Candlesticks and Price Action

1.1Taking a Single Candle Apart

A candle is drawn from four prices for a period: the first trade (open), the last trade (close), and the highest and lowest prices in between (high and low). If the close is above the open the candle is bullish; if it is below, the candle is bearish. Japanese charts often draw bullish candles white or red and bearish ones black or blue; the diagrams in this academy use cyan for bullish and pink for bearish candles.

The thick part between the open and the close is the body. The line above it is the upper wick (or shadow) and the line below it is the lower wick; their tips mark the period's high and low. The same drawing works on any timeframe — one-minute, daily, weekly or monthly.

Candlesticks are said to originate from the record-keeping of rice traders in Edo-period Japan and are now a standard chart type worldwide. Because all four prices sit in one mark, a candle shows at a glance how far the price travelled during the period — something a line that joins closing prices cannot show.

• Bullish candle: the close is above the open (buyers prevailed over the period)
• Bearish candle: the close is below the open (sellers prevailed over the period)
• A wick's tip is a price the market reached but could not hold
• The drawing is the same on every timeframe, from one-minute to monthly

1.2What Bodies and Wicks Say About the Balance of Power

A long body means the price moved a long way in one direction from open to close. A long bullish candle is read as a period in which buyers kept control to the end; a long bearish candle as one in which sellers pushed through. A very small body is called a spinning top, and a candle whose open and close are almost equal is a doji — both are read as balance or indecision between buyers and sellers.

Wicks record prices that were reached and then rejected. A long upper wick shows that selling appeared at higher prices and pushed the market back; a long lower wick shows that buying appeared at lower prices. Two bullish candles of the same body size read differently depending on whether one closes near its high or leaves a long upper wick.

What a single candle means depends heavily on where it appears. A doji after a long advance carries more weight than a doji in the middle of a sideways range. The basic approach is to judge a candle's shape together with its location and the candles that follow.

When the next candle opens away from the previous close, leaving an empty price zone, the space is called a gap. Gaps tend to appear when news arrives outside trading hours, and a bullish candle that gaps up is read as a sign of strong buying interest. As the saying “gaps get filled” suggests, prices often come back into the gap later, but the lower edge of a gap can also act as support.

• Long bullish or bearish candles: strength of one-directional momentum
• Spinning tops and dojis: lack of direction, indecision
• Long wicks: opposing orders appeared at those prices

1.3Pin Bars (Hammers and Shooting Stars)

A pin bar is a candle with a small body and a wick on one side that is at least two to three times the body's length. One with a long lower wick is called a hammer; one with a long upper wick is often called a shooting star.

When a pin bar with a long lower wick forms near a low or a support level, it can be read as the market selling off, meeting buyers in that price zone and recovering by the close. As in the diagram, it may be watched as an early sign that a decline is losing momentum.

A pin bar does not guarantee a reversal. One that appears in the middle of a downtrend, away from any support, often turns out to be a brief bounce. A common approach is to look for confirmation in the following candles, for example whether the next candle trades above the pin bar's high.

The same reading applies to an upper-wick pin bar. After an advance, a candle near resistance that leaves a long upper wick shows selling pushing the price back from higher levels and is treated as a sign that the advance is losing momentum.

• A wick of at least two to three times the body is a common rule of thumb
• Check whether it formed at a meaningful place — support or resistance, a recent high or low
• Some traders wait for the next candle to confirm (a break of the pin bar's high or low)

1.4Engulfing Candles (Outside Bars)

An engulfing candle is large enough to cover the previous candle's body (or, in some definitions, its entire range). A large bullish candle that engulfs a prior bearish one is a bullish engulfing pattern; a large bearish candle that engulfs a prior bullish one is a bearish engulfing pattern.

A bullish engulfing candle after a decline shows that, although sellers were in control the day before, buyers overwhelmed them within a single session and erased the previous move. A bearish engulfing candle after an advance is read as buying momentum collapsing at high prices. The diagram shows a bullish engulfing candle at a low and a bearish one at a high.

To judge how much weight an engulfing candle deserves, look at the size of the engulfing candle, whether volume rose, and where it formed — late in a trend or inside a range. Engulfing candles inside a range are often directionless, so judging them in isolation is best avoided.

• Bullish engulfing: after a decline, a long bullish candle covers the prior bearish one
• Bearish engulfing: after an advance, a long bearish candle covers the prior bullish one
• The size of the engulfing candle and a rise in volume help judge its weight

1.5A Modern Reading of the Sakata Five Methods

The Sakata five methods are a way of reading candlestick combinations traditionally attributed to Homma Munehisa, an Edo-period rice trader. They consist of five types: Sanzan (three mountains), Sansen (three rivers), Sanku (three gaps), Sanpei (three soldiers) and Sanpo (three methods).

Sanzan is a top formed by three peaks, almost the same shape as the Western head and shoulders. Sansen is the family of three-candle reversal combinations, with the morning star and evening star as the best-known examples. Sanku is a move with three consecutive gaps and is regarded as a sign of overextension.

Sanpei covers three white soldiers — three bullish candles in a row, each closing higher — and three black crows, its bearish mirror; both are said to mark the start of a trend. Sanpo includes the rising three methods: a long bullish candle, a few small candles that stay within its range, and another long bullish candle that makes a new high, representing a pause within an advance. The diagram shows three white soldiers followed by a rising three methods.

Although these ideas are centuries old, they rest on a lasting classification of price behaviour: continuation, overextension, pause and reversal. Many modern chart patterns map onto them, so they are worth reading alongside the pattern chapter (Chapter 4).

• Sanzan and Sansen: reversal formations at tops and bottoms
• Sanku: overextension shown by consecutive gaps
• Sanpei: the opening move of a trend
• Sanpo: a pause within a trend and its resumption

1.6Wide Candles on Heavy Volume

Candles show how price moved, but only volume shows how much trading stood behind the move. A long bullish candle on two to three times average volume shows that a lot of money moved in one direction and is treated as a possible sign of large buyers.

When a long range is broken to the upside by a wide bullish candle on heavy volume, the move is read as having absorbed the selling that capped prices before. In the diagram, the price breaks above the top of a quiet, low-volume range with a wide candle on a sharp rise in volume. Breakouts without volume, by contrast, often fail to hold (see false breakouts in Chapter 2).

At the end of a long decline, an extreme-volume bearish candle is sometimes called a selling climax and described as a sign that sellers are exhausted. In practice this is usually recognisable only in hindsight and is hard to identify as it happens.

• Judge volume against its own average
• Check whether the candle that breaks a key level comes with volume
• Read a volume spike together with whether the following candles hold the move

1.7Common Misconceptions and Cautions

The most common mistake is to judge what comes next from the shape of one candle. The same pin bar carries different weight on a daily chart and a five-minute chart, and its reading also depends on the trend and on nearby support and resistance. A candle's shape is only one input.

The second is the effect of the timeframe. A long bullish daily candle is a mix of bullish and bearish candles on an hourly chart. Keep track of which timeframe you are reading and check the longer timeframe's direction first (see multi-timeframe analysis in Chapter 8).

Candles right after earnings releases or economic data can be unusually large or carry unusual volume. It helps to separate temporary event-driven moves from moves that reflect a change in supply and demand.

For stocks, the price also drops mechanically on ex-dividend dates and at stock splits, for reasons unrelated to supply and demand. It is worth checking whether a chart is drawn with adjusted prices.