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Chapter 1 Introduction to Candlestick

Candlestick

Candlesticks are the most popular chart choice among traders as compared to line chart, bar chart and the point & figure chart. It has gained popularity among the traders as it conveys wide range of trading information in one go in a highly visual way. Candlestick charts are also simple to read and interpret. It consists of a body (rectangle part of the candle) and shadow or wicks (lines above or below the body). Each candlestick also consists of an open, high, low and close price. The trader based on his trading horizon sets the time frame of the candlestick chart.

Interpreting Candlestick Chart

Open

The open is the first price traded and is indicated by either the top or bottom of the body of the candlestick.

High

The high is the highest price traded during the time period set for the candlestick, and is indicated by the top of the shadow that occurs above the body (called the upper shadow).The high price could be the open, close or a high hit within the time frame of the candle. If the open was the highest price then there will be no upper shadow.

Low 

The low is the lowest price traded during the candlestick, and is indicated by the bottom of the shadow that occurs below the body (called the lower shadow).The low could also be one of the three prices open, close or a low price hit within the time frame of the candle .If the open was the lowest price then there will be no lower shadow.

The color of a candlestick is based on whether the closing price (or the last traded price, if the candlestick is incomplete) is above (green) or below (red) the opening price. While the candlestick is the process of formation, the candlestick could constantly alter as the price fluctuates. The open remains fixed, but the rest of the parameter i.e. high, low and close could constantly change. When the time period of the candle comes to an end the last traded price is taken as the closing price, after which a new candlestick is formed which continues to convey the price movement over the next time segment.

Close 

The close is the last price traded during the candlestick, and is indicated by either the top or bottom of the body.

Range

The price difference between the upper and lower shadow indicates the range the price moved during the time frame set for the candlestick. It is calculated by subtracting the high from the low of the candlestick. Range indicates the volatility associated with the candlestick. Higher the range, higher is the volatility and vice versa. (Range = High - Low).

Interpreting candlesticks charts is one of the very first steps in learning how to trade. Once a trader has gained knowledge to interpret a chart he can then move on to the other aspects of technical analysis and develop trading strategies as per his needs.

Use of Candlesticks

Candlesticks tend to form patterns which are interpreted by traders to indentify a continuation or reversal of the existing trend. It is also used to spot short term trading opportunities. Different traders make use of candlestick charts differently. Candlestick patterns should be used in conjunction with the prevailing trend.

Candlestick also tends to act as a unique leading indicator providing the trader an edge while entering and exiting a trade. It also gives an early signal of a reversal in trend compared to the rest of the technical indicators. Hence it is widely used in short term trading and in volatile markets.

Candlestick compliments most of the other technical analysis indicators and works well with the western technical tools.

Candlestick patters also tend to act as support or resistance levels and indicate the start of a pullback or bounce.

Time frame

Most candlestick patterns form over a period of 1-3 days, which makes them short-term patterns that are valid for 10-15 trading sessions. For example hammers and hanging man require just one day. Engulfing patterns, bullish belt hold and dark cloud cover patterns require two days. Three white soldier and evening stars require three days for the pattern to complete.

Preceding Trend

Candlestick patterns gain significance based on their location within the trend, a reversal candlestick pattern has validity only if it is formed at the end of the current trend i.e. there should be a prior trend to reverse. Bullish reversals require a preceding downtrend while a bearish reversal requires a prior uptrend. The direction of the trend can be determined using trend lines, moving averages, peak/trough analysis or other aspects of technical analysis.

Tussle between bulls and bears.

Candlestick depicts the fight between the bulls and bears over the set time period.

  • Long green candlestick indicates that the trading session was controlled by the buyer’s i.e. bulls.

  • Long red candlestick indicated that the trading session was controlled by the seller’s i.e. bears.

  • A long lower shadow indicates the bears controlled the price until the bulls took control and made a strong comeback.

  • A long upper shadow indicates that the bulls controlled prices until the bears made an impressive comeback and took control.

  • Small candlestick indicates that neither the bulls nor bears could gain control over prices during the session.

  • A long upper and lower shadow indicates a volatile trading session with both the bulls and bears having gained control but unable to sustain the advantage.

Color of Candlesticks

The color of the candlestick depends on the preference of the trader. The commonly used combinations are

+ ve Day (Close higher than open ) -ve Day (Close lower than open)
Green Red
Blue Red

In the examples below we have made use of the blue and red color combination.

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