Candlestick analysis involves the study of charts, on which shapes resembling candlesticks have been plotted. Information can be obtained by examining the length of the candlestick, its proportions, its color, and its relationship to the candlesticks preceding and following. Even at a glance, candlestick charts provide more information than most other forms of charts, and candlestick analysis has become an essential part of technical analysis.
Where Did Candlestick Analysis Originate?
Credit for the development of candlestick charting is given to the Japanese, stemming from their early application of technical analysis to rice trading in the 1700s. Although Japanese rice trader and author, Munehisa Homma was certainly influential in the study and development of market analysis, there is some question as to whether he was indeed the originator of the candlestick chart, as is commonly attributed.
The author, Steve Nison, who introduced candlesticks to the Western world with his 1991 book, Japanese Candlestick Charting Techniques, believes it is unlikely that Homma actually used candlestick charts. While the basis of these techniques undoubtedly owes much to the work of Homma, Nison suggests that the concrete system of candlestick charting that we use today was probably developed in Japan in the late 1800s.
How Are Candlesticks Plotted?
These shapes comprise four points of price data, which are the opening, closing, high and low prices for the period. The opening and closing prices are shown by a rectangular shape which is called the ‘real body’ of the candlestick. The high and low prices are depicted by a vertical line extending from the top and bottom of the real body. These are called the upper and lower shadow.
Colors are used to illustrate whether the price moved upward or downward during the period. When the real body is white (or alternatively, green), the price closed higher than it opened. A black (or red) real body shows a price that closed lower than it opened.
What Can be Understood from Candlestick Analysis?
Length and color of the real body is one of the first aspects studied in candlestick analysis. One of the most basic points of information which can be obtained from candlestick charts is in the relationship between the opening and closing prices. A long white or green candlestick (sometimes referred to as a hollow candlestick), indicating a higher closing price, signals that there is stronger buying pressure (see picture below). The opposite applies with a long black or red (filled) candlestick, which, due to the lower closing price, indicates greater selling pressure. The length of the candlestick represents the strength of this buying or selling pressure, with a short candlestick depicting minimal price movement and a time of consolidation.
A long candlestick signals whether the general outlook of market players is bearish or bullish. When a hollow candlestick is long compared to surrounding candlesticks, it suggests a bullish sentiment. A filled candlestick which is noticeably longer than others nearby often signals bearish intent.
The length of the shadows also provides significant insight into market activity. A candlestick with no shadow means that the high and low are represented by the open and close for the period. A white or green shadow-less candlestick (known as a Bullish Marubozu) indicates that buyers dominated the price movement from open to close. A black or red Bearish Marubozu shows that sellers were the leading force in price action from beginning to end of the period (see picture above).
Short shadows indicate that the price action didn’t move too far outside the opening and closing prices. This suggests that there was not a large amount of pressure from either buyers or sellers to move the price dramatically against the status quo.
When the shadows are long, this indicates that there was strong action in the direction of the shadow, to drive the prices either up or down, but that this action was counteracted by the close of the period (see picture on right).
Patterns formed on candlestick charts may provide indication of either continuation of a prevailing trend, or an imminent reversal.
Candlestick analysis is a key component of technical analysis, and candlestick charts can provide a great deal of insight into price movement of stocks. Taking time to study these charts and understand what they represent is a worthwhile endeavor for traders seeking to benefit by anticipating the likely changes that market prices will experience.