Candlestick charts combine data from multiple time scales into a single price bar, making it more helpful than standard lines connecting closing prices or open-high and close low bar. Candlesticks create patterns that forecast price direction. Not to mention, color-coding makes this tool look more sophisticated. Traders widely use Japanese candlestick charting techniques to evaluate financial markets. In this piece, we’ll discuss different candlestick charting techniques in detail.
History of Candlesticks Charting
Munehisa Homma, a Japanese rice dealer, introduced the concept of candlesticks charting patterns in the 18th century. Homma noticed that the rice market was impacted by the emotions of merchants while still admitting the demand and supply impact on the prices of rice.
Later on, the western world became familiar with the candlestick charting patterns when Steve Nison used and explained the notion in his book “Japanese Candlestick Charting Techniques” in 1991.
How does the Japanese Candlestick Charting work?
Compared to bar charts, Japanese Candlesticks give more comprehensive and precise price movement data. They show the supply and demand forces that drive price behavior.
The body of each candlestick reflects the price movement between the opening and closing points of underlying securities. While the upper wick indicates price distance from the body’s peak to the trading period’s high, the lower wick shows the price difference between the body’s bottom and the period’s low.
The security’s closing price determines the candlestick’s bullish or bearishness. If a candlestick closes higher than it opened, the body is white. In this scenario, the closing price is at the top while the opening price remains at the bottom.
The body fills up or turns black if the security traded closed lower than it opened. In this case, the body’s bottom is the candle’s closing price, and the top is its opening price. Modern candlesticks include more colors than white and black, such as blue, red, and green. Traders utilizing computerized trading platforms can select different colors for candlestick while setting up charts.
Reliability of Candlesticks Charting Techniques
Not every candlestick pattern works as anticipated. The popularity of candlestick patterns has diminished their dependability due to hedge funds and algorithms analyzing them. These well-funded traders employ lightning-fast execution against individual investors and fund managers who rely upon popular technical analysis tactics.
The five candlestick patterns below generally tend to work well for determining price direction & momentum. Each one interacts with the surrounding price bars to forecast price changes. Not to mention, these candlestick patterns are time-sensitive in a way that they only function inside the chart’s parameters (for instance, daily, weekly, or monthly), and their effectiveness rapidly diminishes 3 – 5 bars following the pattern.
Performance of Candlestick Patterns
This research is based on Thomas Bulkowski’s 2008 book “Encyclopedia of Candlestick Charts,” which ranked the performance of candlestick patterns. He provides stats for two predicted pattern outcomes, including reversal and continuation. While reversal candlestick patterns indicate a price shift, continuation patterns imply price extension.
The examples below show the empty white candlestick represents a higher closing print than the black candlestick.
- Three-line Strike
Three black candles form a bullish three-line strike reversal pattern. Each bar closes near the Intrabars low, posting lower lows. However, the fourth bar reverses widely and closes above the series’ high. The opening point also prints the fourth bar’s low. It anticipates increased pricing with up to 83% confirmation, according to Bulkowski.
Image Source: Candlescanner.com
- Three-black Crows
Three black bars close around the Intrabars lows in an upswing, forming a bearish three-black crows reversal pattern. This pattern implies further declines, possibly sparking a broader-scale slump. The most bearish variant starts at a fresh high (A on the chart), trapping purchasers into momentum trades. Bulkowski claims this pattern accurately forecasts decreased pricing 78% of the time.
Image Source: Candlescanner.com
- Two-black Gapping
The two-black bearish continuation pattern forms after a noteworthy peak in an upswing, with a gap-down resulting in two black bars reporting lower lows. The pattern implies further declines, possibly sparking a wider-scale slump. Bulkowski claims this pattern accurately forecasts decreased prices with an accuracy of 68%.
Image Source: Candlescanner.com
- Abandoned baby
In a downtrend, the black candles series prints lower lows before the emergence of the bullish abandoned baby reversal pattern. For Doji candlesticks having a small range, the market’s gap lowers on the next bar, but no new sellers appear. The pattern gets completed by adding the third bar and anticipates further gains, maybe sparking a larger-scale upswing. This pattern has a 49.73% accuracy rate, as per Bulkowski.
Image Source: Candlescanner.com
- Evening Star
The evening-star bearish reversal pattern initiates with a towering white bar leading an upswing to new highs. This results in a tight range candlestick as the market gaps soar, but no new buyers materialize. On the 3rd bar, the pattern gets completed following a gap down, implying further declines and maybe a more considerable slump. Bulkowski claims this pattern accurately forecasts price declines by 72%.
Image Source: Candlescanner.com
Difference between Candlesticks Patterns and Bar Charts
The link between opening and closing price is displayed in candlestick charts by the body color, but it is shown by horizontal lines protruding from the vertical in bar charts.
The bar chart emphasizes the stock’s closing price relative to the prior period’s closure, while the candlestick variant emphasizes the close concerning the same day’s opening.
Traders can get the same information using Japanese candlesticks or bar charts. However, candlesticks are more visible, giving traders a better idea of price activity. They also show the dynamics (supply & demand) affecting price fluctuation over time. The upper and lower wicks of the candle’s body are called the shadows. The body length and shadows of the candlestick are crucial price indicators.
Conclusion
Candlestick patterns attract traders’ attention, but many of their continuation and reversal signals are unreliable in today’s computerized market. Based on Thomas Bulkowski’s data, a small number of these patterns provide traders with actionable sell and buy recommendations. Therefore, traders must learn to distinguish between profitable and unprofitable patterns.
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