A newbies guide to understanding Candlestick charts

Candlestick charts is a form of chart type that was first developed by the Japanese rice traders with the credit going to a particularly successful rice trader by the name Homma (or Homna) from the Japanese town of Sakata. It is said that Homna built a fortune for himself trading rice futures by using the Candlestick charts. The candlestick charts represent price movements of an instrument with each bar representing price movement over a given period of time. Candlestick charts are plotted on an X and Y axis representing Time and Price respectively.

Candlestick charting was made popular in the West by Steve Nison with the first Candlestick chart having to appear sometime around 1850’s. Today, Candlestick charts have become the defacto chart type across all markets; be it forex or futures or equities.

Comparing Candlestick Charts with other Chart Types

In the following image below, we plot the Candlestick Chart against the other chart types, Bar Chart and Line Chart.

The biggest difference we notice with Candlestick charts is that besides being visually appealing, Candlestick chart tends to reflect the market sentiment much more visually. We do notice though that Candlestick charts do plot price very similar to that of Bar chart.

Candlestick Chart Comparison with Bar & Line Chart
Candlestick Chart Comparison with Bar & Line Chart

Constructing Candlestick Charts

Although all trading and charting platforms these days have the Candlestick charts, it is of value for the trader to understand what the chart represents.

Firstly, Candlestick chart plots the Open, High, Low and Close of a price during a period of time. It is represented by a wick and a body, where the upper and lower ends of the wick shows the high and low while the body displays the open and close. Candlestick charts are colorful and are represented as Green/White for Bullish (price closing higher than its open) or Red/Black for Bearish (price closing lower than its open).

The chart below represents a typical Candlestick chart.

Candlestick Chart - Example
Candlestick Chart – Example

Understanding Sentiment with Candlesticks

Candlesticks by themselves can be used to trade without the aide of any indicators. This is because Candlesticks truly represent the underlying sentiment in the markets. For example, when a Candlestick closes higher than its opening price with little to no upper or lower wicks, it implies a very bullish sentiment. In other words, at that particular point in time, traders were very bullish about a security.

It is due to these sentiments that Candlestick charts were further looked under a microscope to extrapolate certain candlestick patterns with various sentiments. Traders might have come across Candlestick terms such as Doji, Maribozu, Piercing Line and so on. These fancy terms are nothing but a reflection of the sentiment. Therefore, traders use these specific candlestick patterns that occur time and again on the charts and use them as a trading signal.

The chart below depicts how traders use the Candlestick’s formation on reading the market sentiment.

Market Sentiment with Candlestick Charts
Market Sentiment with Candlestick Charts

Pros and Cons of Candlestick Charts

While Candlestick charts are widely used, this charting type does have its own share of pros and cons.

Advantages

  • Visually appealing and makes it easy for the trader to understand market sentiment
  • Works across any time frame and in any markets provided there is enough liquidity
  • Tried and tested candlestick patterns, based on the critical price levels where they form can be used as trading signals by themselves
  • Candlestick trading in itself is an art boasting of a large followers who tend to trade purely based off Candlesticks
  • Candlestick charts are widely used and thus every trading and charting platform provides candlestick charting by default

Disadvantages

  • Depending on the Timezone the candlesticks might vary in shapes and sentiment. A common problem can be seen by comparing candlesticks with GMT close and with a GMT+3 close
  • Can get confusing and can easily overwhelm the trader when comparing candlesticks from one time frame to another
  • There is no guarantee that a pattern once identified is set in stone. Many a times a bearish candlestick pattern such as engulfing candles are often followed by a completely opposite price direction
  • Unreadable in markets where there is little liquidity