A candlestick chart forms the backbone of technical analysis and remains a cornerstone of many analysts. It includes crucial price action data and displays it in easy-to-read candlesticks. They are colored price bars that allow skilled traders to derive essential information about the potential direction of an asset. Candlestick patterns offer reliable and time-tested signals and insights about price action. Given the fast-paced nature of financial markets, the more data analysts can get within a short time, the more efficient the portfolio output.
A brief history of the candlestick chart
The exact origin remains a bit of a mystery, with the majority crediting Japanese rice trader Munehisa Honma from Sakata, Japan. He traded at the Dojima Rice Market in Osaka during the Tokugawa Shogunate, where a futures market for rice emerged in 1710. He also wrote the first book on trading psychology in 1755 and developed a sophisticated network to quote market prices along a 600-kilometer route.
Steve Nison introduced candlesticks and candlestick pattern chart analysis to the Western financial system with his 1991 book “Japanese Candlestick Charting Techniques.” In his book, he credits the creation of candlestick charts to the Meiji period in Japan, which lasted between 1868 and 1912, over five decades following the death of Munehisa Honma in 1803.
All agree that the candlestick chart emerged in Japan and that 250+ years later, it remains the most used chart in technical analysis and the foundation of most trades globally.
Understanding Candlesticks and Candlestick Trading Patterns
The what are candlestick charts question is one of the most asked questions by beginner traders. Since they remain widely used by technical analysts and can account for 80% of all trading volume, understanding the what is candlestick question ranks as a core topic for beginners to learn.
The most beneficial factors of a candlestick chart are:
- Visual representation of price action with reliable insights
- Candlestick patterns can form the core of any technical analysis
- Advanced algorithmic traders may deploy candlestick recognition software, scanning countless candlestick charts for trading set-ups in fractions of seconds
A candlestick chart explained:
- It consists of the opening, closing, high and low over a specified period
- Colors assist visual recognition of how price action behaved
- Candlestick patterns form with up to five candlesticks
- Bullish, bearish, and continuation candlestick patterns exist
- Confirming candlesticks with other aspects of technical analysis can increase reliability
- Over 80% of daily trading value may originate from research based on a candlestick chart
- Reveals emotions by market participants
With 50+ candlestick trading patterns, technical analysts have plenty of potential opportunities to analyze. Regrettably, the widely available knowledge about candlestick patterns can create crowded trades and decrease reliability, primarily when algorithms chase the same set-up, leaving retail traders facing avoidable losses.
Candlestick Components and How to Read Candlestick Patterns
A candlestick consists of four components, and over 30 types of candlesticks exist, with some traders identifying 50+, but most traders relying on 20 to 25. Understanding how to read candlestick charts for day trading will help traders improve, but they must know the drawbacks.
The four candlestick components during each candlestick timeframe are:
- Opening price
- Closing price
- Highest price
- Lowest price
How to read a candlestick chart:
- The open and close price form the body of the candlestick
- The high and low prices form the shadow, also known as the tail or wick, represented as a single line above and below the body
- Colors represent a bullish or bearish candle, like green for bullish and red for bearish
- Some traders prefer hollow and solid candlesticks to identify if price action advanced or declined, and each trader can customize a candlestick chart to their liking
- Candlesticks form patterns, which provide insight about potential future price action, identifying continuation or reversal patterns
- Pure price action traders or naked traders may rely entirely on a candlestick chart, but using other technical indicators can increase the success rate of each trade
What are the drawbacks of a candlestick chart:
- Many confuse a candlestick chart and candlestick patterns as absolute indicators for future price action
- Advanced algorithmic traders relying on high-frequency trading identify candlestick chart patterns and can place trades against them, which is why successful traders avoid crowded trades, meaning if everyone knows the obvious, it is best to move on
Who Uses Candlestick Chart Analysis?
The primary users of candlestick chart analysis are technical analysts and advanced algorithmic traders with AI/ML-assisted trading solutions. Quantitative hedge funds incorporate it and may deploy it in counter-trend strategies based on high-frequency trading. Fundamental traders may rely on a candlestick chart to improve their order entry.
The Difference Between a Candlestick Chart and a Bar Chart
A candlestick and a bar chart offer identical information about price action but display it differently. Understanding the candlestick meaning and differentiating it from a bar chart will allow traders to make an informed decision on which they prefer.
A candlestick chart:
- Shows the relationship between open and close with colors, offering a more effective visualization of price action
- Emphasizes the close of one candlestick to the opening of the next candlestick
- Creates reliable candlestick patterns
A bar chart:
- Shows the relationship between open and close via horizontal lines projecting from the vertical one
- Emphasizes the closing price related to the close of the previous bar
What are Candlestick Forex Patterns, and Which Ones Should You Know?
One of the most notable advantages of a candlestick chart remains the formation of chart patterns. They can provide reliable trading signals, as outlined by Thomas Bulkowski in his 2008 book “Encyclopedia of Candlestick Charts,” where his research indicates success rates between 50% and 83%. Below is a list of candlestick patterns every trader should know, as knowing how to read candlestick chart patterns remains paramount to technical analysis, which accounts for 80%+ of price action and trading volumes.
Six bullish candlestick patterns:
- Inverted Hammer
- Bullish Engulfing
- Piercing Line
- Morning Start
- Three White Soldiers
Six bearish candlestick patterns:
- Hanging Man
- Shooting Star
- Bearish Engulfing
- Evening Star
- Three Black Crows
- Dark Cloud Cover
Four continuation candlestick patterns:
- Spinning Top
- Falling Three Methods
- Rising Three Methods
Candlestick Chart Conclusion
A candlestick chart offers reliable information about price action but remains best used with other aspects of technical analysis to improve reliability. It also shows emotions by market participants, allowing traders to incorporate candlestick patterns into their trading strategies. Advanced algorithmic trading firms use AI/ML-assisted solutions to identify trades.
Which candlestick chart is most reliable?
It depends on individual circumstances, but research by Thomas Bulkowski found an 83% success rate with the Three Line Strike pattern.
Is a candlestick chart reliable?
A candlestick chart can offer reliable trading signals if used by a skilled trader and confirmed by other aspects of technical analysis.
How many types of candlesticks are there?
There are 20+ core candlestick patterns, while 35 to 45 remain widely used, and advanced traders identify 50+.
Is candlestick trading profitable?
Candlestick trading can generate profits, similar to other strategies if used by a skilled trader with experience navigating volatile, fast-paced markets, an understanding of trading psychology, risk management, and the ability to recognize false signals while trading emotionless.