Brief History of Japanese Candlestick Patterns
The story of candlesticks dates back to 18th Century Japan. In early 18th Century Japan, when rice represented the medium of exchange as opposed to currency, feudal lords traded coupon receipts of rice stored in warehouses in Osaka, and eventually these exchanges evolved to became the first modern organized futures exchange (Dojima Rice Exchange), 150 years before the birth of the Chicago Board of Trade (CBOT). In the 1700s legendary Japanese rice trader Homma Munehisa ((1724 – 1803) studied all aspects of rice trading from the fundamentals to market psychology, and subsequently dominated the Japanese rice markets and built a huge fortune. He became the rice king of his day, racking up the present-day equivalent of over $100 billion in trading profits over his illustrious trading career, even making as much as $10 billion over a year’s time, in some cases.
Homm’a trading techniques and principles eventually evolved into the candlestick methodology, later used by Japanese technical analysts when the Japanese stock market began in the 1870s. This method was later picked up by the famed market technician Charles Dow around 1900, who brought its awareness to Western Traders. More recently, Steve Nilson in the 1990s researched and studied candlesticks, writing about them and in turn popularizing them via his classic book on the subject, Japanese Candlestick Charting Techniques. Since their introduction in the West, candlestick charting techniques have become increasingly popular among technical analysts and they remain in wide use today among Forex traders.
The Advantages of Candlesticks
Candlestick charts show the same Open, High, Low, and Close (OHLC) information as bar charts but they have a number of important advantages:
- They visually display who is winning the mini battles between the Bulls and the Bears.
- We get to see in picture form the force (or lack of force) behind each price bar’s movement.
- We can more easily spot the single bar and multi-bar patterns
- We see an easy-to-decipher picture of price action, comparing the relationship between open and close as well as high and low.
- They are more visually appealing.
Note: While there is much we can see from the candlesticks, there is also much we cannot see. Candlesticks do not depict the sequence of events between the open and close, only the relationship between the open and close. We can easily see the high and low, but we cannot tell which came first. Candlesticks can offer valuable information on the relative positions of the open, high, low, and close, but the trading activity that forms a particular candlestick can vary.
The Anatomy of a Candlestick: Bodies and Shadows
Candlesticks are formed using the open, high, low and close of the bar. The principle difference between candlestick patterns and bar patterns lies in the emphasis on the open and close. Bar charts do not treat the open and close with any special weighting. Candlestick charts highlight the “real body” as the wider area between the open and close. If the market closed higher than it opened (bullish), the real body is white or unfilled, with the opening price at the bottom of the real body and the closing price at the top. If the market closed lower than it opened (bearish), the real body is black, with the opening price at the top and the closing price at the bottom. The longer the body, the more trend strength, and the shorter the body, more indecision. The “shadow” is the vertical line running from the real body up to price high (top of upper shadow), or running from real body down to price low (bottom of shadow). The shadow thus measures of high/low range. A long shadow indicates failure for price to maintain its high or low and thus can signal trouble.
- If close is above open, a white candlestick is formed
- If close is below open, a black candlestick is formed
- White or black are between open and close is called the “real body”
- The thin lines above and below the body show the high/low range and are called “shadows”
- The top of the upper shadow is the “high and the bottom of the lower shadow is the “low
Long and Short Bodies
Traders also prefer to trade in the direction of longer candlestick bodies. Long bodies indicate strong buying or selling pressure. The longer the body, the stronger the buying or selling pressure. The buyers or sellers were stronger in mass and took control, forming the longer body. In contrast, short bodies suggest little buying or selling pressure and imply more indecision.
Long white candlesticks represent bullish strength. When the close is a long way up from open, the long white candlestick is formed, indicating that bullish buyers have aggressively pushed the price up from open to close. White candlesticks are generally bullish, but you have to consider them in relation to the big picture. If the market had declined, and is reaching a support level, a long white candlestick bouncing from support can mark a potential turning point. If the market had advanced, and is reaching a resistance level and traders are eager for a break, a long white candlestick breaking the resistance level is a potential message that the level has been clearly broken.
Long black candlesticks represent bearish strength. When the close is a long way down from open, the long black candlestick is formed, indicating that sellers aggressively pushed the price down from open to close. After a long advance to a critical resistance level, a long black candlestick can represent a turning point, where the sellers have launched a counter-attack. Or, if the market had declined to a significant support, a long black candlestick breaking the support level signals that the Bears have breached this level.
Total control: bodies without shadows (“marubosu”)
Sometimes a candlestick is all body and no shadow. It has no shadows extending from the top or bottom of the candle. The Japanese call them Marubozu, and they are difficult to find in a real market, but I am no purest, and so I cut and pasted their closest resemblance below (which are bodies with extremely short shadows):
A white marubozu candle has a long white body and is formed when the open equals the low and the close equals the high. The white marubozu candle indicates that buyers controlled the price of the stock from the open to the close, and is considered very bullish.
A black marubozu candle has a long black body and is formed when the open equals the high and the close equals the low. A black marubozu indicates that sellers controlled the price from the open to close, and is considered very bearish.
Deadlock: small bodies with long shadows (“spinning tops”)
Candlesticks with a long upper shadow, long lower shadow and small real bodies are called “Spinning Tops”.
The pattern indicates indecision between buyers and sellers. The small real body (whether white or black) shows little movement from open to close, while the shadows indicate that both the bulls and bears were very active during the session. The session might have opened and closed with little change, but prices moved significantly higher or lower during the same period. Neither buyers or sellers could gain the upper hand and the result is a deadlock.
Long and Short Shadows
The upper and lower shadows of candlesticks are the thin lines poking above and below the body, and they represent price distance between the open and the high/low period. The price distance between the open and high is called the upper shadow. The price distance between the open and the low is called the lower shadow.
Candlesticks with long upper shadow and short lower shadow indicate that the buyers initially dominated the session, but then sellers later counterattacked and forced prices down from their highs, with the weak close creating the long upper shadow.
Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers initially dominated the bar session, but then buyers later counterattacked and forced prices higher by the end.
Indecision: shadows without bodies (doji)
Sometimes candlesticks lack a body, or retain only a very small one, and they are called doji. It is seen to lack a body because the opening and closing price are virtually equal. The lengths of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross, or plus sign. The doji represents indecision in the market.
Types of Doji:
If the market is non-trending, the doji is not as significant, for non-trending or sideways markets are inherently indecisive. If the doji forms on a trend, it is more significant, as it is a signal that the buyers (of upward trend) or sellers (of downward trend) are becoming exhausted, weak and losing conviction. The buyers or sellers have been tapped out. The Doji witnessed in such a context can signal a ripe opportunity to enter early on in a potential trend reversal or trend correction, taking a trade in the opposite direction of the prior trend.
Bulls Versus Bears
A candlestick enacts the battle between Bulls (Buyers) and Bears (sellers) during the time frame of the candlestick. Each side is waging a mini tug-of-war within the candlestick to via for control, and the bodies and shadows of the candlestick give evidence of the struggle for power. The bottom (intra-session low) of the candlestick represents the Bears in control, and the top (inter-session high) represents the Bulls in control. The closer the close is to the high, the closer the Bulls are to winning the engagement, and the closer the close is to the low, the closer the Bears are to winning.
There are many variations of this struggle and I will narrow it down to 6 variations:
|Bullish||Long white candlesticks indicate that the Bulls controlled the Bar for the most of the battle.|
|Bearish||Long black candlesticks indicate that the Bears controlled the Bar for most of the battle.|
|Indecisive||Small candlesticks indicate that neither side could control the Bar.|
|Bullish||A long lower shadow indicates that the Bears controlled the Bar for part of the battle, but lost control by the end and the Bulls made an impressive counterattack.|
|Bearish||A long upper shadow indicates that the Bulls controlled the Bar for part of the battle, but lost control by the end and the Bears made an impressive counterattack.|
|Indecisive||A long upper and lower shadow indicates that both the Bears and the Bulls had controlled the Bar during different moments, but neither could wrest control from the other, resulting in stalemate. If the body is small, it is a “Spinning Top”, and if it is almost non-existent, and looks more like a cross, it is a “Doji”.|
The above six formations are the generalized formations of candlesticks, and can help guide the trader along to easily spot the characteristics of Bullish and Bearish candlesticks.
Below I will attempt to illustrate some of the more specific candlestick patterns, grouping them into the Bullish and Bearish Formations.
Bullish Candlestick Formations
How to trade the Bullish Candlesticks?
All the above candlestick formations should act as confirmations of trend reversal, and you should be aware of the following three steps:
Step 1 – Wait for the above patterns to appear during an established downtrend. An established downtrend is when price is below the 200-MA of D1 or H4.
Step1 (Alternate)-Better yet, wait for the above pattern to appear during an established uptrend that is currently experiencing a bearish correction. In other words, the price is below the 200-MA of D1 and H4, and thus in an established downtrend, but recently the price has been charging above the 200-MA of smaller time frames, such as H1 or M30.
Step 2 – Confirm the potential for a trend reversal if price is nearing key support levels. These support levels would be defined by horizontal lines across swing highs, or pivot point resistance lines, or even Fibonacci retracement levels. The strength any bulllish candlestick pattern is determined by the nearness to a support level. If the pattern appears in the middle of a trading range, it tends to have little significance.
Step 3 – Confirm the reversal with any of the above Bullish Candlestick Patterns. Keep in mind that it is just as important to see the basic strong signs for Bears (i.e., the long black bodies, or candles with long lower shadows) and weak signs of Bulls (such as short white bodies, or better yet, candles with a long upper shadow).
Optional Step #4: Confirm the reversal with oversold conditions using a popular overbought /oversold indicator (i.e., RSI or Stochastics), or if price appears outside the lower Bollinger Band.
Entry Signal: Buy when conditions 1- 4 above are met.
Exit Signal: Place stop loss x pips above the next lower support level (swing low, pivot or fib). Place take profit at next support level (swing low, pivot or fib). Alternately, place a stop loss of 50-100 pips, and a take profit of 50-100 pips.
Bearish Candlestick Patterns
How to trade the Bearish Candlesticks?
All the above candlestick formations should act as confirmations of trend reversal, and you should be aware of the following three steps:
Step 1 – Wait for the above patterns to appear during an established up trend. An established uptrend is when price is above the 200-MA of D1 or H4.
Step1 (Alternate) – Better yet, wait for the above pattern to appear during an established downtrend that is currently experiencing a bullish correction. In other words, the price is below the 200-MA of D1 and H4, and thus in an established downtrend, but recently the price has been charging above the 200-MA of H1 or M30.
Step 2 – Confirm the potential for a trend reversal if price is nearing key resistance levels (defined by horizontal lines across swing highs, or pivot point resistance lines, or Fibonacci retracement levels). This is very important. The strength any candlestick pattern is determined by the nearness to a resistance level. If the pattern appears in the middle of a trading range, it tends to have little significance.
Step 3 – Confirm the reversal with any of the above patterns. Keep in mind that the exact patterns above do not have to mature. It is just as important to see strong signs for Bears (such as long black candles, or candles with long lower shadows) and weak signs of Bulls (such as short white candles, or better yet, candles with a long upper shadow).
Optional Step #4: Confirm the reversal with overbought conditions using a popular overbought/versold indicator (i.e., RSI or Stochastics), or if price appears outside the Bollinger Band.
Entry Signal: Sell short when conditions 1- 4 above are met.
Exit Signal: Place stop loss x pips above the next resistance level (pivot or fib). Place take profit at next support level (pivot or fib). Alternately, place a stop loss of 50-100 pips, and a take profit of 50-100 pips.
Useful MT4 Candlestick Indicators:
At first it can be difficult to train your eye to see Candlestick patterns when, and as they occur, and so it is practical to insert Candlestick pattern indicators that can be on the alert for these patterns 24 hours of the market.
I have not experimented with all the indicators out there in this category, but I do did find this one interesting, because it did spot the 10 candlestick patterns I had illustrated above:
Another useful indicator you might want to experiment with:
Note: you should not be basing your trades from the candle patterns themselves, but from the candlestick patterns in relation to the market context, along with confirmations from support and resistance.
Hopefully you can now differentiate between long and short bodies, long and short shadows, and spot various types of Bullish and Bearish candlestick formations.
Keep in mind that Candlestick Patterns are just one device in your arsenal of trading tools. They are very useful in honing in on the immediate battle between the bulls and bears, in order to see who is winning the struggle for control over the immediate 1-3 candlesticks. The significance of this struggle depends upon whether or not the prior trend (main trend or corrective trend) is nearing key support and resistance levels, as determined by swing highs and lows, pivot points, or Fibs.
Once the candlesticks reach these levels, the battle between the bulls and bears over who controls the bars is critical for determining a reversal. More than likely you will be seeing candlesticks that display more general bullish or bearish characteristics, as seen from body size and color (long white for Bullish, long black for Bearish), or from long shadows (long lower for Bullish, long upper for Bearish). Sometimes you can see the more popular candlestick formations themselves, such as the ten listed above that have their Bullish and Bearish counterparts: The Bullish Hammers versus the Shooting Stars, the Morning Star versus the Evening Star, The Piercing Line versus the Dark Cloud, the Bullish Engulfing versus the Bearish Engulfing. Some MT4 indicators can be useful in spotting these more specific patterns, if you are not around to see them or have your doubts.
If you get really intrigued with Candlestick patterns, there is plenty more out there on the net to read about. Try not to get too wrapped up about 41+ patterns out there. There is no “holy grail” in any of these patterns, and the time and energy spent learning them all can be better spent on other activities. Writers of these patterns give you examples of when and why they work, but rarely give examples of when and why they do not. The Forex markets of today are much more complicated than the rice markets of 18th Century Japan, and trading in real time with many of these patterns can kill your capital in short order.
Undoubtedly, you will find that candlesticks can give you a more tactical view into the market than any type of chart. And if you do not become a fan of the specific patterns themselves, it is important to pay attention to the length and color of the body and the length and positing of the shadows, as they can give you an insight on whether or not the Bulls or Bears are in control over the bar. Once you become more familiar with the fundamental characteristics of candlesticks (and the more popular of the patterns), then you can use them in conjunction with support and resistance levels in order to better spot a potential reversal from the main trend, or better yet, a reversal from a corrective phase back in the direction of the main trend. It is the main trend that determines the side you should be on, the support and resistance levels that will direct you to where the battles will be fought, and the real-time information from the candlesticks at those levels that will allow you to assess with more probability who might win the battle so that you can join the winning team on its victory march.