Homma Munehisa was an eighteenth century rice trader in Japan. He created a new method of visualising price action over a given time period. Three hundred years later and candlestick charting patterns are still proving to be a very useful tool for traders today. But what exactly are Japanese candlesticks and how can spread betters profit from their use?
Candlesticks are simply a way of visualising the price open, close, high and low for a certain time period. If we look at daily candlesticks, then each candle corresponds to one day. The candle consists of a vertical line which runs from the high of the day to the low of the day. The open and the close will be within that range and they are represented by the length of a thick rectangle. Typically if the day closes higher that it opens, the candle is coloured green and if the day closes lower than it opens, the candle is coloured red. Note that the candle periods do not need to be daily; any time range can be used.
On the surface, candlesticks present an attractive way of describing the price action in a specific period. The real power of Japanese candlesticks, however comes in the recognition of various chart patterns. There are hundreds of different chart patterns that can be used to give clues as to where price is likely to go to in the near future. Numerous chart patterns signify reversal events and many more signify continuation events. Candlestick patterns are not on their own a holy grail of trading profits, they are just one of many tools that you can use in your trading arsenal. Let’s take a look at a couple of these Japanese candlestick patterns.
A bullish hammer is one of the simplest candlestick reversal patterns. This pattern consists of a single candle that tells us that the market might reverse soon. The market needs to be in a bearish trend for this pattern to be useful. We see a small body (meaning the open and close are close to each other) and a large trading range for the day. The open or the close should be at the high of the day. Look for the next day to open up and/or trend up to enter a long position. This pattern works best when found at the end of a strong downtrend into support.
An example bearish reversal pattern is the dark cloud cover. This pattern consists of two candles that occur at the end of a rally. We see a long up candle on the first day where the open is near the low and the close is near the high. The second day presents a long down candle with the open near the high and the close near the low. The second candle closes below the midpoint of the first. This pattern is an excellent candidate for a short when it comes at the end of a long rally into resistance.
There are a vast number of possible candlestick chart patterns and it is beyond the scope of this article to investigate more than a couple of them. Candlestick patterns are best used in conjunction with other technical analysis tools. Combine them with support, resistance, volume analysis and other indicators to refine your trading strategy. Each of these tools adds a small percentage to your edge but it is when you use them all together that you will begin to realise your profit potential.