Let me let you in on a secret. There is a key to long-term investing success. It is nothing complicated and is actually quite simple. In fact, it is so simple that many investors disregard or ignore it entirely
The key is to be able to consistently determine the trend of the stock and when that trend may change.
In other words, knowing what direction the stock is moving in and when that direction will likely change is all you need to know to be a successful investor!
I know this simple secret sounds very easy and some of you may be scoffing at my proclamation.
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The truth is that most investors have difficulty in determining trend, and when it will likely change.
There are tons of indicators and tools designed for this purpose, but most have no better accuracy than a coin flip.
While no tool or indicator is perfect at determining trend and when it will likely change, candlestick charting is a highly accurate technique.
This article will feature 4 of the primary candlestick patterns that every investor needs to know to clarify stock market trends.
First, lets look at some history. Candlestick charting was first credited to the Japanese rice traders nearly 200 years ago. A writer named Steve Nison first brought candlestick charting to the Western investor via his book. Japanese Candlestick Charting Techniques.
Candlestick analysis provides the trader a much easier and more accurate way to determine trend and when that trend may change than traditional bar charts.
Despite the ease of use, many investors avoid candlesticks since they believe they are simply too complicated. The Asian sounding names of the patterns and like doji, hanging man, and spinning tops
Truth is, candlesticks are really simple. In fact, we have distilled the art of candlestick charting down to just four candlesticks that you need to know.
These critical candlesticks are the Doji, the Hammer, Marubuzo, and Heiken Ashi
These 4 candlesticks will clarify trend and when that trend is about to change.
First, let’s take a look at the basics.
Candlesticks are either black/red or white/green. I will be using white and black only in this article. Please keep in mind that depending on the settings in your charting platform, a black candle can also be red and a white candle can also be green.
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 a signal to get long or close your short position.
While, a long black candlestick showing up 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 often signal bearish consolidation pressure on the shares.
The Only 4 Candlesticks You Need To Know:
- The Doji
The Doji is by far my favorite candlestick. Doji’s signal the change of trend. Whenever a Doji appears it is likely that the price trend is about to change.
Per the book, Doji’s signal indecision in price. In other words, price does not know whether to continue to trend or reverse during that time frame. This price indecision is what provides investors the edge when entering trades
The Doji consists of a very small white or black body and a shadow or wick from the top and bottom. It can also be just two shadows making the form of a cross without any discernible body. Doji’s are easy to identify and extremely powerful.
A doji results from the open and close of the time period is equal. They signal a time of indecision between buyers and sellers.
When Doji’s appear on the chart, it signals the end of the trend. This is true for both up trends and down trends.
Investors need to respect Doji’s particularly on longer time frame charts.
- Marubozu Candlesticks
These candlesticks do not have upper or lower shadow lines. A white Marubozu is a clear signal that price is or soon to enter an uptrend during the time frame represented by the candlestick.
A black Marubozu candlestick is a clear signal that price is about to or is in the process of downtrending.
In Marubozu’s and all candlestick patterns, the relative interpretation is critical. What I mean is that candlesticks can only be properly used in relation to other candlesticks on the same chart.
- The Hammer
The Hammer candlestick is a bullish reversal pattern that forms after a decline.
It is also used by investors to signal potential bottoms or support levels. It is best used as a confirmation tool for other market observations.
After the stock or market has fallen, hammers signal a bullish reversal.
The low of the long lower shadow suggests that sellers forced prices lower during the session.
However, the strong finish indicates that buyers regained control to finish the timeframe represented by the candle in a bullish fashion.
Technically, the low of the hammer candle reveals that there remains much bearish sentiment.
However, other market observations should be taken into account prior to entering a trade based on this candlestick pattern. Such confirmation can include 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.
- Heikin Ashi
This is among the rarest candlestick technique of all.
Heikin Ashi candlesticks make trends simple to identify since they average each move. Just the name in Japanese makes this very clear., Heikin Ashi means “average bar”.
Some technical analysis charting software has Heikin Ashi candle stick charting capacity as a standard feature. Others have it available as a modular add on feature. Regardless, it’s smart to understand how the Heikin Ashi candles are constructed. Here’s how:
xClose = (Open+High+Low+Close)/4
o Average price of the current bar
xOpen = [xOpen(Previous Bar) + Close(Previous Bar)]/2
o Midpoint of the previous bar
xHigh = Max(High, xOpen, xClose)
o Highest value in the set
xLow = Min(Low, xOpen, xClose)
o Lowest value in the set
The Heikin-Ashi candlestick is the same as a normal candlestick but with the add on of the new values above. The time sequence is defined by the user–depending on the type of trading being pursued (daily, hourly, long term). The down periods are represented by colored bars, while the up days are represented by open bars.
Finally To Wrap Things Up
Now that we have a basic understanding of candlesticks and the 4 that you must know, let’s recap the critical point.
Most importantly is the fact that these candlestick patterns must be observed relatively. For example, long and short are defined by the surrounding candles on the same chart. There is no fixed length that is long or that is considered short.
In addition, the longer the time frame, the more accurate candlesticks are. Daily candles are more accurate than hour candles and hour candles possess greater accuracy than 5 minute candles.
Finally, never use any technical indicator, including candlesticks, as a standalone tool. Despite how accurate indicators appear, they are alway most effectively used as a confirmation tool to fundamental and other observations.