The interpretation of candlestick charts is based primarily on patterns, the most popular of which are explained below.
Bullish Candlestick Patterns
Hammer – This is a bullish candlestick if it occurs after a significant downtrend. If the candlestick occurs after a significant up-trend, it is called a hanging man (see below). A hammer is identified by a small real body (i.e. small range between the open and closing prices) and a long lower shadow (i.e. the low is significantly lower than the open, high and close). The body can be empty or filled-in.
Piercing Candlestick – This is a bullish pattern and the opposite of a dark cloud cover. The first candlestick is a long black candlestick and the second is a long white candlestick. The second candlestick opens lower than the first candlesticks low, but it closes more than halfway above the first candlesticks real body.
Bullish Engulfing Candlestick – This pattern is strongly bullish if it occurs after a significant downtrend (i.e. it acts as a reversal pattern). It occurs when a small bearish (filled in) candlestick is engulfed by a large bullish (empty) candlestick).
Morning Star – This is a bullish pattern signifying a potential bottom. The ‘star’ indicates a possible reversal and the bullish (empty) candlestick confirms this. The star can be empty or filled-in.
Bullish / Morning Doji Star – A ‘star’ indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g. as in the morning star, above) before trading a doji star. The first candlestick can be empty or filled in.
Bearish Candlestick Patterns
Long Black Candlestick – This is a bearish candlestick. It occurs when prices open near the high and close significantly lower near the periods low.
Hanging Man – These candlesticks are bearish if they occur after a significant uptrend. If this pattern occurs after a significant downtrend, it is called a hammer. They are identified by small real bodies (i.e. a small range between the open and closing prices) and a long lower shadow (i.e. the low was significantly lower than the open, high and close). The bodies can be empty of filled-in.
Dark Cloud Cover – This is a bearish pattern. The pattern is more significant if the second candlestick’s body is below the center of the previous candlesticks body.
Bearish Engulfing Candlestick – This pattern is strongly bearish if it occurs after a significant uptrend (i.e. it acts as a reversal pattern). It occurs when a small bullish (empty) candlestick is engulfed by a large bearish (filled in) candlestick.
Evening Star – This is a bearish pattern signifying a potential top. The ‘star’ indicates a possible reversal and the bearish (filled in) candlestick confirms this. The star can be empty of filled in.
Bearish / Evening Doji Star – A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g. as in the evening star illustration) before trading a doji star.
Shooting Star – This pattern suggests a minor reversal when it appears after a rally. The stars body must appear near the low price and the candlestick should have a long upper shadow.
Long-legged Doji – This is often signifies a turning point. It occurs when the open and close are the same, and the range between the high and low is relatively large.
Dragonfly Doji – This candlestick signifies a substantial intra-day reversal – a shift in sentiment from bearish to bullish – when found in a downtrend. It occurs when the open and close are both the same (at or very near the high of the day), while the low is significantly lower than the open, high and closing prices.
Gravestone Doji – The opposite of a dragonfly doji, this candlestick signifies a substantial intra-day sentiment shift from bullish to bearish when found in an uptrend – indicating the death of a bullish attack. It occurs when the open and close re both the same (at or very near the low of the day), while the high is significantly higher than the open, low and closing prices.
Star – Stars indicate reversals. A star is a candlestick with a small realy body that occurs after a candlestick with a much larger real body, where the real bodies do not overlap. The shadows may overlap.
Doji Star – A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g. as in the evening star image) before trading a doji star.
Spinning Tops – These are neutral lines. They occur when the distance between the high and low, and the distance between the open and close are relatively small.
Doji – This line implies indecision. The market opened and closed at the same price. These candlesticks can appear in several different patterns. Double doji candlesticks (two adjacent doji lines) imply that a forceful move will follow a breakout from the current indecision.
Harami (‘pregnant’ is English) – This pattern indicates a decrease in momentum. It occurs when a candlestick with a small body falls within the area of a larger body. In this example, a bullish (empty) candlestick with a long body is followed by a weak bearish (filled in) candlestick. This implies a decrease in the bullish momentum.
Harami Cross – This pattern also indicates a decrease in momentum. The pattern is similar to a harami, except the second line is a doji (signifying indecision).
How to Trade Using Candlesticks
Candlesticks are a primary indicator, meaning that you do not need to rely on any other indicator to take the trade. Whilst the the use of another indicator can confirm the trend, it can also stop you take some trades as well and potentially missing out on a move.
Each candlestick can be classified into bullish, bearish or neutral as the above section shows. This essentially gives you the direction the market is going. You can use this information to make logical assumptions of where the market should move to next.
Using Candlesticks to Identify Direction
This should be done on a higher time frame. A good example if for those that day trade to look at the previous weeks candlestick. This can give a good idea about how the next week is likely to go.
The above example is a weekly chart. As you can see, there are no indicators on this chart. The last two weekly candles can give you a good idea about what the upcoming week may offer.
In this case, there is a high rejection candle, very close to a shooting star. Followed by a bearish engulfing candle. Both of these are bearish candlestick formations and would lead us to believe that in the upcoming week we will see this market continue to sell off.
The next step is to go down a time frame and identify where is best to sell this market. During the week you should just be looking for set ups to sell this market as that is the direction of the best expected moves.
Using Candlesticks as a Trigger
When using a candlestick as a trigger, you should be looking for a zone to buy or sell. The candlestick will simply give you the confirmation that the market is holding there and that you are in your right to enter the market.
The best places to use them as a trigger is at support and resistance levels.
In the example above, if you have decided that the direction of the market is lower, then you are simply looking for sell signals. The market has broken the support level, which has now turned into resistance. Any rejection candles at the resistance level becomes a sell signal.
The chart above shows two opportunities to sell at a resistance level. The first showing an evening star formation and the second with a bearish engulfing formation.
You would sell after the candles close and place a stop loss above the resistance level (if it were a day trade in this example).
Trend Line Break Trigger
Another candlestick trigger is a trend line break. This can also be a support and resistance level break but the example below highlights a trend line break.
Another way to use a candlestick to enter a market is to wait for a trend line to break with an impulsive candlestick. this shows that the market is ready to continue in the direction and that the retracement is over.
You are looking for an impulsive candlestick, once that is significantly larger than it’s surrounding neighbours and it should ideally close near to the top or bottom of the candle depending on the direction.