Candlesticks have risen in popularity and become an integral part of technical trading here in the west within the last fifteen years. The way you interpret candlesticks is one of the most important skills you can develop as a technical trader. In short, a candlestick is a graphical representation of a stock's price action during a specific period of time, and to correctly interpret candlesticks, you need to understand the picture or the story which a candlestick is graphically telling us.
The basic understanding of candlesticks comes down to the color of the candles. Most charting software will, by default, display candlesticks as black or white. However, it is just as popular to use green and red as well. This two-color system breaks down as follows: if the closing price of a stock is greater than the opening price, the candlestick will be white or green in color, which represents a gain for the day. On the flip side, if the closing price is less than the opening price, the candlestick will be black or red in color, representing a loss for the day.
The candlestick itself is constructed from four key price factors: the opening price of the day, the high price of the day, the low price of the day, and the closing price of the day. A single candlestick will tell us a complete story of what happened during the day by reviewing these four price points. It tells us the opening price, how high it traded during the day, how low it traded, and the price it finally closed at - all of this information in one candlestick it useful information indeed.
The four price points of a candlestick combine to create the three parts of a candle: the upper shadow or wick, the candle body, and the lower shadow or wick. Now, the upper shadow of a candle is drawn to the day's intra-day high or the highest price the stock traded during the day. While the lower shadow is drawn to the intra-day low of the day or the lowest price the stock traded. Finally, the candlestick body's size is created from the opening price and the closing price of the day. All three parts of a candlestick combine to create one complete candle, which is identical in function from day to day, but the combinations of the three parts are wide-ranging and varied in their meaning.
One of the most critical aspects of candlesticks is the story. For example, when you see a long upper shadow, it's a bearish signal. It is good to know that the stock traded up to a higher point, but the story behind the higher price point is the market failed to sustain the price push, and in response, it turned back down. Long upper shadows are always signs of selling pressure instead of what some may see as bullish gains. The flipside is true as well because long lower shadows by their nature are bullish.
Just like with real estate, location is everything with candles. As we have already covered, candlesticks tell us a story, and the story they tell is what makes them so useful. However, the story of a candlestick can mean something in one location and mean something totally different in another location.
For example, if you find a hangman candle at resistance, it is a bearish reversal signal, a weak signal, but it is still a bearish signal. However, if we see this a hangman candle at support, it is called a hammer candlestick pattern, and it is a strong bullish reversal signal. The same candlestick formation, formed from a nearly identical story, can have a completely different meaning if it occurs in a different location. The hangman versus hammer candles is a prime example of this scenario.
In closing, candlesticks are just as relevant today as when they came to prominence in Japan over two hundred and fifty years ago. If you are new to trading and wish to learn more, please consider signing up for our Foundations of Stocks and Options class, which you can do here. Thank you for reading, and we hope to see you next week!