The history of candlestick charts dates back to 17th century when the Japanese started using technical analysis to trade rice. Candlesticks are visually more appealing, and display the price information in a quicker, easier manner. But what exactly is a candlestick? Let's find out.
What are candlesticks?
Just like a standard bar chart, there are four elements necessary to construct a candlestick chart, the open, high, low and closing price of a security for a given time period. A candlestick has the following components:
§ The body of the candlestick – This is called the real body, and represents the range between the opening and closing prices. A black or filled-in body represents that the close during that time period was lower than the open, (normally considered bearish) and when the body is open or white, that means the close was higher than the open (normally bullish).
§ A narrow line or wick - This thin vertical line above and/or below the real body is called the upper/lower shadow, representing the high/low price extremes for the period.
Candlestick reversal patterns
We have seen in our earlier write ups how double tops and bottoms, head-and-shoulders and such technical indicators depict reversal signals. Similarly, candlestick formations can be looked at for the same purpose.
A reversal does not necessarily mean that the current uptrend/downtrend will reverse direction, but merely indicates that the current direction may end. The market may then decide to drift sideways. Candlestick reversal patterns must be viewed within the context of prior activity to be effective. In fact, identical candlesticks may have different meanings depending on where they occur within the context of prior trends and formations.
Bullish reversal patterns
Candlestick reversal patterns can be bearish or bullish. In this article, we'll look at two popular bullish reversal patterns – the hammer and the morning star.
§ Hammer – This is a candlestick with a long lower wick (shadow) and a small real body. The shadow in this case is at least twice the length of the real body, and there is usually no or very little upper shadow. The body can be either black or white, but the main criterion is that this candlestick must occur within the context of a downtrend to be considered a hammer. This is formed when a stock moves significantly lower after the open, but rallies to close well above the intraday low.
§ Morning Star - The formation is comprised of 3 candlesticks. The first candlestick is a tall black real body followed by the second, a small real body, which opens lower. The third candlestick is a white real body that moves well into the first period's black real body. This is similar to an island pattern on standard bar charts.
Bullish reversal candlesticks and patterns suggest that early selling pressure was overcome and buying pressure emerged for a strong finish. Such bullish price action indicates strong demand.
Happy Trading,
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