What is a candlestick chart?
– A candlestick chart is a visual way to show how an asset’s price behaved during a single time interval (minute, hour, day, etc.). Each “candlestick” summarizes four numbers: the opening price, the highest price, the lowest price, and the closing price for that interval. Traders use these charts to spot short-term patterns and to judge market sentiment.
Key parts and definitions
– Real body: the filled rectangle of the candle. It spans the open and close prices and shows whether price rose or fell during the period. If the close is above the open, the body is typically drawn white or green (bullish). If the close is below the open, it’s usually drawn black or red (bearish).
– Shadows (wicks): thin lines extending above and/or below the body. The upper shadow marks the high; the lower shadow marks the low.
– Timeframe: each candle represents a fixed period (e.g., 1 minute, 1 hour, 1 day). Patterns must be read within the chosen timeframe.
Basic interpretation rules
– Long bullish body (long white/green): strong buying pressure — price moved considerably higher from open to close.
– Long bearish body (long black/red): strong selling pressure — price moved considerably lower.
– Short bodies with long shadows: indicate indecision or intraperiod volatility.
– Always interpret candles in context — support/resistance levels, trend, and volume matter.
Common single-candle shapes to know
– Hammer (bullish reversal candidate): small body near the top of the range, long lower shadow. Forms when price fell during the period but recovered to close near the high.
– Hanging man (bearish counterpart): same shape as a hammer but appears after an uptrend; can signal a top.
Two‑day patterns
– Engulfing pattern: the second candle’s real body fully contains (engulfs) the first candle’s body. A bullish engulfing forms after a downtrend and may indicate a reversal up; a bearish engulfing appears after an uptrend and may indicate a reversal down.
– Harami: the second candle’s body is completely inside the first candle’s body and is the opposite color. This shows contraction/uncertainty.
– Harami Cross: the second candle is a doji — open and close are essentially equal — tucked inside the prior candle. It can signal a potential reversal but needs confirmation from subsequent price action.
Three‑day patterns
– Morning Star (bullish reversal): Day 1 — long bearish candle; Day 2 — short candle (gap down possible) showing indecision; Day 3 — long bullish candle that closes above the midpoint of Day 1. Suggests a shift from selling to buying.
– Evening Star (bearish reversal): mirror image — long bullish Day 1, small/indecisive Day 2, then long bearish Day 3 closing below Day 1 midpoint.
Explain like you’re five (simple version)
– Each candlestick is like a short story of that time: where price started, where it went highest and lowest, and where it finished. Big green blocks mean buyers were strong that time; big red blocks mean sellers were strong.
Where the ‘real body’ sits and what it tells you
– The real body sits between the open and close. Its size shows the net price move for the period; its color shows direction (up or down). The shadows show the intraperiod extremes beyond open and close.
How traders use candlesticks in practice
– Candlesticks help identify potential entry and exit points, confirm trend strength or weakness, and flag reversals when combined with other signals (support/resistance, volume, or technical indicators).
– They are widely used across markets — stocks, futures, and foreign exchange (forex). Forex traders favor candlesticks because they display traction and reversals clearly across many timeframes.
Checklist: how to read and use candlestick signals (step‑by‑step)
1. Choose a timeframe that matches your strategy (e.g., day-trade → 1–15 minute; swing → daily).
2. Identify the prevailing trend (up, down, sideways).
3. Spot notable single-candle signals (long bodies, hammers, doji).
4. Look for multi-day patterns (engulfing, harami, morning/evening star).
5. Check location: does the pattern occur near a support/resistance level or moving average?
6. Confirm with volume or a secondary indicator (RSI, MACD) before acting.
7. Use a clear risk plan: define stop-loss and target before entering a trade.
8. Wait for confirmation (e.g., next candle closes in the expected direction) for higher probability.
Worked numeric example
– Suppose a daily candle has: Open = 100, High = 110, Low = 95, Close = 108.
– Real body: between 100 (open) and 108 (close) → bullish (green) body of 8 points.
– Upper shadow: 110 − 108 = 2 points.
– Lower shadow: 100 −
5 = 5 points.
– Full range (high − low): 110 − 95 = 15 points.
– Real body size: 8 points (100 → 108).
– Upper shadow: 2 points.
– Lower shadow: 5 points.
Percent breakdown of the candle:
– Body as % of range = 8 / 15 ≈ 53.3%.
– Upper shadow % = 2 / 15 ≈ 13.3%.
– Lower shadow % = 5 / 15 ≈ 33.3%.
Interpretation (given this single daily candle)
– Bullish bias: close is above open, producing a green (bullish) body.
– Strength of move: body > 50% of the daily range suggests the buying pressure was the dominant force that day.
– Close near the high: a small upper shadow and a close near the intraday high imply buyers were willing to keep the price elevated into the close.
– Recovery from intraday low: the larger lower shadow shows buyers stepped in after the low (bargain hunting or short-covering).
– Conditional confidence: this is a reasonably strong single-candle bullish signal, but probability improves if the candle appears at or just above a support zone or moving average and if next-day price action confirms.
Worked risk-management example (numeric)
Assume:
– Entry method: you plan to enter after a confirmation candle closes above today’s close (108), so you buy at 110 the next day.
– Stop-loss rule: place stop slightly below the swing low (today’s low 95 → stop at 94).
– Target rule: set a 2:1 reward:risk target.
Calculations:
– Entry = 110. Stop = 94. Risk per share = 110 − 94 = 16 points.
– Target price = 110 + 2×16 = 142.
– Account size = $10,000. Risk per trade = 1% of account = $100.
– Position size (shares) = $100 / $16 ≈ 6.25 → round down to 6 shares.
– If trade hits target: profit = (142 − 110) × 6 = 32 × 6 = $192.
– If trade hits stop: loss = (110 − 94) × 6 = 16 × 6 = $96.
Checklist for evaluating a candlestick or candle pattern
1. Identify the candle type (bullish/bearish/doji/hammer/engulfing).
2. Measure body and shadows; compare to the total range.
3. Check location relative to support/resistance and moving averages.
4. Confirm with volume: is volume higher than average on the signal day?
5. Look for follow-through: does the next candle confirm direction?
6. Decide stop-loss location (below swing low or pattern low for longs; above swing high for shorts).
7. Calculate position size from risk per share and your pre-set risk amount.
8. Place a written trade plan with entry, stop, and target before execution.
Common pitfalls and limitations
– Single candles are probabilistic, not certain. They can produce many false signals.
– Timeframe mismatch: a bullish candle on a 5-minute chart carries a different implication than on a daily or weekly chart.
– Ignoring context: patterns at the middle of a wide range are less reliable than those at clear technical levels.
– Overfitting: memorizing dozens of patterns without rules for confirmation leads to inconsistent decisions.
– Survivorship and hindsight bias: practice on historical data can overstate effectiveness if you only study the successful examples.
Practical tips
– Use multi-timeframe confirmation: e.g., daily signal confirmed by weekly trend.
– Prefer signals that align with the longer-term trend.
– Require one confirming price bar (close in expected direction) and preferably above/below the pattern high/low.
– Combine with a momentum indicator (RSI, MACD) or volume spike for greater confidence.
– Keep a trade
journal. Track date/time, instrument, timeframe, candle pattern name, entry price, stop price, target, position size, outcome, and short notes (why you took it, confirmations, emotions). Reviewing this log regularly is how you learn what works and avoid hindsight bias.
Risk management checklist
– Set a fixed risk-per-trade percentage of account equity (common: 0.5–2%). This is the dollar amount you are willing to lose if the stop is hit.
– Define stop-loss level before entering (price that invalidates the setup). For candle patterns, stops often go just beyond the pattern extreme (high/low).
– Decide profit targets or use a trailing stop. Use a risk-to-reward (R:R) guideline — many traders prefer at least 1.5:1 to 3:1 but adjust to the signal’s reliability.
– Cap position size so a single trade doesn’t threaten account stability (e.g., max 2–5% of equity exposure in one position).
– Calculate position size with: Position size (units) = (Account equity × Risk per trade) / (Entry price − Stop price). Example below.
Worked numeric example
– Account equity: $10,000. Risk per trade: 1% = $100.
– Setup: bullish engulfing entry at $50. Stop-loss: $48 (distance = $2). Target: $56 (distance = $6 → R:R = 3:1).
– Position size = $100 / $2 = 50 shares.
– Position value = 50 × $50 = $2,500 (25% of account). Note: you might cap notional exposure (e.g., 10–20% of account) and adjust risk% or stop distance accordingly.
Expectancy and performance metrics
– Expectancy measures average dollars won per trade and is computed as: Expectancy = (Win% × AvgWin) − (Loss% × AvgLoss).
– Example: Win% = 40%, AvgWin = $300, Loss% = 60%, AvgLoss = $100 → Expectancy = (0.4×300) − (0.6×100) = 120 − 60 = $60 per trade. Positive expectancy means the edge is profitable over many trades.
– Track additional metrics: Sharpe ratio (risk-adjusted returns), maximum drawdown (largest peak-to-trough loss), and consecutive losses to size risk tolerance.
Confirmation and rule-based entries
– Require at least one confirming price bar (a close in the expected direction) or a break above/below the pattern high/low.
– Use one complementary indicator: e.g., RSI (relative strength index) divergence or MACD (moving average convergence divergence) momentum, or a volume spike confirming conviction. Define exact indicator thresholds in your rules.
– Use multiple timeframes: trade a daily candle signal that aligns with the weekly trend to improve odds.
Backtesting and sample sizes
– Backtest your candle-pattern rules with at least several hundred trades across different market regimes (bull, bear, sideways). Small samples overstate reliability.
– Use out-of-sample testing: build rules on one period and test on a later period to reduce overfitting.
– Consider simple Monte Carlo resampling of your trade outcomes to estimate possible sequences of wins/losses and worst-case drawdowns.
Trade-management rules (predefined)
– Pre-entry: Identify pattern, confirm with rules, compute position size and stop, set alerts.
– Entry: Enter at predefined price (market or limit). Document time and rationale.
– Management: Move stop to breakeven after X profit (define X as price or ATR multiple), or use trailing stop method you’ve tested.
– Exit: Close at target, stop, or when pattern invalidates. Avoid discretionary exits unless you have a tested rule.
Common pitfalls to avoid
– Chasing patterns without confirmation or in low-liquidity instruments.
– Ignoring commission, spread, and slippage—these reduce returns; factor them into backtests.
– Changing rules mid-backtest to improve historical stats (data-snooping).
– Failing to adapt: patterns can lose predictive power as markets evolve; continually re-evaluate.
Quick checklist before placing a candlestick-based trade
– Is the pattern at a meaningful technical level (support/resistance, trendline)?
– Is the higher timeframe trend supportive?
– Did my confirmation rule trigger (closing bar, volume, indicator)?
– Have I calculated position size and set a stop?
– Have I logged the trade plan in my journal?
Further reading (authoritative sources)
– Investopedia — Candlestick Definition and How to Read Them: https://www.investopedia.com/terms/c/candlestick.asp
– StockCharts (ChartSchool) — Candlestick Charting: https://school.stockcharts.com/doku.php?id=chart_school:chart_analysis:candlestick_charting
– CMT Association — Educational resources on technical analysis: https://cmtassociation.org/education-resources/
Educational disclaimer
This information is educational and illustrative only. It is not personalized investment advice or a recommendation to buy or sell securities. Past performance does not guarantee future results. Always do your own research and consider consulting a licensed financial professional before trading.