Candlestick chart patterns are the most popular form of technical analysis. They are closely related to the Japanese Candlestick Technique and were developed during the 18th century in Japan. Candlesticks have been a valuable tool used to predict market trends because they identify irregularities in trading prices, thus indicating when a stock may be undervalued or overvalued.
Traders and analysts alike use Candlesticks to help them make informed decisions about what stocks they want to buy or sell.
Understanding the body part of the candlestick will help us understand these chart patterns.
The body is the colored portion on a candlestick chart (black or white). The body reveals information about the opening and closing prices. It also helps us determine whether they are higher or lower than the prior period’s close.
- The white indicates that today’s opening price was higher than yesterday’s closing price. Therefore, it had a bearish open.
- The black indicates that today’s opening price was lower than yesterday’s closing price. Therefore, it had a bearish close.
Candlestick patterns are divided into five categories:
1. Bullish Harami
A bullish harami is a candlestick charting feature utilized to spot reversals in a bear trend. It is usually indicated by a slight increase in price, contained by the downward price movement of the given investment from the last couple of days.
The slight price increase is signified by a white candle, while black candles signify the downward price movement.
In easy terms, a bullish harami is a candlestick chart pattern suggesting that a bearish trend may end. Some investors might see a bullish harami as a sign that they should enter a long position on an asset.
2. Bearish Harami
The Bearish harami is a two-bar Japanese candlestick pattern used to spot reversals in an uptrend. It is usually indicated by a slight decrease in price, contained by the upward price movement of the given investment from the last couple of days.
The slight price decrease is signified by a white candle, while black candles signify the upward price movement.
In easy terms, a bearish harami is a candlestick chart pattern suggesting that an uptrend may come to an end. Some investors might see a bearish harami as a good sign of a reversal in a bull price movement.
3. Bullish Engulfing Pattern
A bullish engulfing pattern is a white candlestick that closes higher than the previous day’s opening after opening lower than the previous day’s close.
4. Bearish Engulfing Pattern
It is a chart pattern used in speculative investments which suggest lower prices.
It is a neutral pattern that indicates indecision during the trading day and is also used to indicate a possible reversal in market direction.
Types of Candlesticks
Occasionally, a thick candle color may indicate that the price fell below some predetermined threshold and therefore shows that the price recently has been declining due to its low opening price.
There are the three types of candlesticks used on stock charts:
1. Full Body or Hammer
The Hammer is used for long-term trends. A full circle of open and close prices is drawn in red on a black background. It is a bullish signal that reverses a downtrend and is the most reliable bullish reversal signal.
It is used to indicate gaps in price movement. When prices gap higher, the top of the candlestick becomes a white bar on a green background (black for downwards gaps). When prices gap lower, the bottom of the candlestick becomes a black bar on a red background.
3. Morning Star
The morning star is the most popular candlestick with traders and analysts because it shows short-term trends. A black body that is longer than the previous day’s body is drawn in a V shape. Morning stars are used when traders or analysts see a strong trend developing in a stock.
Does Candlestick Trading Work?
Yes. Candlestick trading is prevalent among stock traders and analysts because it works. It works well in trading patterns that technical analysis would not otherwise identify readily. Technical analysis using candlesticks has been around for many centuries but was not popularly used until the past few decades. Candlesticks are still being used today by many traders, analysts, and investors worldwide to help them make better-informed decisions about their investments.
But recent studies show that candlestick patterns are effective 50 percent of the time.
Traders need to learn how to determine if they are correctly reading a candlestick pattern or not.
An effective rate of 50 percent means a trader should not rely solely on these patterns in their trading. Early in a new stock’s development, it is common to see candlestick patterns like dojis and harami breakouts, which may initially deceive traders.
Are Candlestick Chart Patterns Reliable?
Candlestick patterns can be used as indicators, but they should not be used as arbiters of investment direction. Candlestick patterns are reliable signals, mainly when used with other indicators such as moving averages or volume to determine whether the trend is bullish or bearish.
The most reliable signal stems from fundamentals. That said, a candlestick chart pattern is not necessarily a bad thing if it indicates that the trend may have reversed.
The best traders know that the hype surrounding candlestick chart patterns is unnecessary. The primary focus should be identifying trends and developing a disciplined risk management plan.
The following factors affect the reliability of candlestick chart patterns:
- Time frame of the pattern
- The instrument
- The candlestick pattern
- The pattern size
- The chart pattern
- The market
Are There Candlesticks Patterns That Always Work?
No. Just because a candlestick pattern appears on one trading chart does not mean it will appear when you look at that same data in a different time frame. Candlestick patterns sometimes do not appear in a given time frame, which means they are not reliable signals. When this happens, they are considered false formations or patterns instead of valid ones.
Candlestick patterns are helpful for spotting trends in the market and can help you gain an advantage over other traders.
If you use it correctly, candlestick trading is reliable. But remember that a stock’s price movement can be influenced by factors other than candlestick patterns alone.