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Definition and use of Candlesticks
Candlestick charts are a type of chart tracking securities price.
They are so named because the rectangular shape and lines on either end resemble a candle with wicks.
Each candlestick usually represents one specific period of price data of a specific asset (forex, stocks, futures, options, ect). Candlesticks shape into patterns which can be used to predict or try to predict the movement of the asset price.
Some investors find them more visually appealing than the standard bar charts and the price actions easier to interpret. In this post we will highlight the most reliable candlesticks patterns which are used to identify entry and exit points by the experienced trader.
How to Read a Single Candlestick
Each candlestick represents one period's worth of price data about a specific asset through four pieces of information: the opening price, the closing price, the high price, and the low price.
The color of the central rectangle (called the real body) tells investors whether the opening price or the closing price was higher.
A black or filled candlestick means the closing price for the period was less than the opening price; hence, it is bearish and indicates selling pressure.
On the other side, a white or hollow candlestick means that the closing price was greater than the opening price. This is bullish and shows buying pressure.
The lines at both ends of a candlestick are called shadows, and they show the entire range of price action for the day, from low to high: the upper shadow shows the stock’s highest price for the day and the lower shadow shows the lowest price for the day.
Unlike other oscillators, such as the Stochastic or MACD, DPO is not a momentum indicator and for this reason even better is the use of the Detrended Price Oscillator combined with momentum indicators like the RSI or the MACD.
The bearish evening star reversal pattern starts with a tall white bar that carries an uptrend to a new high. The market gaps higher on the next bar but fresh buyers fail to appear, yielding a narrow range candlestick. A gap down on the third bar completes the pattern, which predicts that the decline will continue. According to Bulkowski, this pattern predicts lower prices with a 72% accuracy rate.
As the name indicates, the Morning Star is a sign of hope and a new beginning in a gloomy downtrend. The pattern consists of three candles: one short-bodied candle (called a doji or a spinning top) between a preceding long black candle and a succeeding long white one. The color of the real body of the short candle can be either white or black, and there is no overlap between its body and that of the black candle before. It shows that the selling pressure that was there the day before is now subsiding. The third white candle overlaps with the body of the black candle and shows a renewed buyer pressure and a start of a bullish reversal, especially if confirmed by the higher volume.
The Bullish Engulfing pattern is a two-candle reversal pattern. The second candle completely ‘engulfs’ the body of the first one, without regard to the length of the tail shadows. The Bullish Engulfing pattern appears in a downtrend and is a combination of one red candle followed by a larger hollow/green candle. On the second day of the pattern, price opens lower than the previous low, but the buying pressure pushes the price up to a higher level than the previous high.
It is advisable to enter a long position when the price moves higher than the high of the second engulfing candle—in other words when the downtrend reversal is confirmed.
Similarly, in the Bearish Engulfing pattern the second candle completely ‘engulfs’ the body of the first one. The Bearish Engulfing pattern appears in an uptrend and is a combination of one green candle followed by a longer red candle. On the second day of the pattern, price opens higher than the previous low; the selling pressure pushes the price down to a lower close than the previous low.
It is advisable to enter a short position when the price moves lower than the low of the second engulfing candle.
The Hammer is a bullish reversal pattern, which signals that a stock is nearing bottom in a downtrend. The body of the candle is short with a longer lower shadow which is a sign of sellers driving prices lower during the trading session, to be followed by strong buying pressure to end the session on a higher close.
Before we jump in on the bullish reversal action, however, we must wait for a confirmation of the upward trend, like a significant increase in trading volume or the breakout of the high of the hammer by the following candle.
The hanging man is a type of bearish reversal pattern, made up of just one candle having the same shape of the hammer and showing up in an uptrend market. It has a long lower wick and a short body at the top of the candlestick with little or no upper wick. In order for a candle to be a valid hanging man most traders say the lower wick must be two times greater than the size of the body portion of the candle, and the body of the candle must be at the upper end of the trading range.
The Inverted Hammer also forms in a downtrend and represents a likely trend reversal or support. It’s identical to the Hammer except for the longer upper shadow, which indicates buying pressure after the opening price, followed by considerable selling pressure, which however wasn’t enough to bring the price down below its opening value. Again, bullish confirmation is required and it can come in the form of a long hollow candlestick or a gap up, accompanied by a heavy trading volume.
A shooting star is a type of reversal pattern presaging a falling price. The Shooting Star looks exactly the same as the Inverted hammer, but instead of being found in a downtrend it is found in an uptrend and thus has different implications. Like the Inverted hammer it is made up of a candle with a small lower body, little or no lower wick, and a long upper wick that is at least two times the size of the lower body.
The long upper wick of this candlestick pattern indicates that the buyers drove prices up at some point during the period in which the candle was formed but encountered selling pressure which drove prices back down for the period to close near to where they opened. As this occurred in an uptrend the selling pressure is seen as a potential reversal sign. After encountering this pattern traders often check for a lower open on the next period before considering the sell-signal valid.
As with the Inverted hammer most traders will see a longer wick as a sign of a greater potential reversal and like to see an increase in volume on the day the Shooting Star forms.
The doji is characterized by a small trading range, with an opening and closing price that are virtually equal.
The doji represents indecision in the market and it is a signal that the buyers are losing conviction when formed in an uptrend and a signal that sellers are losing conviction if seen in a downtrend.
A doji is a key trend reversal indicator. This is particularly true when there is a high trading volume following an extended move in either direction. When a market has been in an uptrend and trades to a higher high than the previous three trading days, fails to hold that high, and closes in the lower 10% of that day's trading range, there is a high probability of a downtrend in the coming days.
Similarly, when the market has been in a downtrend and trades to a new low that's lower than the three previous trading days, fails to hold that low, and closes in the upper 10% of that day's trading range, there is a high probability of an uptrend in the following days.
The Piercing Line is a two-candle bullish reversal pattern, also occurring in downtrends. The first long black/red candle is followed by a white/green candle that opens lower than the previous close. Soon thereafter, the buying pressure pushes the price up halfway or more (preferably two-thirds of the way) into the real body of the black/red candle.
Dark Cloud Cover
Dark Cloud Cover consists of a long white/green candlestick followed by a black/red candlestick that opens above the high of the white candlestick and closes well into the body of the white candlestick.
It is considered as a bearish reversal signal during an uptrend.
Investors should use candlestick charts like any other technical analysis tool in order to assess the psychology of market participants in the context of stock trading.
They provide another kind of analysis which forms, together with technical and fundamental analysis, the basis for trading decisions.
Choose the Speedlines trading system to pick the best entry points
Like other trading tools, also Candlestick alone are not enough to indicate the precise entry point, you need to combine candles with a trading system that tells you exactly when to enter.
For this purpose, check out Speedlines, The Binary Optioner's flagship trading system.
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