Candlestick patterns in trading and how to trade them

What are candlestick patterns

Candlestick patterns are graphical representations of price movements in financial markets that consist of individual candles on so-called candle charts. The history of candlestick charts is said to date back to 18th century Japan, where candlestick charts were used in commodity markets, mainly rice markets. The basic principles of the operation and use of candlestick charts were developed by Muneshimo Homma, a Japanese trader from the city of Sakata. It was not until the 20th century that candlestick charts were introduced to the world from Japan. Today, candlesticks are among the most widely used method of graphically depicting price charts in the financial markets.
 

Description of individual parts of the candle

The main advantage of a candlestick chart is the amount of information it can convey to traders at a glance. Each candle consists of a body and a wick and 4 prices (opening, closing, maximum and minimum). In addition, we can tell by the colour of the candle body whether the price was falling (red - bearish) or rising (green - bullish) during the time period we set.


 

Why are candlestick patterns important for trading?

Analyzing candlestick patterns is part of technical analysis - one of the most popular and widely used approaches in online trading. Based on the analysis of historical market data, it allows traders to gain a certain statistical advantage in determining the future price development of the asset they are trading. Simply put, if a candlestick pattern known as bullish engulfing appears on a chart, for example, a trader knows that there is a definite chance that the market will go up.

Thus, candlestick patterns are an indispensable tool when trading in any type of market and traders should be familiar with them. In this article, we will therefore introduce the most important of the candlestick patterns. We will show you the basic types of bullish (rising) candlestick patterns, bearish (falling) candlestick patterns and we will also show you the so-called continuous candlestick patterns, which signal the continuation of the market in the same direction. Of course, we will also teach you how to recognize all these on a chart.

Bullish and bearish candlestick patterns

Just as we divide the market into bullish (rising) and bearish (falling), we also divide the patterns on candlestick charts. Correct and timely identification of these candle patterns serves as one indication for traders to estimate the likely direction of the market. We deliberately choose words like "indication" and "likely" here because markets are erratic and their development can never be determined with 100% accuracy.

Thus, the candlestick patterns that we will show here should only serve as one of the indicators for you when trading using technical analysis. However, it is always better to back up your judgments with other analytical tools such as indicators. Purple indicators, which we have developed precisely to estimate the potential future direction of the market, may be a suitable choice.

Basic bullish candlestick patterns

These bullish candlestick patterns are often sought out by traders as indicators of possible future uptrends or reversals in the market.

Hammer

Candlestick pattern consisting of one candle. It has a small body and a long lower shadow, so it really resembles a hammer in shape. This pattern suggests that the bears may be losing strength and the bulls are beginning to take control. However, you should wait for the next candle to be drawn before acting on it.

Bullish engulfing

This is a candlestick pattern consisting of two candles. Typical for a bullish engulfing pattern is that the second candle in the sequence completely "engulfs" the body of the first candle. This candlestick formation indicates a potential market reversal to an upward movement.

Morning star

This bullish candlestick pattern consists of three candles. It starts with a long bearish candle, followed by a small candle with an opening price close to the closing price of the first candle and finally comes a long bullish candle. The Morning Star formation indicates to us a possible reversal from a downtrend to an uptrend.

Bullish Harami

This pattern consists of two candles. It starts with a long bearish candle followed by a small bullish candle which is completely inside the body of the first candle. The Bullish Harami indicates a possible reversal to the upside and is considered a signal that the bearish pressure is losing strength.

Basic bear candlestick patterns

Now that you have an idea of what the bullish versions of candlestick patterns look like in theory, let's show them together with the bearish ones on real charts from the market.

Candlestick pattern signaling market indecision

Doji candlestick pattern

Like the hammer pattern, the doji candlestick pattern is also made up of only one candle. In this case, however, it resembles a “+” sign rather than a candle. This is because the classic doji has the same closing and opening price and the same long lower and upper shadow. A doji pattern means indecision in the market, buyers and sellers are equally strong and so it is not clear which way the price will move next.
 

The Doji candlestick pattern appears in several forms on the markets

_{Different variations on the doji pattern on the STOXX50 index chart (CH - classic doji; I - long-legged doji; J - dragonfly doji; K - gravestone doji; L - 4 price doji)}

Continuous candlestick patterns

We will now show two candlestick patterns that do not signal a reversal in the trend, but rather its continuation. Traders can use continuous candlestick patterns to confirm that the market is possibly going to be continuing in a given direction.

Three white soldies

This pattern consists of three long bullish candles. They follow each other and close near their highs. These candles have little or no shadows. If you find a three white soldier candlestick pattern in the chart, it means that the bulls have taken control of the market and it is very likely that the market will continue to rise.

Three black crows

The opposite of the three white soldiers. If you see three black crows sitting on a downtrend, believe that there is a high probability that the trend will continue to decline. The formation is made up of three bearish candles that are characterized by a long body and little or no shadows. Thus, the candles are closing near their lows. This pattern clearly signals the predominance of sellers and trading against it is very risky.

Risks of candlestick patterns

Candlestick patterns must be understood in a broader context. Sometimes the formations are not exact as described by the theory, they may vary a little. Another problem is that they can give a false signal.

_{Candlestick patterns on the USDCAD currency pair}

In Figure 11 we have a daily chart with the USDCAD currency pair. In the area marked with the letter A there is a chart that could be described as a morning star. However, unlike our pattern above, in this apparent morning star, the second candle did not form a gap at the open, nor did it form the lowest point of the formation. The formation is therefore not entirely accurate. Still, there has been a trend reversal as this bullish pattern often suggests.

In area B, on the other hand, we have the equivalent of an evening star. The formation in our case is even stronger because the second candle of the pattern has a long upper shadow, so we can consider this candle as a pin bar that signals the rejection of higher prices. Therefore, we might have thought that there would be a trend reversal, but instead the market continued on its strong uptrend.

In area C we have a clear three black crows candlestick pattern. The disadvantage of this formation is that with such a strong move, the price has travelled a long distance and there is a risk that the market will stall or reverse soon. This makes it clear that candlestick patterns need to be understood in a broader context and we need to look for so-called confluences with other methods of technical analysis that will increase their accuracy.