires a trend to issue a signal and would be just as applicable if it occurred at the end of an uptrend, although one would expect the candles to be opposite in colour.
If the second candle is a doji, where the open and close are the same price, then the formation is know as a Harami cross. The signal is a strong reversal signal especially when it comes at the end of a trend. The larger the body of the first candle the stronger the signal.
The Harami cross in the above diagram occurs at the end of a down trend. The Doji occurs after a long body down candle and therefore issues a strong bullish signal.
This formation occurs at the end of a downtrend. It can also occur at the bottom of a congestion band. It is the inverse of a dark cloud formation and signals change. That could be a change in trend or short term direction in the case of a congestion phase.
The first real body of the formation is a strong down candle. The body of the next candle has its low below the low of the first and the top of the real body is at least half way up through the real body of the first candle.
The last two bars comprise the piercing line formation. The close of the second is above the half way mark of the real body of the first candle.
Three Candle Formations
The Morning Star formation requires three candles to create the formation. It signals a trend reversal, complete with confirmation. As the name implies this formation signals a low or a base forming in the market. It therefore requires a well defined down trend.
The first real body of the formation should be quite strong and therefore should have a tall real body.
The second candle is likely to have a narrow body the direction of which is irrelevant. The second candle occurs in a star position, in which case it appears as an isolated candle having gapped down at the open.
The third candle in the formation, the confirmation candle, should penetrate higher, at least half way, into the real body of the first candle.
Morning Doji Star
The diagram below is identical to that above except for the second candle in the formation. It is a Doji where the open and closing prices are the same.
The Evening Star
The Evening star formation is also a three candle formation that occurs usually at the top of an uptrend. It signals a top in the market, the end of the up trend and the reversal of that trend. It is the inverse of the Morning Star formation.
It is a requirement of the Evening Star formation that a clear uptrend can be identified. The first candle must be a strong up candle with a tall body.
The second candle should have a higher opening and a small real body, if any at all as in the case of a Doji. Once again it doesn't matter whether the candle is white or black, up or down. The size of the body or the lack of a real body should be enough to render the direction of this particular candle in the formation largely irrelevant.
The third candle is the confirmation of a change in trend and its real body should push at least half way into the real body of the first candle.
Evening Doji Star
The star position refers to the isolation of a bar, above or below the recent activity of the market. It is defined essentially by the gap open and in the case of the Doji formation this is the same price as the close.
The Doji increases the potential and possibly the strength or impact of the reversal signal.
Three Black Crows
The Three Black Crows formation is a sign that a bull market could be reversing. It consists of three down days where each day has a lower low and lower high. The close should be close to or lower than the close for the previous day and each open should be within the real body of the previous day.
A bull market is required to generate this signal. It may occur over and over again in a bear market, one would expect that, but when it shows up in an up trend, it presents as a pretty strong signal.
Three White Soldiers
Three White Soldiers is a reversal signal in a bear market. As one would expect it is the opposite of three black crows. It requires a bear market and is made up of three consecutive white candles or up days, where the close is progressively higher and the open is within the body of the previous day.
Three days of higher highs and higher lows is a good definition of a trend, in this case it signals a change in trend.
Falling Three Methods
The Three Methods falling formation is a bearish continuation pattern. It signals continuation of a bear market trend. The first candle is quite strong, in which case it should have a long black body. The next three candles that follow are small relative to the first candle and in the opposite direction, in this case up days. The last candle, the fifth candle, is another long black candle that should close below the real body of the first candle.
Rising Three Methods
This formation is the opposite of the falling three methods. It is a continuation pattern in a bull market trend.
The first candle is a long white candle, an up day. The next three candles are down days, but completely engulfed by the body of the first candle. The closes must be within the first real body and the low from the first candle must remain intact during the formation.
The final candle should move to make a new high and closes above the real body of the first candle. This then completes the formation and signals higher prices.