This brings us to candlesticks, which you should be very familiar with, as they are probably the clearest way to see quickly what the market is doing.
Over the last few decades, traders have begun to use candlestick charts far more frequently than any other technical analysis tool. Candlesticks aren’t magic, but very close to it, and some traders rely totally on what they say to govern their trading. Candlestick charts have a simple, easy to analyze appearance. Unlike bar or line charts, candlestick charts provide more detailed information about the market at a glance. With this information, you can use candlestick charts.
To be a good trader, you could practise recognizing patterns in candlesticks until you know them without having to dissect the components – kind of like the way Grandmasters of Chess don’t spend time looking at each possible move, but just see the overall shape of the board, and move appropriately.
Brief History of Candlestick Charts
The principles behind candlestick charting were first developed over 250 years ago by Munehisa Homma*, a Japanese businessman who traded rice futures.
Homma realized that the rice futures market was strongly influenced by the emotions of the traders. He knew that traders tended to hold on to their positions for as long as the market moved their way. If something happened in the market and the traders lost confidence, they would reverse their positions quickly.
Homma understood that what happened between the open and the close of rice futures was essential to technical interpretation, so he developed a process to reliably track trader confidence and identify trends in the market.
The Benefits of Candlestick Charts
Today, candlestick charts are one of the most common tools traders use for technical analysis. Most traders prefer to use the candlestick chart because it can help them to:
- Determine the current state of the market at a glance. Just by looking at the color and length of a candlestick, traders can determine instantly if the market is strengthening (becoming bullish) or weakening (becoming bearish).
- See the direction of the market more easily. On a candlestick chart, the color and shape of the candlestick can help traders determine if an uptrend is part of bullish momentum or simply a bearish spike.
- Identify market patterns quickly. Candlestick charts display specific bullish and bearish reversal patterns that cannot be seen on other charts.
When we look at candlesticks, we nearly always want to see them in terms of the surrounding candles. One candle on its own doesn’t tell us anything like as much – sure, it’s interesting if the open is higher or lower than the close, for instance, or if the body’s long or short, but it really doesn’t give us much information to go on when taken out of context.
But when we know what went before, the candle takes on a whole life of its own, indicating whether the stock is over or undersold, or just right, and if it’s a good time to be trading anyway.
First the basics; as a reminder, the candle shows us the open, close (those two are indicated by the body or thick part of the candle) and the highest and lowest values that the stock made during the day (the lines above and below the candle body, or shadows). You can get exactly the same information from a bar chart, with ticks on the bar for the open and close, but it doesn’t give you such an immediate visual message.
The candlestick body is a rectangle that represents the level of trading activity for a specified period. For example, on a chart with a ten minute time scale, a candlestick would represent all of the trading activity in a ten minute period on the market. Candlestick shadows (also called tails or wicks) are the thin lines above and below the body. An upper shadow displays how high trading went while a lower shadow shows how low it went.
The body is clear, or on some charts green, when the open is at the bot-tom of the body, and the close at the top, that is, the price is going up; and it is solid (black) or red when the close is below the opening price. Note that we sometimes talk of prices ‘gapping’ from day to day, and this is particularly easy to identify with candles – a gap happens when the open is higher than the previous close, for example, in a bullish run. The bodies of the two candles do not overlap at all, even if some intraday prices, shown by the shadows, do.