11/12/2024, 00:20 What Is a Candlestick Pattern?

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TRADING TECHNICAL ANALYSIS

What Is a Candlestick Pattern?

Learn about an ancient method of chart analysis
By ALAN FARLEY Updated June 09, 2024

Reviewed by CHARLES POTTERS

Fact checked by YARILET PEREZ

Part of the Series

Guide to Technical Analysis

Candlestick Pattern Explained

Candlestick charts are a technical tool that packs data for multiple time frames
into single price bars. This makes them more useful than traditional open, high,
low, and close (OHLC) bars or simple lines that connect the dots of closing
prices. Candlesticks build patterns that may predict price direction once
completed. Proper color coding adds depth to this colorful technical tool, which
dates back to 18th-century Japanese rice traders. [1]
Candlestick charts
are used by traders

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11/12/2024, 00:20 What Is a Candlestick Pattern?

Traditionally, candlesticks are best used on a daily basis, the idea being that
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each candle captures a full day’s worth of news, data, and price action. This
suggests that candles are more useful to longer-term or swing traders.

Most importantly, each candle tells a story. When looking at a candle, it’s best
viewed as a contest between buyers and sellers. A light candle (green or white
are typical default displays) means the buyers have won the day, while a dark
candle (red or black) means the sellers have dominated. But what happens
between the open and the close, and the battle between buyers and sellers, is
what makes candlesticks so attractive as a charting tool.

KEY TAKEAWAYS
Candlestick patterns are technical trading tools that have been used for
centuries to predict price direction.
There are dozens of different candlestick patterns with intuitive,
descriptive names; most also have a corollary pattern between the
upside and downside. For instance, an “abandoned baby top” has its
corollary in an “abandoned baby bottom;” “tweezer bottoms” have
their upside corollary in “tweezer tops.”
Traders supplement candlestick patterns with additional technical
indicators to refine their trading strategy (e.g., entry, exit).
Candlesticks are based on current and past price movements and are
not future indicators.

Candlestick charts
are used by traders

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Let’s first take a look at the basics of candles so you can understand the various
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parts of a candlestick.

How to Read a Candlestick Pattern

A daily candlestick represents a market’s opening, high, low, and closing (OHLC)
prices. The rectangular real body, or just body, is colored with a dark color (red
or black) for a drop in price and a light color (green or white) for a price
increase. The lines above and below the body are referred to as wicks or tails,
and they represent the day’s maximum high and low. Taken together, the parts
of the candlestick can frequently signal changes in a market’s direction or
highlight significant potential moves that frequently must be confirmed by the
next day’s candle.

Candlestick charts
are used by traders

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Image by Julie Bang © Investopedia 2019

Difference Between Foreign Exchange (FX) Candles and Other

Markets’ Candles
Before we delve into some specific candlestick patterns, here is a small word
about the difference between foreign exchange (FX) candlesticks and
stock/exchange-traded fund (ETF)/futures and all other candlesticks. Because
the FX market operates on a 24-hour basis, the daily close from one day is
usually the open of the next day. As a result, there are fewer gaps in the price
patterns in FX charts. FX candles can only exhibit a gap over a weekend, where
the Friday close is different from the Monday open.

Many candlestick patterns rely on price gaps as an integral part of their

signaling power, and those gaps should be noted in all cases. As for FX candles,
one needs to use a little imagination to spot a potential candlestick signal that
may not exactly meet the traditional candlestick pattern. For example, in the
figure below taken from an FX chart, the bearish engulfing line’s body does not
exactly engulf the previous day’s body, but the upper wick does. With a little
imagination, you’ll be able to spot certain patterns, although they might not be
textbook in their formation.

Candlestick charts
Examples of Candlestick Patterns are used by traders
The examples below include several candlestick patterns that perform
exceptionally well as precursors of price direction and potential reversals. Each
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works within the context of surrounding price bars in predicting higher or lower
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prices. They are also time sensitive [2] in two ways:

They only work within the limitations of the chart being reviewed, whether
intraday, daily, weekly, or monthly.
Their potency decreases rapidly three to five bars after the pattern has been
completed.

Doji and Spinning Top

A doji (plural is also doji) is a candlestick formation where the open and close
are identical, or nearly so. A spinning top is very similar to a doji, but with a very
small body, in which the open and close are nearly identical.

Both patterns suggest indecision in the market, as the buyers and sellers have
effectively fought to a standstill. But these patterns are highly important as an
alert that the indecision will eventually evaporate and a new price direction will
be forthcoming.

Here are some visual examples of doji and spinning tops:

Bullish/Bearish Engulfing Lines

An engulfing line is a strong indicator of a directional change. A bearish
Candlestick charts
engulfing line is a reversal pattern after an uptrend. The key is that the second
are used by traders
candle’s body “engulfs” the prior day’s body in the opposite direction. This
suggests that, in the case of an uptrend, the buyers had a brief attempt higher

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but finished the day well below the close of the prior candle. This suggests that
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the uptrend is stalling and has begun to reverse lower. Also, note the prior two
days’ candles, which showed a double top, or a tweezers top, itself a reversal
pattern.

A bullish engulfing line is the corollary pattern to a bearish engulfing line, and it
appears after a downtrend. Also, a double bottom, or tweezers bottom, is the
corollary formation that suggests a downtrend may be ending and set to
reverse higher.

Hammer
A hammer suggests that a down move is ending (hammering out a bottom).
Note the long lower tail, which indicates that sellers made another attempt
lower, but were rebuffed and the price erased most or all of the losses on the
day. The important interpretation is that this is the first time buyers have
surfaced in strength in the current down move, which is suggestive of a change
in directional sentiment. The pattern is confirmed by a bullish candle the next
day.
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Hanging Man
A hanging man pattern suggests an important potential reversal lower and is
the corollary to the bullish hammer formation. The story behind the candle is
that, for the first time in many days, selling interest has entered the market,
leading to the long tail to the downside. The buyers fought back, and the end
result is a small, dark body at the top of the candle. Confirmation of a short
signal comes with a dark candle on the following day. [3]

Candlestick charts
are used by traders

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Abandoned Baby Top/Bottom

An abandoned baby, also called an island reversal, is a significant pattern
suggesting a major reversal in the prior directional movement. An abandoned
baby top forms after an up move, while an abandoned baby bottom forms after
a downtrend.

The pattern includes a gap in the direction of the current trend, leaving a candle
with a small body (spinning top/or doji) all alone at the top or bottom, just like
an island. Confirmation comes on the next day’s candle, where a gap lower
(abandoned baby top) signals that the prior gap higher was erased and that
selling interest has emerged as the dominant market force. Confirmation comes
with a long, dark candle the next day.

Candlestick charts
are used by traders

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Take Special Note of Long Tails and Small Bodies

Candlesticks that have a small body—a doji, for example—indicate that the
buyers and sellers fought to a draw, leaving the close nearly exactly at the open.
(Such a candlestick could also have a very small body, effectively forming a
spinning top.) Small bodies represent indecision in the marketplace over the
current direction of the market.

This suggests that such small bodies are frequently reversal indicators, as the
directional movement (up or down) may have run out of steam. Careful note of
key indecision candles should be taken, because either the bulls or the bears
will win out eventually. This is a time to sit back and watch the price behavior,
remaining prepared to act once the market shows its hand.

Another key candlestick signal to watch out for are long tails, especially when
they’re combined with small bodies. Long tails represent an unsuccessful effort
of buyers or sellers to push the price in their favored direction, only to fail and
have the price return to near the open. Just such a pattern is the doji shown
below, which signifies an attempt to move higher and lower, only to finish out
with no change. This comes after a move higher, suggesting that the next move
will be lower.

Candlestick charts
are used by traders

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Which Candlestick Pattern Is Most Reliable?

Many patterns are preferred and deemed the most reliable by different traders.
Some of the most popular are: bullish/bearish engulfing lines; bullish/bearish
long-legged doji; and bullish/bearish abandoned baby top and bottom. In the
meantime, many neutral potential reversal signals—e.g., doji and spinning tops
—will appear that should put you on the alert for the next directional move.

Does Candlestick Pattern Analysis Really Work?

Yes, candlestick analysis can be effective if you follow the rules and wait for
confirmation, usually in the next day’s candle. Traders around the world,
especially out of Asia, utilize candlestick analysis as a primary means of
determining overall market direction, not where prices will be in two to four
hours. That’s why daily candles work best instead of shorter-term candlesticks.

How Do You Read a Candle Pattern?

A candle pattern is best read by analyzing whether it’s bullish, bearish, or
neutral (indecision). Watching a candlestick pattern form can be time
consuming and irritating. If you recognize a pattern and receive confirmation,
then you have a basis for taking a trade. Be careful not to see patterns where
there are none. Let the market do its thing, and you will eventually get a high-
probability candlestick signal.

The Bottom Line

Candlestick charts
Candlestick analysis has been around for centuries and works for the same
are used by traders
reason as other forms of technical analysis: because traders follow it.
Candlesticks can be combined with other forms of technical analysis, such as

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momentum indicators, but candles ultimately are a stand-alone form of

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charting analysis.

Daily candlesticks are the most effective way to view a candlestick chart, as
they capture a full day of market info and price action. If you opt to use shorter-
term candles, be cognizant that their meaning lasts only for a few of the periods
that you choose—for example, a four-hour candle pattern is only valid for
around a few four-hour periods.

Candlestick signals come in individual candles (e.g., doji) as well as multi-

candle patterns like bullish/bearish engulfing lines, bullish/bearish abandoned
babies, and bullish hammers/bearish hanging man patterns. Candlesticks are
great forward-looking indicators, but confirmation by subsequent candles is
often essential to identifying a specific pattern and making a trade based on it.
In particular, candlestick patterns frequently give off signals of indecision,
alerting traders of a potential change in direction.

ARTICLE SOURCES

Part of the Series

Guide to Technical Analysis

Key Technical Analysis Concepts

Getting Started with Technical Analysis

Essential Technical Analysis Strategies

Technical Analysis Patterns

1 Introduction to Technical Analysis Price Patterns

2 5 Most Powerful Candlestick Patterns

CURRENT ARTICLE

3 Continuation Pattern
NEXT UP Candlestick charts
are used by traders
4 Trendline

5 Price Channel

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6 Channeling: Charting a Path to Success TRADE

7 Playing the Gap

8 Double Tops and Bottoms

9 Triple Tops and Bottoms

10 Head And Shoulders Pattern

11 How to Trade the Head and Shoulders Pattern

12 Flag

13 Pennant

14 Triangle

15 Wedge

16 Cup and Handle Pattern

17 Trading Fibonacci Retracements

18 Elliott Wave Theory

19 Trader's Guide to Using Fractals

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