What is a Candlestick Chart?

With its distinctive shape, the candlestick is a tried and true indicator that dates back to 18^th-century Japanese rice traders who realized that emotions could play a role in the direction of a market. In order to visually represent that emotion, they created the candlestick chart to display daily price movements. This article will define how investors can look at candlesticks to immediately understand the trend of a stock. The article will also describe different types of candlestick patterns and what they mean for investors.

How to read a candlestick chart

Hollow candlestick– A hollow candlestick is one where the body of the candle is not shaded. The analogy is that a hollow candlestick represents a candle that has not melted. This indicates that a stock’s closing price was higher than its opening price.

Example: Coca-Cola stock closes the previous day's session at 49.79. Because stocks do not "sleep" but have movements in the futures market even when the United States exchanges are not open, the stock drifts upward and opens the next day at $49.81.The stock rises to $50 during the day before closing at $49.90. In this case, the candlestick for that day will be hollow because the stock ended at a higher price than where it opened. The only two data points investors need are the opening price $49.81 and the closing price $49.90.

Filled candlestick– A filled candlestick is one where the body of the candle is shaded. The analogy is that the candle has melted. In this case, it indicates that the stock’s opening price for that period was above its closing price.

Example: IBM’s stock closes the previous day’s session at $121.19. It drifts lower in the overnight hours and opens the next day at $120.24. During the day, it continues to slide and ends the day at $118.98. In this case, the candlestick would be filled because the closing price ($118.98) was below the opening price ($120.24).

The distinctive wicks (or tails) on either end of the candlestick allow investors to see the high and low of a stock. This simply shows how high (the top wick) or low (the bottom wick) the stock moved during the day regardless of where it opened or closed. The wicks can help investors determine the momentum or direction of a stock.

Example: In our Coca-Cola example, the stock opened at $49.81 and ended at $49.90. However, we pointed out that the stock got as high as $50. This would be indicated as a small wick above the top of the candlestick that would show investors that the stock rose to that level before falling back to its close of $49.90. Similarly, although the stock opened at $49.81 it may have dipped below that level. If so, the candlestick would show a wick that represents what the low of the day was (which is different from the opening or closing price).

The key point to remember is that a hollow or shaded candlestick by itself does not take into account whether a stock is up or down for the day based on the last period’s close. In other words, it only gives the story of the price movement for that period.

Candlesticks can be based on different time periods

For active traders, particularly day traders, looking at the daily price movement of a stock may be too long. Traders can set candlesticks for a variety of time periods. Aggressive traders are looking for stocks with high liquidity so they can enter and exit trades quickly. The meaning of the candlestick doesn’t change, but the meaning of the “opening” and “closing” price would be different. For example, if an investor is using a 4-hour candlestick from the market open at 10:00 a.m. to 2:00 p.m., the “opening” price is the price the stock was at 10:00 a.m., which may be different than what it opened at for the day. Subsequently, the “closing” price would be the stock’s price at 2:00 p.m. which may be different than what it will close out for that day. In general, the narrower the time period, the less accurate a candlestick chart may be. But for investors looking for short-term, rapid price movement, especially for those doing options trading using stop losses or market orders, they can be very effective.

On the other hand, buy-and-hold investors may look at weekly candlesticks. Investors with a low-risk tolerance will want to see small price movements (or short candlesticks) which would indicate a very stable stock that is not moving very far in either direction. Several long weekly candlesticks may indicate that there is more volatility in a stock than an investor is comfortable handling.

Identifying patterns with candlesticks

By understanding what the different shapes and colors of candlesticks mean, investors can detect patterns. Some of the common patterns are briefly described below:

1. Bearish Engulfing Pattern – this indicates a situation where there are more sellers than buyers. The indicator is when a long red shaded candlestick immediately follows a short green shaded candlestick. Because sellers outnumber buyers, they are considered to dictate price movement which can indicate a stock that will drop further.
2. Bullish Engulfing Pattern – this indicates there are more buyers than sellers. The indicator is a long green shaded candlestick immediately following a short red shaded candlestick. When buyers outnumber sellers, the price may be ready to head higher.
3. Bearish Evening Star – this indicator is when the last candle in a pattern is a long shaded red candle that opens below the previous day's small candle (can be red or green). It will also dip deep into the shaded green candle from two days prior. This shows that there sellers are taking control.
4. Bearish Harami – this indicator happens during an upturn when a small red shaded candle lands inside the previous day’s green shaded candle. This pattern shows indecision, which could indicate price movement in either direction. The key for investors will be to see where the next session’s candle falls.
5. Bullish Harami – this indicator is the opposite of the bearish harami. It happens during a downturn when a small green shaded candle appears. Like the bearish harami, it does not indicate with certainty that the stock is about to climb.
6. Bullish Rising Three – for this pattern you need to see five days of candlesticks. The first candlestick would be a long, hollow green candle indicating an up day for the stock. That would be followed by three shaded candles that show the price moving lower, but never outside of the first day’s range. The last day of the pattern would show another long, hollow green candle. This indicates that the overall momentum is bullish.
7. Bearish Rising Three – Essentially this is the opposite of the bullish rising three and would indicate that the overall momentum of a stock is bearish. The first candlestick would be a long, shaded red candle indicating a down day for the stock. That would be followed by three shaded candles that show the price moving higher, but never outside of the first day’s range. The last day of the pattern would show another long, shaded red candle indicating a price moving below the first day’s price.

The final word on candlesticks

Candlesticks and candlestick patterns date back to the 18^thcentury when Japanese rice traders who saw a link between investors’ emotions and the price movement of an asset. Today, candlestick charts are one of the most common forms of technical analysis as they can tell investors a reasonably accurate story of the price movement of a stock.

Candlesticks have several components and each plays a key role in interpretation. The first is whether the candlestick is hollow or filled. This is an indication of whether the opening price was below the closing price (hollow) or if the opening price was above the closing price (closed). A second indicator is the length of the body which shows how much price movement there was during the period being measured. The third component is the wicks. These extend from the top and bottom of the candlestick to show the high and the low for a stock (which may be different from its open and close). Finally, the color of the candlestick is important for identifying patterns with a series of candlesticks. Green candlesticks indicate that the closing price of that candlestick was higher than the previous session’s closing price while a red candlestick indicates that the closing price was below the previous session’s closing price.

Although candlesticks are most commonly used to plot daily movement, they can be plotted in shorter or longer time periods to fit the needs of investors. Active traders will choose to look at candlestick charts that may show hourly price movement, whereas buy-and-hold investors may only want to see weekly candlestick charts.