Candlestick Analysis in Trading

In this article, I am going to discuss Candlestick Analysis in Trading. Please read our previous article discussing How to Study Candlestick in detail. The ultimate guide you will ever need to understand CANDLESTICK and its behaviors. After the study, you will not need to recognize any CANDLESTICK patterns. As part of this article, you will understand the following four things related to Candlestick Analysis in Trading.

1. Understanding candlestick
2. How to read a candlestick?
3. How to read a chart using a candlestick?
4. How do I find an opportunity to use a candlestick?

Part1: Understanding Candlestick Analysis

What is a candlestick?

• Candlesticks are a reflection of what buyers and sellers are doing. CANDLES TELL YOU who is in control in that specific time frame
• Candlesticks tell us immediate information about the supply-demand relationship.
• Multiple candles form patterns that tell us a story
• Understanding candlesticks is paramount to successfully day trade

Elements of candlestick

• The High
• The Open
• The Low
• The Close
• The Change(BODY)
• The Range

Part2: How to read candlestick

STEP 1: The size of the body (open to close)

Remember that in every bar, the same number of contracts/shares are sold and bought at that time frame

• The only reason for a bar to end up with a higher price is that the buyers were committed to one direction and more aggressive than the sellers. The reverse is true for a bear wide range bar
• So, the candle body shows to what extent they move the price and the strength behind the move

BODY:

Generally, we have to consider 3 types of body

1. Narrow range candle
2. Average candle
3. Wide range candle

The candle body shows lots of information, such as

Let us see some example

STEP 2: The length of wicks

The length of any wick, either to the top or bottom of the candle, is ALWAYS the first point of focus because it instantly shows strength, weakness, and indecision, and most importantly, where SMART-MONEY enters.

• Larger wicks show that the price has moved a lot during the duration of the candle, but it got rejected, which shows the presence of supply or demand.
• The lower wick acts as support, and the upper wick acts as resistance

Let’s understand the pin bar

What is a pin bar telling us?

  

When candles cannot break through a zone 70-80% of the time, they will go the opposite way.

Part 3: How to read a chart using a candlestick?

Step 1: First, read the DIRECTION OF the current CANDLE with respect to the previous candle

That means the relationship of each bar is high/low relative to the previous bar. What is it telling us?

 

Step 2 Context (read the current bar sentiment with respect to the previous bar)

Candlestick should analyze the context of the move. You should never try to read the market by looking at one day’s action in isolation. A candlestick must always be analyzed in the context of what has happened in the past.

Context is what the current candlestick shows with respect to the previous candlestick.

• Is the current candlestick larger or smaller than the previous ones? Which shows momentum increases or decreases
• Is the size changing meaningfully or not? Buying or selling pressure
• Does volatility increase or decrease
• Is the change happening during an active trading period or not? For example, candlesticks in mid-period are generally dead or inactive.

 

Step 3 Testing (Read what it is showing when testing key level (support or resistance))

Testing refers to the market moving towards a price level to “test” if the price level will accept or reject the market’s advances. Key levels are

• Previous candles high/low
• Last swing high/low
• The previous day’s high/low
• Major support or resistance

The high and low of each price bar are natural support and resistance levels, and the wick generally acts as a supply and demand zone. The test of these levels or zones shows the undercurrents of the market and is critical for reading price action.

 

Step 4: Expectation

With a clear read of DIRECTION, CONTEXT, TESTING. we can form expectations of the market in the third candle. We would expect the market to move in a certain way in the third bar with our read of DIRECTION, CONTEXT, and TESTING. The confirmation or failure of our expectations of the third bar reveals more about the market and adds to our candlestick analysis.

To form expectations, we need to make a very simple assumption about how the market should behave and should not behave.

Essentially, the market has momentum and inertia. bearishness should follow bearishness, and bullishness should follow bullishness. When it does not obey this assumption, we have to be cautious, Maybe a possible change in market direction.

 

Part 4: Finding Trading Opportunity

A candlestick pattern is useless if its location is incorrect; where it happens is the most important variable. So, we should analyze the candlestick at support and resistance for opportunity, either reversing or continuing the trend.

AT resistance, we expect the price to reverse or supply to exceed demand, confirming the supply or resistance level. Like at the support, we expect the price to reverse to confirm demand over supply.

Some key pointers should be considered when trading reversal. This means that candlestick action validates our support and resistance level. Explained below

Point 1: Momentum loss when approaching a key level(support resistance)

Below is an example of a bullish reversal

Point2: Clear Rejection from resistance in the form of the pin bar multiple rejections

In an established uptrend, any Clear Rejection from resistance in the form of the pin bar confirms the resistance level, and it indicates buyers tried but failed to close above the resistance.

MULTIPLE REJECTION SHOWS THAT BUYERS TRIED OVER AND OVER AGAIN TO PUSH THROUGH THE LEVEL BUT FAILED

Point3: Price Unable to close above the resistance level or below the support level

When Buyers try hard each time to close above the resistance level, each time they failed shows supply coming and trying to dominate demand.

Point 4: Candle color change

For bearish reversal. The price should break the previous candle low and close below the low at resistance. It shows bullish strength completely lost.

Point5: REVERSAL MOMENTUM CANDLE FROM KEY LEVEL

When a reversal momentum candle forms from the key level, it confirms the strength of the level of the opposite party. When a bullish strength candle forms from support, it confirms the support level as strong.

What candlestick action disconfirms the resistance? Opposite for support

There is a certain point also considered when the price approaches support or resistance. That validated or invalidated our support or resistance level

Candle spread increases when approaching the resistance level

With a widespread up, while the price is getting close to the resistance, we would expect to see the resistance broken due to the extra effort by buyers

If the price hugs the support and holds, it disconfirms the demand and shows the presence of supply

• If there is a strong support or resistance level, the price should immediately react within a few candles
• Price hold (unable to react) after a move down to support. Sellers overcoming buyers is the repeated inability of prices to REACT away from the danger point(support). Such hugging of support usually leads to a breakout

What do we learn?

Part1: Understanding candlestick
Part2: How to read candlestick
       Wide range bar(show strength or momentum)
       Narrow range bar(momentum or strength decreases)
       A pin bar(shows rejection or either supply or demand came in)
       Doji(indecision )

Part3: How to read a chart using a candlestick

      First, read the current candle direction with respect to the previous candle.
      Second, read the current candle sentiment with respect to the previous candle.
      Third, read the testing key level
      Expect what you fill

Part4: How to find opportunities using candlestick

Step to find a trading opportunity for reversal
       Point1 Momentum loss when approaching resistance /support
       Point2 Clear Rejection from resistance in the form of the pin bar multiple rejections
       Point3 Price unable to close above the resistance
       Point4 CANDLE COLOR CHANGE
       Point5 REVERSAL MOMENTUM CANDLE FROM KEY LEVEL

What candlestick action disconfirms the resistance?
Candle spread increases when approaching the resistance level
If the price hugs the resistance and holds, it disconfirms the demand and shows the presence of demand

Candlestick Analysis in Trading Summary:

Candlestick analysis is a technique derived from Japanese rice traders in the 18th century, notably by Munehisa Homma. It has since been refined and adapted to modern financial markets such as stocks, forex, and commodities. Candlestick patterns are a form of technical analysis, and charting traders use to identify potential price movements based on historical price data.

Each candlestick typically represents one day’s worth of price data about a stock (though any timeframe can be used—minutes, hours, days, weeks, or months). A candlestick has three parts:

1. Body: The thick part of the candlestick represents the open and close.
2. Wick/Shadow: The thin lines above and below the body represent the high and low.
3. Color: The body is usually colored to indicate whether the stock closed higher (often white or green) or lower (often black or red) than it opened.

Basic Interpretation of Candlestick Analysis in Trading:

• Bullish Candle: When the close is above the open (usually white or green), indicating buying pressure.
• Bearish Candle: When the close is below the open (usually black or red), indicating selling pressure.
• Long Body: Shows strong buying or selling pressure.
• Short Body: Indicates little price movement and consolidation.
• Long Wicks: Suggest rejecting higher or lower prices and potential trend reversal.
• No Wicks: A strong signal of continued movement in the direction of the body.

Common Candlestick Patterns:

Here are some of the most well-known candlestick patterns and what they typically indicate:

Single Candle Patterns:

• Doji: Indicates indecision or a struggle for turf positioning between buyers and sellers.
• Hammer: A bullish reversal pattern that occurs during a downtrend.
• Shooting Star: A bearish reversal pattern that occurs during an uptrend.
• Marubozu: A strong bullish, or bearish movement with little or no wicks.

Multi-Candle Patterns:

• Engulfing: A pattern that can signal a reversal. A bullish engulfing pattern occurs when a large green candle follows a small red candle, ‘engulfing’ it. The opposite is true for a bearish engulfing pattern.
• Harami: Indicates a possible trend reversal, characterized by a small candle followed by a much larger candle of the opposite color.
• Morning Star: A bullish reversal pattern that occurs at the bottom of a downtrend.
• Evening Star: A bearish reversal pattern that occurs at the top of an uptrend.

Using Candlestick Analysis in Trading:

• Confirmation: Traders often wait for additional confirmation before acting on a pattern. For example, following a bullish engulfing pattern, they might wait for an increase in volume on the following candle.
• Context: The patterns are more significant near support or resistance levels, moving averages, or other technical indicators.
• Time Frame: Patterns should be considered in the context of the timeframe observed. Patterns on longer timeframes (e.g., daily, weekly) are generally more reliable than those on shorter timeframes (e.g., one-hour, 15-minute).
• Combination with Other Analysis: Candlestick patterns are most effective when combined with other forms of technical analysis, such as trend lines, Fibonacci levels, and momentum indicators.

Limitations of Candlestick Analysis:

• Self-Fulfilling Prophecy: Some argue that patterns work because enough traders believe in them and act in a way that the patterns predict.
• Subjectivity: Sometimes, what one trader interprets as a particular pattern, another might not.
• False Signals: No pattern always works, as candlestick patterns can often produce false signals.

Candlestick analysis is popular among traders because it provides a quick visual representation of price action and potential market sentiment. However, like all trading strategies, it is not infallible and should be part of a comprehensive trading plan.