By Dianne L. Fecteau
Many traders use candlestick charts and quickly learn to look for such candles as doji, hammers and the hanging man. Few traders, though, think about the emotions that cause these different candles to form. However, an understanding of the psychology can give you the most insight into what’s unfolding in the market.
The candlestick body is the heart of the price movement. The longer the body, the stronger the price movement. For example, if price begins to decline and candle bodies get longer, bearish momentum is increasing. There are more sellers than there are buyers. The lengthening bodies suggest fear is the predominant emotion. If traders are holding long trades at profit, they’re selling to avoid giving back a large portion of their gains. Traders who recently bought are fearful that the price move against them will continue. They decide to cover their longs and get out of the market.
On the other hand, if during a price decline the bodies begin to get smaller, it indicates that sellers are disappearing—everyone who wanted to sell has done so and buyers may be entering the market. The emotion has shifted to a more optimistic hope that they’re buying at a good price.
This is especially true if the candles start to show long lower shadows during a price decline. Shadows signal hesitation. Lower shadows suggest that the market is rejecting lower prices. Buyers become more hopeful that the lower price represents a bargain. They buy. As a result, price shoots up and the candle’s body doesn’t form around the lows. This is why hammers, at the bottom of a downtrend, can be powerful signals. The Japanese say that price is “hammering out a bottom,” according to Steve Nison who brought candlesticks to the western world of technical analysis. Understanding the psychology of the market participants helps a trader see why, if the next candle closed below the hammer’s low point, it would be a warning that prices may continue downward. Sellers became active again and the fear negates the hammer’s signal. This is one of the few times where it’s safe to short at support.
Similarly, when price is moving upward and the candles begin to have upper shadows, it gives the trader a clue that the market is rejecting higher prices. Holders of long trades may be selling in order to protect profits and those that bought at the top, hoping for higher highs, are selling to prevent further losses.
Look at the examples on the monthly AUSD/USD chart for November. Beginning in August 2008, price began a decline with long-bodied, red candles with few shadows. Then in October 2008, a long lower shadow appeared. The body was still long so it wasn’t clear the downtrend was over. However, such a long shadow suggested that buyers were coming in to buy and the sellers (bears) weren’t able to overcome their determination to do so. The next candle’s body was much smaller and with its long lower shadow, it encouraged traders to attempt some long positions. The psychology shifted to one of optimism. Anybody that sold short at the end of the downtrend as it probed lower prices (point A on the chart) was probably happy to cover those shorts at point B. That gave more power to the coming uptrend.
Notice that as the pair started to climb from its early 2009 lows, the blue candles had few upper shadows. Only recently have upper shadows began to appear. It’s reasonable for the trader to assume that traders holding profitable longs are becoming anxious. To protect those profits they’re selling. At the same time, the bears are getting a bit bolder and are willing to risk shorts.
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The candles known as spinning tops have small real bodies (either red or blue) and long shadows. These can be doji candles as well, a candle that has the same open and close price. (Note the doji at the top, just before the final high). They’re usually part of larger candle formations but they can appear as a series of candles. You see several of them on this chart within the circle I’ve labeled “1”. These candles indicate indecision. The buyers aren’t sure they want to buy; the sellers aren’t sure they want to sell. In this example, buyers and sellers dithered for several months before price fell to a support level where buying began again in earnest. The longer bodies said there was trader optimism. More money was coming into the market. Knowing this allows the small, retail trader to feel more confident about taking a long trade as well.
Shooting stars, those candles with a small body near the bottom of the price range, and a long upper shadow at least twice the length of the real body, hint that resistance may be near if they occur after an uptrend. The one that occurs on this chart at the point I’ve marked with a “2” hints the pair is running into problems. It wasn’t enough to stop it in its tracks and cause a trend reversal but the trader who sold at the close of this monthly candle had a rather quick and nice profit as a result. The high of these candles often becomes support or resistance. Notice how price kept returning to that point over the next few months before price began its final climb.
Pay attention to the bodies and shadows and you can glean what is driving other, larger players in the Forex market. I’ve been describing one-session candles in this article so remember that one session does not usually suffice to make a trading decision without support from other technical indicators. For example, with hammer or doji candles you might look at support and resistance, or overbought or oversold indications. Candles, though, can provide strong clues to the psychology in the market. As they form into more complex candlestick patterns such as morning and evening stars or engulfing patterns, the emotions at play in the market become clearer. I’ll look at the psychology behind some of those patterns in another article.
© Dianne Fecteau, 2009.