By Nilay Guha – Trade with Precision
Candlestick analysis has generated a library of books describing in great detail the names of the different types and patterns and their market significance. Due to their origins in the idiomatic Japanese language, exotic names like dark cloud cover, shooting stars, three white soldiers, spinning tops and high waves have become part of the lexicon of trading.
But a basic and often overlooked point in candlestick analysis is whether or not knowing and memorizing these myriad evocative names really makes anyone a better trader. Our view is that - while knowing all of these various names may make market traders better conversationalists - it has no real impact on how successfully candlestick patterns can be applied to practical trading.
We are not in any way suggesting pattern recognition isn’t important. In fact, we swear by the efficacy and utility of candlesticks for technical analysis. But we believe there is a much simpler way to apply and exploit them to their full potential in our trading than memorizing scores of exotic names. We have distilled the essence of candlesticks to delineate the key traits traders need to know in order to effectively leverage their power and reap the benefits.
In our opinion, there are broadly only three types of candlesticks. These are the only three individual types of candles that a trader needs to be aware of and recognize when they present themselves on the charts. They are bullish, bearish, and indecisive candles. Let us look at each in more detail.
Bullish candles are those where the bulls have clearly had their way in a session, as indicated in the chart above. In the first candle marked ‘A’, the session opened in the bottom quarter of the range and was driven up by the bulls, closing in the top quarter of the range, indicating a clear win by the bulls. The second candle marked ‘B’, also known as a rejection candle, shows an open in the top quarter of the range with prices being dragged down by the bears during the session. However, the market rejected the price level set by the bears, and rallied to close in the top quarter on the range, again a clear win for the bulls. The third candle, marked ‘C’ is similar to the second candle, except for the fact that the open and close were at the same level. Consequently, this candle lacks a real body.Bearish candles are those that denote a win by the bears in a particular session, and are illustrated in the chart above. The logic here is similar to that of the bullish candles but in reverse.
The size and location of a candle’s wicks or shadows are significant and this is seen in the candlesticks annotated as ‘B’ and ‘C’ in both charts above. Thus, as noted above a candle with a long wick to either side is usually called a rejection candle, and denotes the strong rejection of a certain price level by the market. If this long wick is located below the real body, then the candle is bullish. If it is located above the real body then the candle is bearish. It should also be noted that rejection candles are bearish or bullish based on the location of their wicks, irrespective of the color of their real bodies. So a candle with a red body, but with a long wick below, is bullish even though it is technically a bear candle. And conversely, a candle with a long wick above is bearish, even if it is green and theoretically a bull candle as marked in ‘C’ above.
Indecisive candles, are those where neither the bulls nor the bears have had a win, with the session ending in a draw. Here the open and close are both somewhere around the middle of the range, signifying the inability of either the bulls or the bears to dominate the session. From a technical analysis perspective, indecisive candles are still significant because when they manifest themselves they represent market indecision. Therefore, a large bullish move, followed by a series of indecisive candles, represents a potential pause in market momentum before the next move. Conversely a large bearish move followed by a series of indecisive candles represents a potential pause in market momentum. These pauses are key as they can offer lower risk entry into a trade before the next big move is spurned by returning market momentum.
As we have seen, it is not necessary to spend hours memorizing hundreds of candlestick pattern names. Understanding the market dynamics behind the price action denoted by candlesticks and their patterns, is usually more than enough to get a sense of who is controlling the market; the buyers or sellers.