How to Read Candlestick Charts: A Guide for Beginners

Seasoned traders have a secret language to interpret market moves. The code is the candlestick charts. The charts translate complex stock price movements into simple visual patterns, and help you gauge market sentiment. Let us decode this essential visual tool to help you navigate the stock market confidently.

What is a Candlestick Chart?

Candlestick patterns are widely used in technical analysis to unriddle market sentiment and potential price movements. A candlestick chart is a financial graph representing price action over a specific timeframe, whether a 5-minute intraday interval, a daily swing chart, or a monthly long-term view.

Developed centuries ago by Japanese rice merchants, candlestick charting remains a staple for modern technical analysis. Unlike simple line charts that plot only closing prices, candlesticks provide a comprehensive picture of price action by packing four distinct price points into a single shape.

Traders use these shapes to assess price movements and the relative influence of buyers (bulls) or sellers (bears) during a given period.

Components of a Candlestick: Body and Wicks

Every candlestick has two primary elements — the body and the wicks (or shadows). These components interact differently under different circumstances. Its knowledge is the foundational step in reading stock market charts.

The Real Body: The thick, coloured rectangular section of the candle. It shows the absolute difference between the opening and closing prices of that session. If the closing price finishes above the opening price, the body is displayed in green (or white), indicating an increase in price. If the closing price settles below the opening price, the body turns red (or black), indicating a decrease in price.

The Wicks (Shadows): The thin vertical lines projecting above and below the body. These represent the extreme price peaks and troughs reached during that specific period.

How to Read OHLC Data

The acronym OHLC stands for Open, High, Low, and Close. This is the core raw dataset driving every candlestick.

In a green (bullish) candle, the open sits at the base of the real body and the close sits at the top. This indicates that the closing price was higher than the opening price during the session.

In a red (bearish) candle, the open sits at the top of the body and the close sits at the bottom, indicating that the closing price was lower than the opening price.

The upper and lower wicks mark the extreme session high and low, regardless of candle colour.

By observing the size of the candle body relative to its wicks, you can assess price movement and market activity. A long body with short wicks can indicate a relatively strong directional price move, whereas a tiny body with long wicks can indicate greater indecision between buyers and sellers.

Top Bullish Candlestick Patterns

Bullish patterns typically appear after a downtrend or correction, and may indicate a potential shift in price direction.

• Hammer: A single-candle pattern featuring a small real body near the top of its range and an elongated lower wick that is generally at least twice the length of the body, with little to no upper wick. It can indicate that prices moved lower during the session but recovered before the close.

• Bullish Engulfing: A two-candle pattern where a modest red candle is followed by a large green candle whose body engulfs the previous body. This visual shift can indicate a change in buying and selling pressure.

• Morning Star: A three-candle formation starting with a strong red candle, followed by a small-bodied candle that indicates a pause or loss of downward momentum, and concluded by a decisive green candle that closes well into the first candle's body. It can indicate a potential bullish reversal.

• Three White Soldiers: A three-candle bullish pattern featuring consecutive long-bodied green candles, each opening within the previous candle's body and closing near its session high. This sequence can indicate sustained buying pressure.

Top Bearish Candlestick Patterns

Bearish patterns typically emerge near the top of an advancing trend, and may indicate weakening buying pressure or a potential change in price direction.

• Shooting Star: The visual inverse of a hammer. It has a small body positioned at the lower end of the range and an upper wick that is generally at least twice the length of the body. It can indicate that prices moved higher during the session but retreated before the close.

• Bearish Engulfing: A two-candle reversal where an initial green candle is fully enveloped by a subsequent larger red candle. This can indicate a shift towards selling pressure.

• Evening Star: The bearish counterpart to the morning star. It consists of a tall green candle, a small-bodied hesitation candle at the top, and a deep red candle closing below the midpoint of the first candle, which can indicate a potential bearish reversal.

• Dark Cloud Cover: A dual-candle bearish pattern where a strong green candle is followed by a red candle that opens above the previous candle's close but closes below the 50% midpoint of the green candle's body, indicating increased selling pressure.

Which Candlestick Patterns Suggest a Trend Reversal?

Reversal candlestick patterns can signal a potential shift in the prevailing market trend. Common patterns include:

1. Doji

A Doji forms when opening and closing prices are virtually identical, reflecting market indecision. Variants include the Dragonfly Doji, Gravestone Doji and Long-Legged Doji, each characterised by different shadow formations.

2. Harami Patterns

A Harami is a two-candle pattern in which a smaller candle is contained within the body of the preceding larger candle.

• Bullish Harami: Appears during a downtrend and may indicate weakening selling momentum.
• Bearish Harami: Appears during an uptrend and may indicate weakening buying momentum.

3. Engulfing Formations

Bullish and bearish engulfing patterns consist of two candles, with the second candle's body engulfing the first. They can indicate a change in market sentiment.

4. Hammer and Shooting Star

A Hammer has a long lower shadow and can appear after a decline, while a Shooting Star has a long upper shadow and can appear after an advance. Their interpretation depends on the surrounding market context.

5. Morning Star and Evening Star

These are three-candle patterns that can indicate a potential reversal after a downtrend or uptrend, respectively.

How to Use Candlestick Patterns in Your Trading Strategy

Candlestick patterns should be considered alongside broader market context and other technical indicators.

1. Identify Market Context and Trend

Consider the prevailing trend and timeframe before interpreting a reversal pattern.

2. Seek Technical Confluence

Support and resistance, momentum indicators and trading volume can provide additional context.

3. Wait for Confirmation

A subsequent candle can provide confirmation before a pattern is interpreted as a reversal signal.

4. Backtest Against Historical Data

Historical data can be used to assess how specific candlestick patterns have behaved across different market conditions.

5. Enforce Risk Management

Stop-loss levels and position sizing can be used to manage the risks associated with trading based on technical patterns.

FAQs

What is a candlestick chart?

A candlestick chart is a visual representation of price movements over a specific period. Each candlestick shows the open, high, low and close (OHLC) prices.

How do you read a candlestick chart?

A candlestick’s body shows the difference between its opening and closing prices, while the upper and lower wicks show the period’s high and low prices. The candle’s colour indicates whether the closing price was higher or lower than the opening price.

What is OHLC in candlestick charts?

OHLC stands for Open, High, Low and Close. These four price points form the core data represented by a candlestick.

What does a green candle mean?

A green candle generally means that the closing price was higher than the opening price during the specified period.

What does a red candle mean?

A red candle generally means that the closing price was lower than the opening price during the specified period.

Which candlestick patterns are bullish and bearish?

Common bullish patterns include the Hammer, Bullish Engulfing, Morning Star and Three White Soldiers. Common bearish patterns include the Shooting Star, Bearish Engulfing, Evening Star and Dark Cloud Cover.