3 Candlestick Patterns Every Trader Should Know

Today’s investors and traders are bombarded with information.  In the past it was always a question of not enough information to make smart investing decisions.  Today, it is a question of how to filter the onslaught of data made possible by the internet.

info overload

Every investor has their own method of filtering the data.  Whether its using basic fundamental information only, technical price tools, or a combination of both.  Each of these methods is simply a way to filter the massive amount of information to help make profitable decisions.

There is a popular subset of technical analysis that investors and traders use to filter price data.

bear bull candle

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This subset is called candlestick charting.

Although candlestick charting is often the default charting tool in many trading platforms, active traders and even long-term investors often avoid learning how to properly use it.

The reason for this is the fact that candlesticks can seem confusing to the uninitiated.  Not to mention the dozens of strange sounding terms like doji, hanging man, and spinning tops, just to name a few.

Truth is, candlesticks are really simple.  In fact, we have distilled the art of candlestick charting down to just three candlesticks that you need to know.

These things are the Doji, the Hammer, and the Marubuzo.

These 3 candlesticks are all an investor needs to know to use candlesticks to make smart decisions.

First, let’s take a broader look at candlesticks.

Candlestick analysis has quickly gone from being an obscure, seldom used method of technical analysis to being one of the most popular ways to interpret stock charts in a very short period of time.

A trader by the name of Steve Nison  is credited with popularizing the once underground secrets of Japanese candlestick charting techniques.

steve nison book

Candlestick analysis provides the trader a much deeper look into price movement on stock charts than simple bar based stock charts.  In addition, candlestick based stock charts are much easier on the eyes and able to be quickly interpreted visually.

This quick interpretation makes physically screening for stocks to trade, by scrolling through charts, a much easier endeavor than the regular bar charts.

How to Use Candlesticks

The simplest way to use candlesticks is to determine buying or selling pressure during a particular candlestick formation.

A long white candlestick is signaling strong buying pressure during that time period.  While a long black candlestick is a sign of strong selling pressure.

Remember, long or short candlesticks are not exactly defined.  They are relative to the surrounding candlesticks of the same time frame.

Long white candlesticks appearing after downtrends can be a signal that the trend has reversed and it’s time to enter long positions.

At the same time, a long black candlestick appearing after an extended uptrend often signals that the upward trend has exhausted itself and its time to short the stock.

Short white candlesticks indicate bullish consolidation, while short black candlesticks generally signal bearish consolidation pressure on the shares.

The Only 3 Candlesticks You Need To Know:

  1. The Doji

The Doji is the most powerful candlestick of all.  Doji’s signal the change of trend.  Traditionally, Doji’s mean indecision in the market.  However, a careful study will reveal that when a doji appears during a trend, it often signals that the trend is about to change.

The Doji is a candlestick that consists of a very small white or black body and a shadow from the top and bottom.  It can also be just two shadows making the form of a cross without any discernible body. They are very easy to identify, unlike some other chart patterns.

doji

A doji forms when the open and close of the time period is equal.  They signal a time of indecision between buyers and sellers.

When Doji’s appear it often means the end of the trend.  This is true for both up trends and down trends.

Dojis are very powerful signals, particularly on the longer time frames such as daily.  They need to be respected and acted upon by traders

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  1. Marubozu Candlesticks

These candlesticks do not have upper or lower shadow lines.  A white Marubozu is a clear signal that the buyers are in control of the market during the time frame represented by the candlestick.

A black Marubozu candlestick is a clear signal that sellers are in control of the price action during the time frame.

marubuzo

Black or white Marubozu do not have the traditional upper or lower shadows and the high and low are represented by the open or close.

A White Marubozu develops when the open equals the low and the close equals the high.

The formation signals that bulls controlled the price action from the first trade to the last trade.

Black Marubozu develop when the open matches the high and the close equals the low.

This reveals that bears controlled the price action from the first trade to the last trade.

 

  1. The Hammer and Hanging Man

Like a Doji in a downtrend, the Hammer is a bullish reversal pattern that forms after a decline.

In addition to a potential trend reversal, hammers often signal bottoms or support levels.

After the stock or market has fallen, hammers signal a bullish reversal.

The low of the long lower shadow indicates sellers pushed prices lower during the session, right into the hands of bargain-hungry buyers.

hammer

Like most candlestick patterns, hammers demand bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. Such confirmation could come from a gap up or long white candlestick. Hammers are similar to selling climaxes, and heavy volume can serve to reinforce the validity of the reversal.

It is critical to note that even the best candlesticks do not tell you everything.

Stockcharts.com explains what candlesticks do not tell you this way. With a long white candlestick, the assumption is that prices advanced most of the session. However, based on the high/low sequence, the session could have been more volatile. The example above depicts two possible high/low sequences that would form the same candlestick. The first sequence shows two small moves and one large move: a small decline off the open to form the low, a sharp advance to form the high, and a small decline to form the close. The second sequence shows three rather sharp moves: a sharp advance off the open to form the high, a sharp decline to form the low, and a sharp advance to form the close. The first sequence portrays strong, sustained buying pressure, and would be considered more bullish. The second sequence reflects more volatility and some selling pressure. These are just two examples, and there are hundreds of potential combinations that could result in the same candlestick. Candlesticks still offer valuable information on the relative positions of the open, high, low and close. However, the trading activity that forms a particular candlestick can vary.

The true strength of candlesticks

When you take candlesticks out of the realm of theory and into practice, the most critical thing to remember is to use them as part of a complete analysis.  Do not use candlesticks as a standalone tool for making investing decisions.  The true strength of candlesticks is as a confirmation tool for both technical and fundamental analysis.