Table of Contents
What is a candlestick chart?
Components of a candlestick chart
Interpreting patterns on a candlestick chart
Potential benefits and limitations of using candlestick charts
The bottom line
How to Read a Candlestick Chart
Candlestick charts show incremental movements in the price of an asset for a given period of time, they may help investors identify very short-term trading opportunities.
Investors who look at charts for stocks and other financial assets often want to know how the current price compares to the price a month or year ago. Is it higher or lower? Which way does the price seem to be headed? How long has it been going up or down?
But other investors might compare prices now against the price just one day ago, one hour ago or even five minutes ago.
Simple line charts are used for historical trends by tracking the movements of a market or asset price across longer time spans. But candlestick charts tend to be used more often for tracking very recent price moves and for short-term trading strategies, not long-term investment decisions.
A candlestick chart, so called because the chart display is a series of vertical rectangles resembling candlesticks, gives more price information than line charts, which typically display only a single price for each trading day. A candlestick chart shows investors the degree of price movement within smaller time increments. Looking at one is like zooming in on the line chart to see a more granular picture of price movement.
Candlestick charts were first used about 300 years ago by rice traders in Japan, to try to gauge whether prices were poised to rise or fall. Some of the Japanese names for certain observed price patterns in the rice market are still used by traders today in analyzing candlestick charts for all sorts of financial markets—stocks, exchange-traded funds (ETFs), currencies, commodities, government bonds, and derivatives.
The volume and liquidity of an asset influence the choice of time increments for charting. For example, stock and ETF traders might use 15-minute or hourly intervals to find any developing trends or signs of a price reversal, in one or more trading days. Currency traders, on the other hand, might use the shortest time increments, such as one or five minutes. They do so because so much currency trading is done globally, and a possible trend or reversal may occur in the span of a few minutes.
Candlestick charting is used to try to gauge immediate market sentiment—the collective inclination of traders to buy or sell, at a given time— and whether the sentiment is on a continuing trend or reversing. Trading decisions also are driven by whether candlesticks suggest the sentiment is becoming more bullish or bearish.
Candlestick charts often are used in technical analysis—the study of price patterns and trends of an asset or market. Technical analysis is different from fundamental analysis, which looks for the intrinsic value of an asset, such as a stock price based on a company’s sales and earnings growth, for instance.
A candlestick has the following components:
The wide part of the candlestick, filled with a color indicating whether the asset traded higher or lower in the designated time increment.
. Green, or sometimes white, indicates the price closed higher than it opened. Red, or sometimes black, indicates the opposite—a closing price that was lower than the open.
The thin line above or below the body, sometimes called the shadow, showing the highest or lowest intra-period prices. The upper wick in particular resembles the wick on a candle.
The depiction below shows two basic candlesticks, with the candle colored green to denote a bullish move (the price closed higher for the time increment), and red candle for a bearish one (price closed lower). The thin lines above and below the candles—the wicks—show the intra-period high and low for the time frame being examined.
Four price points are found in a single candle: open, close, high, and low. These are for the incremental time period chosen—one day, one hour, or 15 minutes, etc. A new candle is created as each time increment passes. Longer candles and wicks indicate a bigger price change in the given time period.
Let's say a trader wants to examine, in 15-minute increments, the intraday movement of a widely traded ETF that tracks the S&P 500 Index. In the course of a normal U.S. stock market trading day, from 9:30 a.m. to 4 p.m. New York time, that comes to 26 increments. The chart below covers a span of five trading days, or 130 such increments, each signified by a candlestick.
The trader can study the candlesticks, examining the size and color of the body and the length of the wicks, to discern price trends or where trends might be reversing, giving the trader an opportunity to buy or sell shares of the ETF.
Traders will use candlestick charts to look for patterns that suggest either a continuation of a short-term price trend or a reversal in a trend. Patterns may be perceived from one or more candlesticks, such as:
. This considers the size of a candle’s body and length of its wicks, which may suggest a reversal in price direction. Examples of a single-candle pattern are the Hammer, a bullish (green) candle with a short body and a long lower wick, or Hanging Man, a bearish (red) candle also with a short body and a long lower wick. They look the same, and they can signal an imminent price upturn or downturn, respectively, based on the context of adjacent candles.
. Two adjacent candles are examined for their size and position differences, including differences in their bodies and wicks. Examples of this type of pattern are bearish engulfing and bullish engulfing patterns, in which the length of the second candle is longer than the first candle, and harami patterns, in which the first candle encompasses the second.
. The size and position of a series of at least three candles are examined either to confirm a price trend or detect a reversal. Some examples: a long bearish candle followed by a short bearish candle, followed by a long bullish candle; a long bullish candle followed by a short bullish candle followed by a long bearish candle; three consecutive long bullish candles, each with a higher close than the one before. The names of these patterns are known as Morning Star, Evening Star, and Three White Soldiers, respectively.
Candlestick charts offer investors some benefits, including:
. A line chart displays only a single price for each point along the line; candlesticks show opening, closing, high and low prices.
. Candlestick charts clearly show the degree of short-term price volatility in each period.
. Candlesticks give traders an idea of immediate sentiment among traders—the balance of buyers and sellers and whether that balance is shifting.
At the same time, candlestick charts can have some limitations:
. Stock traders often examine only a few days of candlesticks, at most, while currency traders look at minutes and hours. Candlestick charts are less useful for longer periods and long-term investors.
. Candlestick charts, showing price fluctuations in short spans, can appear cluttered, getting in the way of a longer-term perspective.
. Many hedge funds and high-frequency trading firms use algorithms based on candlestick patterns, crowding out small investors and making it difficult for them to find profitable candlestick-driven trades.
Candlestick charts show incremental movements in the price of an asset for a given period of time, from as little as a minute to a day or so. They may help some investors identify very short-term trading opportunities in stocks, ETFs, currencies and other markets. Day traders and professional fund managers sometimes use these charts for making many trades in a single day. Candlestick charts, however, tend to be less useful for long-term investors, whose wealth goals and investment decisions span years or even decades.
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