As a trader, you want unbiased evidence to support your trading decisions and strategies. Candlestick patterns are an effective way to eliminate emotion from your trading and mitigate risks. These charts are practical trading analysis tools for anyone looking to understand the price action trading patterns.
This blog is the complete guide to candlestick patterns and it teaches you how to evaluate candlestick patterns. It also details the most common types of candlestick patterns so you can become better acquainted with evaluating trends within markets and devise trading strategies based on real data.
Price Action and Income is here for all of your price action trading questions. Our daily forecasts and premium education videos continue to help countless traders worldwide hone their trading skills to create sustainable incomes. Continue reading to discover the tools you need to understand candlestick patterns and start using them in your trading strategy today.
What Are Candlestick Charts?
Candlestick charts were invented by a Japanese rice trader in the 1700s, and they are still one of the most effective trading analysis tools we have. Candlestick charts have individual candles which traders use to understand price action. Candlestick price action utilizes the open position, close position and the price highs and lows for specific time periods.
Price action helps traders analyze the market with a more objective view rather than basing their decisions on political news and pure speculative trading techniques. It gives traders an unbiased strategy based on market trends and patterns.
Traders use candlestick patterns across a wide range of markets, including forex and cryptocurrency trading. These patterns can indicate reversals or a continuation of trends. There are also buy or sell entry candlestick patterns within the market. The bottom line is, you can use candlestick patterns in many ways. The more you study them, the more you’ll be able to use them appropriately. However, it’s important to note these charts aren’t failproof.
The periods each candle depicts depend on the time frame the trader chooses. The most common timeframe to select is the daily time frame. The candle shows the open, close, and highs and lows for the day within the daily timeframe. These different components help you forecast the future price action.
What Are the Parts of a Candlestick Chart?
There are three main components to candlestick patterns: the upper shadow, real body, and the lower shadow.
Upper Shadow- The upper shadow represents the vertical line between the high of the day and the closing price on a bullish candle and an opening price on a bearish candle.
Real Body- The candle’s real body represents the differences between the opening and closing prices (the colored portion of the candle represents the real body).
Lower Shadow- Lastly, the lower shadow of the candle is the vertical line between the low of the day and the open on a bullish candle and the close on a bearish candle.
How to Interpret Price Action Using a Candlestick Chart Bullish Candle Vs. Bearish Candle
Candle trading strategies operate in response to both increasing (bullish) or decreasing (bearish) patterns. Bullish candles occur when the close is higher than the open for a given position. Bearish candles represent price action that has a lower close than open.
These candlestick patterns can identify areas of both support and resistance. Bullish candlesticks indicate support, while bearish candlesticks indicate resistance. Bullish candlesticks also confirm uptrends, while bearish candlesticks confirm downtrend resistance areas.
Bullish candles break established resistance areas while bearish candlesticks break support areas.
Common Candlestick Patterns
Bullish Engulfing Pattern
The Bullish Engulfing Pattern is a bullish candlestick pattern that shows bears being engulfed by bulls. The bullish engulfing pattern contains two candlesticks, a smaller bearish candle on day 1 and a larger bullish candle on day 2. Typically, the bearish candle’s real body can fit inside the bullish candle’s real body.
On the second day, the market gaps down. During this time, bears try to retain control of the market. However, bulls come in and push prices back up past the price point from the previous day. The interpretive power from a bullish engulfing pattern comes from the change of sentiment- a bearish gap in the morning followed by the bulls’ rejection pushing the candle to close at highs. Bears pushed the price too low, and bulls have had enough.
Bearish Engulfing Pattern
Bearish goofing patterns are the opposite of bullish engulfing patterns. Day 1 has a smaller bullish candle whose real body can typically fit within the bearish candle’s real body. Day two experiences a gap-down phase where bears have had enough of the bulls’ price driving. The bear’s push results in prices below the previous day’s open.
The bearish engulfing pattern displays the opposite change of sentiment from the bullish engulfing pattern. The first day’s candlestick shows bullish signs of support, but the bears have had enough. They fight the bulls’ optimism and close the candle at lows for the day.
Dark Cloud Cover
Dark cloud covers are bearish candlestick reversal patterns, similar to bearish engulfing patterns. Dark cloud covers contain a large bullish candle on day 1. Day 2 experiences a gap up at open and then a bearish retracement that pushes the price to about 50% of day 1’s real body.
In Dark cloud covers, bears reject the gap up of day 2 and follow it with a retracement period, in which demand drops as supply builds.
The Doji is a transitional candlestick pattern that signifies uncertainty or agreement between bears and bulls. Dojis are typically at the top or bottom of price swings and indicate a reversal. However, traders can also view the Doki as a sign of continuation.
Dojis occur when the opening and closing prices are equal. Long-Legged Dojis, otherwise known as “Rickshaw Men,” have longer high and low shadows, meaning prices fluctuate more throughout the day.
The Doji represents undulating price action throughout the day. Bulls try to push the price high at the open, and bears reject the gap up. However, as bears try to establish their position, bears fight back and drive the price back up. This process can go both ways, with bears initiating the pattern as well. Either way, the price closes where it opened.
Dragonfly Dojis are known as bullish reversal patterns. They typically occur at the bottom of downtrends and help traders locate support points. Used with other patterns, traders can use the dragonfly to identify uptrends.
Dragonfly Dojis have very similar open, high, and closing prices. However, the most critical component of the Dragonfly is its long lower shadow. The long lower shadow displays how bears tried to test the demand, and the bulls rejected it.
Bears were able to push the price down. Hence, the long lower shadow. However, bulls found an area of support, and they fight back until close, driving the price back to the open position by day’s end.
The evening star candlestick is a three-day bearish reversal trend that consists of a large bullish candle on day 1, a smaller bearish candle on day 2, and a large bearish candle on day three. Bulls are in charge on day 1, running their way to glory. The second day shows even more promise with a gap up at the open.
However, the bulls stumble during the middle of the day, and at day 2 close, the candle is small. Though the day 2 candle can be bullish, neutral, or bearish, bearish day 2 candles more commonly signify evening star candlestick patterns.
Day three begins with a gap down, and bears drive the price down throughout the day, sometimes eliminating the day 1 gains completely.
The gravestone Doji is an example of a bearish reversal pattern occurring at the top of uptrends. It can serve as a helpful identifier of resistance levels to a price increase. You typically use the gravestone in conjunction with other indicators to determine the possible uptrend.
Gravestone Dojis look like an inverted “T” candlestick. They have a long upper shadow, but they open and close at the same position. The Gravestone Doji show an up gap at the beginning of the day, with bulls controlling. Bulls may continue this trend into the middle of the day. However, bears initiate retracement, and the price closes at or near its opening price.
The hammer candlestick pattern is a bullish reversal pattern that most often occurs at the bottom of downtrends. Hammer patterns help traders identify areas of support and demand. The hammer candlestick indicator can reveal that downtrends are over and that short positions can be covered.
The hammer always has a long lower shadow, resulting from the market testing demand at the beginning of the day. The bulls locate the area and push the price near opening prices.
You can either have a green hammer or a red hammer candlestick pattern. The green candlestick shows more bullish promise than the red, but they are both bullish indicators. The green candlestick simply means bulls pushed past the opening prices. A red candlestick means the bulls pushed the price near its opening spot.
The Hanging Man Candlestick pattern is a bearish reversal pattern similar to the Hammer candlestick pattern, in the opposite direction. In both patterns, the closing price is near identical to the open price. Both patterns also contain long shadows, though the Hanging Man has a long upper shadow instead of a long lower shadow.
As with the Hammer pattern, the Hanging Man can have a green or red candle at the close. If there is a red hanging man at the end of the day, it is more likely a bearish indicator. If there is a green candle, the outlook is still bearish, just not quite as bearish.
Hanging man patterns occur at the end of long uptrends. They appear when prices hesitate significantly throughout the day. Buyers push the position higher at the open, but the bears catch on and eliminate the gains from the open.
The Harami is a trend reversal pattern that can either be bullish or bearish depending on the price action’s direction. If the Harami is bearish, the real body of the day 1 candlestick will be green and if it is bullish, the real body of the day 1 candlestick will be red. In both cases, the day 2 candlestick will be smaller and the opposite color.
Bearish Haramis occur at the top of uptrends after a large bullish candlestick. The most important aspect of the bearish Harami is that prices gap down on day 2, and do not recover by the close. This behavior signifies uncertainty brewing within the market.
Bullish Haramis are the opposite of bearish Haramis, and they occur at the bottom of downtrends with a large bear candlestick on day 1 and a smaller bullish candlestick on day 2. The most important aspect of the bullish Harami is a short gap up on day 2. The price gets held up, and a support point emerges.
The Inverted Hammer
The Inverted Hammer primarily occurs at the end of downtrends and is a sturdy indicator of a bullish market outlook. However, unlike other patterns, the best indicator of sustained bullish activity occurs after the Inverted Hammer pattern.
Inverted Hammer patterns occur when the open, high, and close patterns are nearly identical. They also all have long upper shadows at least twice the length of their real bodies. After prolonged downtrends, an Inverted Hammer signifies bullish activity because it shows the bears losing their power to drive the price any lower than its previous low.
Sellers pushed the price back to its opening position, but the increasing powers and the long upper shadow shows bulls gained strength and tested the bears’ prowess.
The Morning Star
The Morning Star is the counterpoint to the Evening Star. It is a bullish reversal pattern and usually occurs at the bottom of a downtrend. Day one contains a large bear candle. Day 2 has a shorter bearish candle, and day 3 includes a large bullish candle.
The second day of the Morning Star has a gap down at open. However, throughout the day, bulls prevent the price from dropping and day two closes at roughly the same price it opened with a minimal lower or upper shadow. Day 3 begins with a bullish gap up, and bulls continue to push the price further throughout the day, often covering the losses from day 1.
The Piercing Pattern is a bullish reversal pattern similar to the Bullish Engulfing Pattern. The Piercing Pattern is a two-day pattern with a bearish candle on day 1 and a bullish candle on day 2.
Piercing Patterns have to retrace at least 50% of day one’s losses. Additionally, day two opens with a gap down, only to see bulls cover much of the previous day’s losses in day 1. The rejection of the gap during day 2 typically signifies a bullish outlook. Further pushing into day 1’s losses shows even more bullish sentiment.
The Shooting Star candlestick pattern is a bearish reversal pattern that happens at the top of uptrends. It occurs most often when the open, low, and close prices are the same, and they typically have a long upper shadow twice the size of the real body.
Bearish shooting stars are stronger when the bears can push the price lower than the opening price. When prices close above the open, the Shooting Star is less bearish, but still signifies a reversal event.
Tweezer Tops and Bottoms
There are two types of Tweezer candlestick patterns: the Tweezer Top and the Tweezer Bottom. The Tweezer Top formation consists of a two-day pattern with a bullish candle on day one and a bearish candle on day 2. The Tweezer Bottom candlestick formation contains a bearish candle on day one and a bullish candle on day 2.
The Tweezer Top pattern is a bearish pattern at the top of an uptrend when bulls take the price too high. It closes with promise on day one, but on day two, investor sentiment reverses completely, as the market opens with a downward spiral, often eliminating the entire gains from day 1.
The Tweezer Bottom pattern happens in the exact opposite fashion. Sellers drive the market down to depths too low for the bulls to handle. The next day opens with a significant gap up and continues into the real body, recovering much of day 1’s losses.
Should I Consult Other Tools Beyond Candlestick Charts?
The short answer is yes. You should consult other tools when developing a trading strategy. A single tool can’t build a house. You need a trading toolbox if you want to experience sustained success and have a solid trading foundation. Enroll in courses and engorge yourself with as many learning materials as you can.
How Can I Get Started Trading?
Getting started trading doesn’t require extensive training or unlimited funds. Armed with a few key knowledge points and some open funds, candlestick charts are an excellent way to wet your feet in the trading game. However, if you’re interested in pattern-day trading, you need a margin account. Margin accounts require $25,000 to continue trading.
Conclusion- Evaluating Candlestick Patterns
Learning how to evaluate candlestick patterns is essential for any trader looking to try their hand using price action trading strategies. Understanding these patterns will help you make unemotional decisions using quantifiable data and unbiased trends. However, understanding candlestick patterns doesn’t guarantee you trading success.
To be a successful trader, you need to analyze multiple trading angles. You also need to stay up to date on current events and how they affect your market. The best traders don’t limit themselves to one theory. They absorb as much knowledge as possible and then put that knowledge to use where most applicable.
Price Action and Income offers daily trading forecasts and continuing education, so you always feel like you’re one step ahead of the market. Using key methods such as the Propulsion Method, the Exponential Profit System, and EPS Trade Forecasts, you can become a seasoned price action trader. Contact us today to take your trading to the next level.