i. Candlesticks are a visual price representation and make it easier to understand price movement.
ii. They are of three types - bullish, bearish, and indecision.
iii. The length of the body and the wicks of the candlesticks can tell a lot about the price movement.
What are candlesticks?
Candlesticks are basic price bars that represent the movement of the price of a currency and it is the most basic part of trading.
It is believed that candlesticks were developed way back in the 18th century by a Japanese rice trader named Munehisa Homma.
In those days rice trading in Japan was on the rise as Japan has always been a major cultivator of the paddy.
The Japanese traders made complete use of candlesticks to track the price and momentum of the markets for almost a century before word spread out and the candlesticks became known all over the world.
The concept of these candlesticks was first introduced to the rest of the world by Steve Nison in his book titled “Japanese Candlestick Charting Techniques”.
It is quite possible that candlesticks have been refined over the years resulting in the candlesticks that are present today, but the main concept has remained the same.
Steve Nison authored a few more books on candlesticks and trading in general, these books are to date considered to be good starting references for budding traders.
Candlesticks represent the entire price movement of the currency in the form of bars.
The candlesticks allow the trader to know at what price the currency open at during the trading session and at what price did it close at the end of the trading session.
It also provides information regarding how high and how low the price moved in the trading session.
Candlesticks are visually very convenient to interpret compared to other tools that represent price movements.
Candlesticks can be applied to all timeframes in order to know the price movement of that particular time period.
Traders can apply candlesticks on the monthly charts to see how the price moved over the span of the month, and can also be applied to timeframes as low as, but not restricted to, 1 minute charts in order to know how the price of the currency moved over the minute.
Construction of candlesticks
The construction of candlesticks isn’t rocket science but comprises of logical and convenient representation of aspects of price movements that are important to traders so as to make trading decisions.
Candlesticks comprise of two things – The body of the candlestick and wicks on either side of the body. Candlesticks could be of three types primarily – a bullish candlestick, a bearish candlestick, and an indecision candlestick.
1. Bullish candlestick
A bullish candlestick indicates that the price of the currency closed above the price at which it opened in that time period, hence the bulls or the buyers were in control at that time period.
The body of the candlestick would comprise of the open which would be at the lower end of the candlestick, and the close which would be at the upper end of the candlestick.
The wicks on the candlestick at either end indicate the high and low price in that time period.
In a bullish candlestick, a wick on the top indicates how high the price moved and a wick on the bottom indicates how low the price moved.
2. Bearish candlestick
A bearish candlestick indicates that the price of the currency closed below the price at which it opened in that time period, hence the bears or the sellers were in control at that time period.
The body of the candlestick would comprise of the open which would be at the upper end of the candlestick, and the close which would be at the lower end of the candlestick.
In a bearish candlestick too, a wick on the top indicates how high the price moved and a wick on the bottom indicates how low the price moved.
3. Indecision candlestick
Indecision candlesticks are those candlesticks that do not comprise a body. This means that there is no space in between the open price and the close price.
Hence, the price of the currency closed at the same price at which it opened. This indicates that neither the buyers nor the sellers were in control at that time period.
Wicks in the indecision candlesticks indicate the same thing, a wick on the top indicates how high the price moved and a wick on the bottom indicates how low the price moved.
What can you infer from the candlesticks?
Candlesticks indicate the nature of the price movement over the time period i.e. either bullish or bearish.
Traders interpret this by looking at the relationship between the open price of the currency and the price at which it closed.
As discussed earlier, if the price at which the candlestick closes is above the open price, the candlestick is bullish, and if the close price of the candlestick is below the price at which it opened, the candlestick is bearish.
Traders can acquire more information regarding price movements from these candlesticks. This information is based on how big or small the body of the candlestick is and how long are its wicks.
1. Size of the body
The size of the body of candlesticks is the space between the open price and the close price of the currency.
A bullish candlestick with a narrow body indicates that the buyers were in control at that time period but just by a margin, whereas a bullish candlestick with a long body indicates that the buyers were in control and the control wasn’t just by a margin, there had good influence over the sellers.
The same is the case with bearish candlesticks.
2. Length of the wicks
Wicks on candlesticks are caused when the price of the currency moves in a certain direction but does not sustain that price level and moves back away from it.
Candlesticks with long wicks on either side indicate that at some point in time one group of market participants (buyers or sellers) were in good control, but then the other group quickly caused the price to reverse.
Traders often look for such candlesticks on the price charts in order to identify major price levels which are being protected by either the buyers or the sellers.
Traders often look for candlesticks that have long bodies as this indicates more control by either buyers or sellers.
Candlesticks with no wicks also indicate good control, as no wicks mean that the price opened and kept moving in one direction only.
How are Candlesticks used?
Since candlesticks represent a lot that is happening in the price of the currency, traders utilize this in many ways.
1. As a tool for price representation
There are traders that use candlesticks solely to get a picture of the price movement of the currency. They interpret candlesticks only to identify if the price movement has been bullish, bearish or if there is indecision.
These traders incorporate candlesticks along with any indicator in order to make trading decisions.
Since these traders obtain the trading signals from the indicators solely, the use of candlesticks here is just for price representation of the currency.
2. Along with support and resistance
Price action traders look to trade around some major levels on the price charts of currencies. When the price reaches such levels, there is some action going on.
Candlesticks are the appropriate tools that assist traders to interpret such actions around major levels.
Traders will look for long bodies of candlesticks or for long wicks of the candlesticks around these levels, which confirms the strong presence of market participants at that particular level.
Traders also look for certain candlestick patterns that are formed at these levels which allow them to confirm a bias and trade accordingly.
3. Candlestick patterns
Candlestick patterns are traded widely by price action traders. These patterns tell a lot about the manner in which the price of the currency.
Traders often couple candlestick patterns along with certain value areas or zones that they identify looking at previous price movements on the chart. These patterns could be both bullish and bearish.
i. Bullish or Bearish Engulfing Pattern
This is a two candlestick pattern. A bullish engulfing pattern is formed when a prior bearish candlestick is completely engulfed by a bullish candlestick, by engulfing it means that the body or the first candlestick is smaller and inside the body of the second candlestick.
A bearish engulfing pattern is formed when a prior bullish candlestick is completely engulfed by a bearish candlestick.
ii. Inside Candlestick Pattern
This is a two candlestick pattern in which the second candlestick is completely inside the first candlestick.
This means that the body of the second candlestick is inside and smaller than the body of the first candlestick.
Traders usually enter into trades when the price of the currency crosses the high or low of the first candle.
iii. Doji Candlestick Pattern
Dojis are those types of candlesticks that consist of nobody at all or if the body is there then it is very narrow and wicks longer than the size of the body.
These candlesticks are not traded standalone, they are traded when these candlesticks are formed around value zones, which confirms the presence of demand or supply around such areas.
iv. Pin Bar Pattern
Pin bars are those candlesticks that have little to no wicks on one side and long wicks on the other side.
Pin bars formed during uptrend or downtrend, or around major value areas indicate a strong presence of either buyers or sellers.
These are some examples of commonly used candlestick patterns. This is not an exhaustive list of candlestick patterns, there are many patterns that traders have identified and utilize to make trading decisions.
It should be noted that it is not necessary to learn all types of candlestick patterns but it is important to learn what information each candlestick pattern looks to convey to traders.
Many believe that candlesticks and their patterns tell a story about the price movement of currencies, if traders interpret these stories correctly, they automatically have an edge over others.
The forex market is not an efficient one but is driven by the sentiment and psychology of the various traders all over the globe that trade the markets.
Candlestick patterns are the footprints that are left behind by these traders. Hence it is essential to learn how to interpret or decode these patterns rather than mugging up the different patterns.