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Lesson 3: Candlestick Chart Patterns

Lesson 3: Candlestick Chart Patterns

Japanese candlestick charts are the most popular method to quickly analyse price action, particularly with technical traders.

To understand a book, you need to be able to read the words. To understand sheet music, you need to be able to read the notes. To understand price behavior, you need to be able to read and interpret the charts.

So, let’s get to one of the cornerstones of technical analysis, which is reading a candlestick chart and spotting reversal candle chart patterns.

What is a Japanese Candlestick

A Japanese candlestick is a type of price chart that shows the opening, closing, high, and low price points for each given period. Although price charts come in different styles, Japanese candles have become by far the most popular because they provide the quickest visual grasp of price action and the market sentiment behind it.

It was invented by Japanese rice merchants centuries ago and become the dominant charting style since they were first introduced to the West by analyst Steve Nison in 1989.

Japanese candlesticks are a vast topic. However, our goal here is to introduce you to the most important among them and how to use candlestick patterns to spot high-probability trade setups.

How to read a Japanese candlestick chart

To read Japanese candlestick charts and patterns, you'll need to familiarise yourself with three elements on each candle: its color, its body, and its wick. Its color tells you the direction of movement within the period, its body displays the market's opening and closing levels and its wick shows the high/low range.

Let us study the parts of each candlestick, shown in the figure below.

  • On most charts today, green candlesticks indicate upward movement, and red ones move down. However, occasionally white (up) and black (down) is used instead
  • On a green candle, the top of the body is "the close" and the bottom is "the open". On a red one, the opposite is true
  • On both candles, the top of the wick (sometimes called the shadow) is the highest point that the market has hit within the period – and the bottom is the lowest

The length of the bodies and the wicks, in absolute terms and relative to each other, can tell us a great deal about market sentiment over the duration of a given candlestick. That can be significant for candles covering longer periods like an entire day, week, or month. As with any technical indicator, candles and their patterns over shorter durations are less meaningful because price movements within a given day or less often can be caused by random money flows unrelated to any real market sentiment.

Here’s the key to understanding the relationship between wick (or shadow) and body length and the meaning of an individual candle:

  • The longer the wicks are relative to the body, the greater the indecision and the greater the back-and-forth struggle between buyers and sellers, and the more likely the current trend will cease or reverse.
  • The shorter the wicks are relative to the body, the more decisive the move up or down, and the more likely that the move will continue in the same direction.
  • A long higher close body with few or no shadows shows buyers outnumbered sellers and were in control during the entire period covered by the candle, steadily pushing price higher. The longer the candle body, the greater the buying strength.
  • A long lower close body with few or no shadows shows that sellers outnumbered sellers and were in control during the entire period covered by the candle, steadily pushing prices lower. The longer the candle body, the greater the selling strength.
  • A small body relative to the wicks suggests the same indecisiveness to a lesser degree. If the body is red, the sellers were modestly stronger; if green, the opposite is true.

Lower Wicks

A relatively long lower wick suggests initial strong pessimism and selling which reversed as buying increased at the lower bargain price, and short-sellers took profits. In other words, a lower price level was tested and held firm, turning back attempts to drive the price lower.

A short lower wick suggests less indecision, less testing of lower prices, and lighter selling pressure that required few buyers to reverse it. If the currency pair closes at its low for the period covered, the candle won’t have a lower wick.

Upper Wicks

A relatively long upper wick suggests initial optimism or buying pressure that reversed as sellers stepped in and buyers took profits. In other words, a higher price level was tested and held firm, turning back attempts to drive price higher.

A short upper wick shows less indecision, less testing of higher prices, less struggle between buyers and sellers. If the closing price is "the high" for the period covered, the candle won’t have an upper wick.

Types of Japanese Candlestick Patterns

Japanese candle charts mostly indicate reversal or indecision (i.e., possible reversal), whereas Western charting patterns like a double top, double bottom, head and shoulders, cup and handle, triangles and many other tend to indicate continuation (trend pausing before resuming) or reversal.

Japanese candlestick chart patterns are classified as bullish, bearish, or neutral.

  • Bullish reversal Japanese candlestick patterns. Bullish patterns may form after a market downtrend and signal a reversal of price movement. They are a chart pattern indicator for traders to consider opening a long position to seek profit from any upward trajectory.
  • Bearish reversal Japanese candlestick patterns. Bearish candlestick patterns usually form after an uptrend and signal a point of resistance. Heavy pessimism about the market price often causes traders to close their long positions and open a short position to take advantage of the falling price.
  • Continuation Japanese candlestick patterns. If a candlestick pattern does not indicate a change in market direction, it is what is known as a continuation pattern. These can help traders to identify a period of rest in the market when there is market indecision or neutral price movement.

For all of these patterns, you can take a position with CFDs (contracts for difference). This is because CFDs enable you to go short as well as long – meaning you can speculate on markets falling as well as rising. You may wish to go "short" during a bearish reversal or continuation, or "long" during a bullish reversal or continuation – whether you do so depends on the pattern and the market analysis that you have carried out.

Follow the steps below to trade chart patterns:

  • Learn the principles of technical trading at CAPEX Academy
  • Sign up for a live account and trade thousands of shares, indices, ETFs, currency pairs, cryptos, and more
  • Identify chart patterns using our comprehensive charting tools
  • Open your position

Not ready to trade with real capital? Open a CAPEX demo to trial your chart pattern strategy with $50,000 in virtual funds.

Single Japanese Candlestick Patterns

These are some of the simplest patterns you can find, comprising just one trading period. Often, they form the building blocks of longer patterns.

Spinning Top

Japanese Candlestick Patterns - Spinning Top

The spinning top candlestick pattern has a short body centered between wicks of equal length. The pattern indicates indecision in the market, resulting in no meaningful change in price: the bulls sent the price higher, while the bears pushed it low again. Spinning tops are often interpreted as a period of consolidation, or rest, following a significant uptrend or downtrend.

On its own the spinning top is neutral, but it can be interpreted as a sign of things to come as it signifies that the current market pressure is losing control.

Doji

Japanese Candlestick Patterns - Doji

When a market’s open and close are at the same price point, the candlestick resembles a cross or plus sign – traders should look out for a short to the non-existent body, with wicks of varying length.

There are four main types of Doji candles to watch out for:

  • Long-legged Doji has a lengthy wick both above and below the body
  • Gravestone Doji has a high wick above the body and nothing underneath
  • Dragonfly Doji has a long wick beneath the body and little to no wick above it
  • Four-price Doji has no wick at all

This Doji’s pattern conveys a struggle between buyers and sellers that results in no net gain for either side. Alone a Doji is a neutral signal, but it can be found in reversal patterns such as the bullish morning star and bearish evening star.

Thus, they’re more meaningful when finding after a long move up or down because they suggest the move may end and reverse.

Marubozu
Japanese Candlestick Patterns - Marabozu

Marubozu comes from the Japanese word for ‘bald’. It means a candlestick that has no wick whatsoever.

  • A green Marubozu opened and closed at its lowest and highest levels respectively, indicating a clear bullish sentiment
  • A red Marubozu opened and closed at its highest and lowest levels respectively, indicating a clear bearish sentiment

The more body, the more decisive the move and the clearer the dominance of buyers or sellers. Green (or white) suggests buyers' dominance, so usually suggests more upside. The red (or black) version suggests the opposite.

Hammer

Japanese Candlestick Patterns - Hammer

You can spot a hammer candlestick by its long wick below a comparatively short body, with little to no wick above. The body should be two to three times shorter than the lower wick.

This shows that the market hit a new low during the session but bounced back and closed much higher. So, while there was significant selling pressure, buyers stepped in to push back the bears before the close.

While bearish sentiment is weakening, that doesn't necessarily mean a reversal is imminent. So most technical traders will wait for a confirmation before opening a position on a hammer – usually a strong upward move in the next period.

Inverted hammer

Japanese Candlestick Patterns - Inverted Hammer

An inverted hammer looks the same as a hammer, just upside down.

It indicates a buying pressure, followed by a selling pressure that was not strong enough to drive the market price down. The inverse hammer suggests that buyers will soon have control of the market.

Hanging Man – Bearish

Japanese Candlestick Patterns - Hanging Man

A hanging man looks identical to a hammer, the only difference being where it crops up.

While a hammer appears after a bear market, a hanging man will do so after an uptrend. They're taken as a sign that selling sentiment is growing against buyers, and therefore that a reversal may be coming soon.

Sellers had control of the market but met strong resistance. However, that resistance only managed to keep the price in check, it didn’t continue the bull run. So, sentiment may be about to change.

A red-hanging man is usually taken as a stronger signal than a green – though both are considered bearish patterns.

Shooting Star - Bearish

Japanese Candlestick Patterns - Shooting Star

The shooting star is the same shape as the inverted hammer but is formed in an uptrend: it has a small lower body and a long upper wick.

Usually, the market will gap slightly higher on opening and rally high during the time period before closing at a price just above the open – like a star falling to the ground.

The shooting star can close slightly above the opening (green) or below the opening (red), but both indicate that a reversal may be imminent.

Please note that:

  • Doji and spinning top patterns are neutral, while the others are reversal.
  • Inverted Hammer and Shooting Star share the same shape and are the inverted forms of the Hammer and Hanging Man.
  • With these single reversal Japanese candlestick patterns, it is recommended to wait for signs of a new bear market before trading.

Double Japanese Candlestick Patterns

When a signal is formed from two consecutive periods, it’s known as a double candlestick pattern. These often hint at upcoming trend reversals but can also be used to identify continuations.

Engulfing

In the engulfing pattern, a candlestick is immediately followed by another larger one in the opposite direction.

Japanese Candlestick Patterns - Bullish Engulfing

Bullish Engulfing occurs when a bearish candle (lower close) is followed by a noticeably longer bullish candle (higher close), which “engulfs” the range of the prior bearish candle. The longer the bullish candle, the more it “engulfs” or exceeds the range of the prior bearish candle, the more bullish the pattern. Obviously, as always, context and timing matter. The pattern is more bullish if this pair appears after an extended downtrend, at strong support, or both, because these other signs confirm that the odds are higher that the downtrend is exhausted.

Japanese Candlestick Patterns - Bearish Engulfing

Bearish Engulfing occurs when a bullish candle (higher close) is followed by a noticeably longer bearish candle (lower close), which “engulfs” the range of the prior bullish candle. The longer the bearish candle, the more it “engulfs” or exceeds the range of the prior bullish candle, the more bearish the pattern. Obviously, as always, context and timing matter. The pattern is more bearish if this pair appears after an extended uptrend, at strong resistance, or both, because the odds are higher that the uptrend has become exhausted.

Piercing line

Japanese Candlestick Patterns - Piercing Line

The piercing line is also a two-stick pattern, made up of a long red candle, followed by a long green candle.

There is usually a significant gap down between the first candlestick’s closing price, and the green candlestick’s opening. It indicates a strong buying pressure, as the price is pushed up to or above the mid-price of the previous day.

The close on the second candlesticks must be more than halfway up the body of the first candle.

The piercing line signals a reversal after a down-trend.

Triple Japanese Candlestick Patterns

Triple candlestick patterns are often seen as some of the strongest signals of an upcoming move.

Morning Star – Bullish

Japanese Candlestick Patterns - Morning Star

A morning star plays out as a market hits a point of indecision after an extended downward movement, then begins to recover.

Traders may take this as a sign that the recovery will turn into a lasting uptrend.

Evening Star – Bearish

Japanese Candlestick Patterns - Evening Star

An evening star is the opposite of a morning star, showing a bull market that hits a point of indecision and then begins to retrace.

Evening Star and Morning Star are the bearish and bullish variations on the same theme:

  1. The first candle is in the direction of the trend, ideally with a long body that suggests a strong final push that exhausts the move.
  2. The second candle is a Doji, suggesting indecision and that the first candle was the last big push for the trend.
  3. The third candle is in the opposite direction of the trend and should close beyond the midpoint of the first candle, preferably with a long body showing a decisive reversal move.

Three White Soldiers – Bullish

Japanese Candlestick Patterns - Three White Soldiers

This candlestick pattern is comprised of three long-bodied bullish (higher close) candles after a downtrend and signals a longer-term reversal higher.

To be a valid pattern:

  1. The second candle’s body should be longer than that of the first and should close near its high with little or no upper wick.
  2. The third candle’s body should be the same size or larger than that of the second and also should close at or near its high with little or no upper wick.

Technical traders use it as one of the clearest signs that the bear market is over.

Three Black Crows – Bearish

Japanese Candlestick Patterns - Three Black Crows

The opposite of the above Three White Soldiers. This candlestick pattern is comprised of three long-bodied bearish (lower close) candles after an uptrend and signals a longer-term reversal lower.

To be a valid pattern:

  1. The second candle’s body should be longer than that of the first, and close near its low with little or no lower wick.
  2. The third candle’s body should be the same size or larger than that of the second and also should close at or near its low with little or no lower wick.

A technical trader may take the three black crows as an opportunity to open a short position to attempt to profit from the following bear run.

Rising and Falling Three

Three-method formation patterns are used to predict the continuation of a current trend, be it bearish or bullish.

Japanese Candlestick Patterns - Rising Three

The bearish pattern is called the ‘falling three methods. It is formed of a long red body, followed by three small green bodies, and another red body – the green candles are all contained within the range of the bearish bodies. It shows traders that the bulls do not have enough strength to reverse the trend.

Japanese Candlestick Patterns - Rising Three

The opposite is true for the bullish pattern, called the ‘rising three methods’ candlestick pattern. It comprises three short reds sandwiched within the range of two long greens. The pattern shows traders that, despite some selling pressure, buyers are retaining control of the market.

How to trade using Japanese candlesticks

Though the patterns are classified as a reversal (indicate a reversal of the trend’s direction), continuation (indicate trend continuation), or indecision, depending on which is their more common role, these are generalizations. Like any technical indicator, they don’t always work and should be used in combination with others that confirm or refute them.

Japanese Candlestick Patterns Example
Source: CAPEX WebTrader

The evidence from the technical analysis is useful for timing entries and exits but is rarely unequivocal. It’s up to you to weigh contradictory or inconclusive signals from the total of your technical analysis and fundamental analysis and discern where the balance of evidence points. How to read candlestick patterns and any other indicator depends on the context in which it occurs in the markets.

As with everything, context and timing make a difference when interpreting Japanese candlestick patterns: A bullish reversal Japanese candlestick pattern (like a hammer or bullish engulfing pattern) is more suggestive if it comes after an extended downtrend than it is after a brief one, especially if that brief one comes within a longer-term uptrend.

That same bullish reversal candlestick pattern will have more credibility if it happens to occur at a strong support level where we’d expect a downtrend to be more likely to reverse.

If the picture isn’t clear enough, look for another opportunity. Remember, some of the best trades you’ll ever make are the ones you decide not to take. Missed opportunities only hurt your ego; bad trades hurt your capital.

  • Learn the ins and outs of technical analysis in CAPEX Academy
  • Open a CAPEX trading account to benefit from powerful charting tools across thousands of markets
  • Identify opportunities using your preferred Japanese candlestick patterns
  • Open your position, ensuring you have the right risk management strategy in place

Or if you’d rather practice spotting and trading Japanese candlestick patterns without putting up any real capital, open a CAPEX demo. You’ll get $50,000 in virtual funds to try out trading CFDs on forex, shares, indices, cryptocurrencies, and more.

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