If you must have just one tool in your trader’s toolbox, it will be candlestick. How can you use this powerful tool to trade the financial market? If you love day-trading, how can you use this tool to your advantage? In this article, we’ll discuss how to read candlestick chart for day trading.
Let’s dive in.
WHAT IS A CANDLESTICK CHART?
A candlestick chart is a graphical representation of market prices (stock, forex, cryptocurrency etc). It is made up of a series of alternating green and red candlesticks (also called candles).
The financial market is greatly influenced by human emotions. A careful study of human interaction in the financial market shows a recurring pattern. Candlesticks displace these patterns in graphical form. For a history of the candlestick, please check this article.
WHAT IS DAY TRADING?
Market patterns in measured by comparing current market condition with past performance. Candle sticks can be set to represent a given period of time (5min, 15min, 1 hour, 1 day etc). Day trading is a measurement of the market condition within the duration of a day. This means that the market opens and closes within a 24 hour period.
Day trading: means opening and closing a trading position within one day. The trading duration can last from 1 hour to 24 hours. Several trades can be opened within a given day.
This style of trading have the benefits of long-term trades as it filters the fluctuations that is common in scalping trading, yet it still has the benefits of short-term trading as trades can be closed even within a couple of hours.
HOW TO READ BASIC CANDLESTICK PATTERN
A candlestick has four components:
- The open
- The close
- The high
- The low.
Each of these components indicates a unique point in the market. A candle can shed light on the market sentiment at a given time. However, when read in groups and along with other trading indicators, candlesticks are a power tool to trade the financial market.
Now, let us discuss the 4 main aspects of a candlestick.
IDENTIFY THE OPEN, HIGH, LOW AND CLOSE PRICES FOR EACH DAY
For the sake of this discussion, we’ll be using a 1-hour candlestick as an example. One candle = 1 hour.
Open: This is the price at which the market opens. For example, at 1600 Hour, 00 sec, (16:00:00 UTC) the price of USDEur was at 0.9520. In this example, the Open price is 0.9520
Close: It is the price at which the market closes. If at 1659 hour, 59sec (16:59:59 UTC), the price of USDEur drops to 0.9343, the Close price will be 0.9343.
Because the closing price is lower than the opening price, the candle is said to be a bear candle, and is usually identified by the color red.
Continuing with the USDEur analogy…
High: During the course of the 1-hour period, the price of USDEur moved from 0.9520 to 0.9610. Then moved back down. In this instance 0.9610 is the highest point the trading pair got to in the given period. 0.9610 is the High (the highest price of the candle).
Low: USDEur continued its downward movement to 0.9301, but went no further. This is the lowest price it went in the one-hour period. In this case 0.9301 is the Low.
Finally, it moved back up to 0.9343, and it was at that position at 1659 hour, 59sec (16:59:59 UTC). A second later, a new candle was formed. 0.9343 therefore, is the closing price. If the price does not change within the next second 0.9343 will become the opening price of the next candlestick… and this process starts all over again for each candle that forms.
COMPARE THE OPENING AND CLOSING PRICES TO SEE IF THERE WAS A CHANGE IN DIRECTION
The relations between the open, high, close and low of a candle, speaks volume about the market sentiment at a given time.
The distance between the Open and the High is called a wick (just like a physical candle wick). Similarly, the distance between the Close and the Low is also called a wick (like an inverted candle wick).
The distance between the open and the close is called a body.
The position of the Close in relation to the Open determines if the candle is a bull or bear candle.
When the Close is lower than the Open, it is a Bull candlestick. Bull candles are indicated with the color Green (by default).
When the Close is higher than the Open, it is a Bear candlestick. Bear candles are indicated with the color Red.
Bulls represent buyers.
Bears represent sellers.
There are buyers and sellers at every given time in the market. You can compare the market to a thug-of-war between the buyers and the sellers. The candle color only indicates the dominant side at a particular time. When the bulls win the battle, the candle is green. If the bears win, it is red.
- If the Close price is lower than the Open price, it means that there were more sellers than buyers.
- If the gap between the Low and the Closing price is small or very small (that is, a short wick), it means that the sellers really dominated the market.
- If the gap between the open and close price is large, in that case the bear candle will be long. This indicates that the sell sentiment was strong.
- When you combine a long red candlestick body with a very short or almost non-existent wick, it means the selling force was quite strong.
All four points mentioned above indicates that:
- Sellers won the tug of war, and that
- They won by a reasonable margin.
When there are consecutive bearish candles, and the sell sentiment is strong, this is a ‘sell opportunity.’
While candlesticks alone can indicate traders’ emotion, and by extension, market trend. Most professional traders, however, combine the signal from candlestick patterns with other trading tools to determine when to enter the market.
- If the Close price is higher than the Open price, it means that there were more buyers than sellers.
- If the gap between the High and the Opening price is small or very small (that is, a short wick), it means that buyers really dominated the market.
- If the gap between the open and close price is large, in that case the bull candle will be long. This indicates a strong buy sentiment.
- When you combine a long Green candlestick body with a very short or almost non-existent wick, it means that the buying sentiment was quite strong.
All four points mentioned above indicates that:
- Buyers won the tug of war, and that
- They won by a reasonable margin.
When there are consecutive bullish candles, and the buy sentiment is strong, this indicates a ‘buy opportunity.’
While candlesticks alone can indicate traders’ emotion, and by extension, market trend. Most professional traders combine the signal from candlestick patterns with other trading tools to determine when to enter the market.
If we’ve understood the concept of candlesticks down to this point, it’s time to discuss a different aspect of candles: candlestick chart patterns.
NOTE: If you do not understand any of the points mentioned here, feel free to pause here and return to the section above.
WHAT ARE THE DIFFERENT CANDLESTICK PATTERNS?
Before we discuss the different types of Candlestick chart patterns, it is important to note that Candlesticks are a graphic representation of market sentiments. Kindly note these key point in mind, as we discuss the subsequent sections.
As a memory aid please note that most of these patterns are named after physical objects.
Now, let’s discuss the different types of Candlestick chart patterns.
There are many candlestick patterns that a beginner trader should know. But the four most common are:
As the name implies, the hammer is a candlestick pattern that looks like a physical hammer or mallet. A hammer is made up of a ‘head’ and it’s handle. In a similar vein, they hammer candlestick has a short head (the candlestick body) and a long wick (like a physical hammer’s handle).
This pattern is formed at the bottom of a bearish trend. This signals the end of a bearish pattern and the start of a bullish pattern. It is a bearish reversal pattern.
The Hanging Man
This resembles a malnourished human. With a head and a lean body. The hanging man looks similar to the hammer except for the longer wick. Its wick is about twice or thrice the size of the actual hammer. This is a bearish reversal pattern.
If this pattern forms at the end of a bullish trend, it is an indication of the end of the trend and the start of a downtrend.
The long downward wick, which is about double or triple the size of the head, is an indication that more sellers than buyers are beginning to enter the market, therefore the long wick. When a hanging man shows at the top of the bullish trend, it indicates that the bullish trend is becoming weak and buyers are beginning to lose momentum.
The doji is a very important pattern. It shows that momentum in a given direction is beginning to die. Dojis are formed when the opening and closing price of a candle at a given time frame is virtually the same. It is identified by its very short wick and an almost non-existent body.
The Piercing Line
This is, usually, located at the end of a downtrend. It is a bullish candlestick pattern. When formed at the end of a downtrend it indicates a reversal pattern.
A piercing line is a powerful and common candlestick indicator. When combined with other trend indicators, the piercing line is a reliable pattern to trade, as it not only indicates a change in trend, but can also be used to determine when to enter a trade.
There are many other Candlestick patterns, the simple and complex ones, both single candlesticks pattern and double or triple candlestick patterns.
Candlesticks are better analyzed in combination with other technical indicators. The key to trading candlesticks is to spot them in patterns when they are formed. And trade it at the right time. So,
- Start by analyzing the basic elements of a candlestick chart – open, high, low, and close.
- Next, focus on the specific indicators used to create the chart (resistance and support levels, Ichimoku cloud, and trend lines etc.)
- Look for patterns in the market,
- Compare these patterns with the market’s current price to identify any trends
- Finally, use the information gleaned from the chart to make trading decisions.
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This is part of a series. In a previous article, we introduced candlesticks. In the subsequent articles, we’ll discuss in detail the different candlestick patterns and how they can be used to trade the financial markets.
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