In this chapter, we will be continuing our education by looking at the second part to reading Price Action; Candlestick Analysis. The image above should be familiar to you from Chapter 5: Introduction to Charts, where we briefly touched upon understanding what the candle actually represents.
In this chapter we are going to be discussing the candlesticks in more detail by looking at the following; A quick introduction on candlesticks, some of the main candlesticks and what they represent, a look at certain candlestick patterns and finally we will look at how to read the candlesticks on the chart. Okay, let’s begin!
Understanding what the candlesticks are showing you, is a necessary part to trading successfully. We will start this Chapter off by a brief re-introduction to the basic candlestick. The candlesticks show you the sentiment in the market, this could be either; Bullish, Bearish or Undecided. The upper and lower wicks of the candles represent the highest and lowest that price went, during the lifetime of that particular candle.
A Green candle generally represents Bullish sentiment. This means for the period that the candle opened and closed, the bulls/buyers pushed price up.
A Red candle generally represents Bearish sentiment. This means for the period that the candle opened and closed, the bears/sellers pushed price down.
A candle that is not significantly Green or Red, i.e. it has little to no body as it has closed at or near the same level it opened, means that the market is undecided. In the period that the candle opened and closed, the market had no clear sentiment and neither the Bulls or the Bears had control. This is also known as indecision in the market.
This basic but important information forms the basis for understanding how to read the candles, which we will look at in more detail a little later on. What I want to cover next, is how the candlesticks are represented across different chart Time-Frames.
Candlesticks and Time-Frames
As we have already established earlier in the Free Forex Beginner Course, a single candlestick represents the price movement for the given chart Time-Frame that we are looking at.
So if we are looking at the 15 MIN chart then each candle represents 15 Minutes worth of data. In an hour you will see four candles form on the 15 MIN Chart, as there are four 15 Minute increments in an hour. The same hourly data will be represented by two candles on the 30 MIN Chart and one candle on the 1 HR Chart.
Let’s look at this visually so we can make more sense of it:
From the image above; we can see that the same data shown by the four candles on the 15 MIN Chart, can be represented by a single candle on the 1 HR Chart.
Generally the lower charts tend to be more ‘messy’ such as the 1 MIN and 5 MIN Charts respectively, whereas the higher charts such as the 1 HR and DAILY Charts are more ‘clean’ as they are more compact, i.e. they are visually easier to read as the same data is shown in less candles. Taking this even further, the 1 MIN Chart will show 60 candles for the same data than can be expressed in just one candle on the 1 HR Chart.
Therefore my personal preference is to trade the higher Time-Frames, as they show a clearer picture of the market. Let’s now identify some of the main and recurring candlesticks on the charts and what they represent in terms of sentiment.
There are obviously a number of different candlesticks that will form on the chart, these will range from large and small bodied candles, large and small wicks etc.
There are however some candles that will form when there is a certain bias in the market, these candles are very important in telling us the market sentiment that currently exists or is starting to form. Let’s take a look at some of the most common recurring candlesticks.
As you can see the Marubozu is a candle that does not have any wicks either above or below. So the Marubozu has a high/low of it’s open and close respectively. It is a strong movement as overall it has moved in one direction only. Depending on where the Marubozu appears in regards to other factors such as Support and Resistance, it usually signifies continuation in the given direction.
Always remember to view the market in terms of a battle between the Bulls and the Bears.
A Bullish Marubozu suggests that Buyers had firm control for the time period the candle opened and closed, the strength is very clearly with the Bulls/Buyers.
A Bearish Marubozu suggests that Sellers had firm control for the time period the candle opened and closed, the strength is very clearly with the Bears/Sellers.
The Spinning Top Candle Pattern, shows that during the lifetime of the candle both the Bulls and the Bears tried at some point to push in their directions, however neither was able to really get a foothold as the candle closed fairly close to it’s opening level.
The Spinning Top therefore suggests that their is indecision in the market, leaning slightly towards a Bullish sentiment for the Bullish Spinning Top and a Bearish Sentiment for the Bearish Spinning Top.
A Spinning Top could potentially be the start of a reversing trend, if for example the market was in a clear uptrend and then we got a Spinning Top, this shows that the Bears are trying to fight back, they have disrupted the move up. The same would apply in a downtrend, with the Bulls this time fighting back the Bearish trend.
Hammers / Shooting Stars
The Hammer and the Shooting Star are quite easy to spot as they have a distinctive long wick. They also suggest that a possible trend reversal is about to begin.
The Hammer has a long lower wick, small body at the top and little to no upper wick.
The Shooting Star has a long upper wick, small body at the bottom and little to no lower wick.
The long lower wick on the Hammer shows that the Bears initially pushed price down forming the low of the candle, however they could not hold the momentum as the Bulls pushed price right back up. A similar tale is told on the Shooting Star, the long upper wick suggests that the Bulls initially took the price higher, only to be pushed straight back down by the Bears.
The Doji is the name given to a candle that opens and closes at the same level, as we have identified earlier in this chapter these show that there is indecision in the market, neither the Bulls or the Bears are in control. The Doji is similar to the Spinning Top in that they both show indecision, the difference being the Doji shows more indecision as it has little to no body. Dojis are usually classified into the following four types:
Regular Doji – This is the most common type of Doji candle pattern. Both Bulls and Bears tried to make a move in their directions, but ultimately failed to make an impact and hold, they are evenly matched.
Long-Legged Doji – Virtually the same as the regular Doji, however the Bulls and the Bears pushed even further in their directions, the end result though, was the same. They closed either very close to or at the open of the candle.
Gravestone Doji – This is an interesting Doji, it shows that the Bulls tried to push price up, but they were overpowered by the Bears who pushed price right the way back down again, to close at the open. When found in an uptrend, it could possibly signal a reversal.
Dragonfly Doji – Again quite an interesting Doji, it shows that the Bears tried to push price down, but they were overpowered by the Bulls who pushed price back up again to close at the open. When found in a downtrend, it could possibly signal a reversal.
So these are just some of the main candlesticks that will continue to form on the charts. You will also get what we call Candlestick Patterns, these are made up of multiple candlesticks and they also tell us more information on the current/forming market sentiment, Let’s take a look at a few of them.
Just like the Recurring Candlesticks; Candlestick Patterns can be very useful in showing us what is happening between the Bulls and the Bears. Who currently has the strength? Who currently has the weakness? etc.
The Harami Candlestick Pattern consists of two candles, a large candle and a small one. They are created when a smaller candle forms after a significantly larger one, with the smaller candle being contained within the larger candle. They are known as possible reversal Candlestick Patterns.
When found in a downtrend the Bullish Harami suggests that a possible reversal to the upside is about to take place.
When found in an uptrend the Bearish Harami suggests that a possible reversal to the downside is about to take place.
As the name suggests the Engulfing Pattern is where one candle envelopes or ‘engulfs‘ the other. Like the Harami Pattern, the Engulfing Pattern suggests that a possible trend reversal is about to take place.
The Bullish Engulfing Pattern forms when a larger Bullish candle totally engulfs a smaller Bearish candle. The open and close of the smaller Bearish candle is contained within the larger Bullish candle. It indicates a possible reversal when it appears in a downtrend.
The Bearish Engulfing Pattern forms when a larger Bearish candle totally engulfs a smaller Bullish candle. The open and close of the smaller Bullish candle is contained within the larger Bearish candle. It indicates a possible reversal when it appears in an uptrend.
The Morning Star is made up of three candles; a large Bearish candle followed by a smaller indecision candle (which could also be a Regular Doji), finally ending and confirming the Morning Star Pattern with a Bullish candle that closes well into the large Bearish candle i.e. it has closed above the midpoint of the Bearish candle.
The Morning Star is considered to be a possible reversal when found in a downtrend.
The opposite to the Morning Star, The Evening Star also consists of three candles and is made up of the following; a large Bullish candle followed by a smaller indecision candle (I have included a Doji example here), finally ending and confirming the Evening Star Pattern with a Bearish candle that closes well into the large Bullish candle. Here you can see that the Bearish candle actually takes out the low of the Bullish candle, indicating strong Bearish pressure.
The Evening Star is considered to be a possible reversal when found in an uptrend.
Again these are just a few of the Candlestick Patterns that you will regularly come across on the charts. There are a lot more, however I do not see the worth in just aimlessly listing a ton of different Candlestick Patterns, the patterns I have shown here are generally the most prominent/main Candlestick Patterns you will come across.
In the final section for Chapter 9 – Candlestick Analysis, we are going to be putting this information together so we can learn how to read the raw data (the candlesticks).
How to read the Candlesticks
By now you should have a greater understanding of candlesticks in general, as well as a good idea about some of the different Recurring Candlesticks and Candlestick Patterns that can be found on the charts.
In this section we will look at an example on how to read the charts by also remembering what we learnt in the previous Chapter about Support and Resistance. Without Support and Resistance, reading the Candlesticks basically becomes a lot harder and obscure, as they are not being placed in a structural context. The two must come together in order for us to start reading Price Action.
Remember how we spoke about, how the charts should be viewed as a battle between the Bulls and the Bears? Well that is exactly what we need to do when we look at the chart. As each candle forms, we need to be running a commentary in our heads about what this candle means in terms of the overall Market Sentiment.
Let’s take a look at the GBP/EUR Daily Chart
The chart above shows our Support and Resistance areas, marked by the lines. Remember rejection areas above are Resistance and rejection areas below are Support. Let’s assume that these have been placed before any of the candles shown on the chart above were formed. Let’s now look at reading the chart, by splitting it up into 5 sections.
Below we will discuss why these sections have been highlighted and their significance going ahead.
So the chart above has been separated into 5 different sections, let’s look at these in more detail:
Section 1 begins with a breakthrough of previous Resistance which is now the current Support area, we know from Chapter 8 – Support and Resistance, that Resistance broken becomes Support and Support broken becomes Resistance. So when price comes back down to this area in the future, what we expect to see is a supportive move back up.
Looking at Section 1, we can see that the Bulls have a firm control in the market, as can be seen by the multiple Bullish candles taking price up. We expect price to continue in this fashion until it comes to the Resistance Area above, where the Bulls will encounter the opposite force of the Sellers/Bears.
In Section 2, we can see that price is no longer moving in a strong uptrend, and instead it has slowed down significantly grinding into a sideways range. This means that the Bulls and the Bears are fighting for control; Is this a coincidence? Most certainly not! We had already predicted before hand that the Bulls were going to find some trouble here, as it was a Resistance area and that is exactly what has happened.
We now await to see if price will either breakthrough the Resistance area and continue the move higher (just like it did in Section 1), or if the Bears will now get a foothold in the market and have enough strength to push the Bulls back down.
In the 3rd Section, we can see an obvious move down, this shows that the Bears took control of the market. Again this is not just a coincidence, the magic of Support and Resistance has enabled us to identify this possible move back down beforehand. I am sure you can begin to see and appreciate the importance of Support and Resistance.
Also the beginning of Section 3; shows a Doji and then a Bearish Spinning Top. As we learnt earlier these are Recurring Candlesticks that indicate indecision in the market, so this too fits in with what we expected to see at this particular point on the chart.
Where then do we expect price to find Bullish pressure? We identified this back in Section 1 as being the Support area below. As you can see we have another Doji at the end of Section 3, again indicating indecision. We are already aware that this area contains Bulls/Buyers and we may see a possible move up.
Section 4 begins with a huge Bullish candle, the wicks are very small and so this is almost a Bullish Marubozu, three candles later we see another strong Bullish move up in what could also be expressed as a close Bullish Marubozu. The fact of the matter is, the Bulls are back in contention pushing price up heavily.
We expect price to continue in this fashion until our Resistance area, and as you can see the Bears come into the market once again at our Resistance area, with a Bearish Spinning Top forming before the move down. Initially the Bearish move back down seemed to be quite strong, as we started with two fairly large Bearish candles.
However the move could not be sustained as Bullish pressure once again, pushed price back up. The Bulls seem to be regaining control and a possible break of the Resistance area may take place.
Finally in Section 5, we can see that the Bulls manage to push through the Resistance area, but this is only briefly as we see a Shooting Star and a Long-Legged Doji, which were quickly followed by a Bearish move back down through the new Support area. We see section 5 ending with a Bullish Spinning Top at the Resistance area…price it seems, may be heading down once again.
So as you can see when we look at the chart from the perspective of a battle between the Bulls and the Bears, and we link this to what we know about Support and Resistance and Candlestick Analysis, we are actually able to look at the chart and visualise possible future Price Action.
This concludes Chapter 9 – Candlestick Analysis, you should now be quite comfortable with the basic candlesticks as well as some of the more advanced candlesticks and patterns and what they mean in terms of the battle between the Bulls and the Bears. See you on the next Chapter, where we will be discussing a very important aspect of trading; Money Management.