What is a Candlestick Chart?
A candlestick chart is a charting tool used to display the price movement of an asset. It first originated in Japan in the 18th century and has been used for centuries to identify price action patterns, thereby providing a reference for judging the future trend of an asset. Today, cryptocurrency traders use candlestick charts to analyze historical price data and forecast future price movements.
Multiple candlesticks often form specific patterns that show potential signals of rising, falling, or sideways price action. Below, we will look at how these patterns reveal market sentiment and help you seize trading opportunities.
How Does a Candlestick Chart Work?
Suppose you are tracking the price of an asset such as a stock or cryptocurrency over a period of time (e.g., a week, a day, or an hour). A candlestick chart can visually present this price data.
A candlestick consists of a body and two lines (commonly referred to as wicks or shadows). The body of the candlestick represents the price range between the opening price and closing price during the time period, while the wicks or shadows represent the highest and lowest prices reached during that period.
If the body is green, it indicates that the price rose during the time period. If the body is red, it means the price fell, which is called a bearish candlestick.
How to Read Candlestick Chart Patterns
Candlestick chart patterns are made up of multiple candlesticks arranged in a specific order. There are a wide variety of candlestick patterns, each with its own unique meaning. Some patterns reflect the strength of buyers and sellers, while others may signal a trend reversal, continuation, or indecision.
It is important to note that candlestick patterns themselves are not direct buy or sell signals, but a way to observe price action and market trends, helping traders identify upcoming potential opportunities. Therefore, interpreting these patterns in the context of the broader market background often provides more reliable reference value.
To reduce the risk of loss, many traders reference candlestick patterns in combination with other analytical methods, such as the Wyckoff Method, Elliott Wave Theory, and Dow Theory. In addition, they typically use technical analysis (TA) indicators such as trend lines, Relative Strength Index (RSI), Stochastic RSI, Ichimoku Cloud, and Parabolic SAR.
Candlestick patterns can also be used in conjunction with support and resistance levels. In trading, a support level is a price level where buying pressure is expected to be stronger than selling pressure, while a resistance level is a price level where selling pressure is expected to be stronger than buying pressure.
Bullish Candlestick Patterns
Hammer
A hammer is a candlestick with a long lower wick at the bottom of a downtrend, with the length of the lower wick at least twice the length of the body.
A hammer indicates that despite significant selling pressure, buyers (the bullish side) still pushed the price back up to near the opening level. A hammer can be either red or green, but a green hammer typically signals a stronger bullish trend.
Inverted Hammer
The inverted hammer pattern is shaped like a hammer, but unlike a regular hammer, its long wick is above the body rather than below it. As with a hammer, the length of its upper wick must be at least twice the length of the body.
An inverted hammer usually appears at the bottom of a downtrend, signaling a potential upward reversal. The upper wick shows that the price has halted the downtrend, but sellers eventually pushed it back down to near the opening price, forming the typical inverted hammer shape.
In short, an inverted hammer may indicate that selling pressure is weakening and a bullish turn is likely soon.
Three White Soldiers
The three white soldiers pattern consists of three consecutive green candlesticks, with each opening price within the body of the previous candlestick and each closing price above the high of the previous candlestick.
In this pattern, the candlesticks have very short or even no lower wicks, typically indicating that buyers are stronger than sellers and are driving the price higher. Some traders also reference the size of the candlestick bodies and the length of the wicks; larger bodies often signal stronger buying pressure.
Bullish Harami
A bullish harami consists of a long red candlestick followed by a shorter green candlestick, with the entire body of the green candlestick contained within the body of the red candlestick.
A bullish harami can form over two or more periods, indicating that the bearish trend is slowing down and may be coming to an end.
Bearish Candlestick Patterns
Hanging Man
A hanging man is the bearish equivalent of a hammer. It usually appears at the end of an uptrend, with a short body and a long lower wick.
The lower wick indicates that significant selling pressure emerged after the uptrend, but buyers eventually regained dominance and temporarily pulled the price back into the upward range. In this scenario, buyers are attempting to extend the rally, but as more sellers enter the market, the market direction becomes uncertain.
If a hanging man pattern appears after a long uptrend, it can be a warning sign that the bull market is losing momentum, signaling a potential downward reversal.
Shooting Star
A shooting star is a candlestick with a long upper wick and a very short or non-existent lower wick, with a small body that is typically near the bottom of the range. The shape of a shooting star is very similar to an inverted hammer, except that it usually forms at the end of an uptrend.
This candlestick pattern indicates that the market briefly hit a local high, but sellers then took control and drove the price back down. Some traders choose to sell or open short positions when a shooting star appears, while others prefer to wait for the next candlestick to confirm the pattern before making a decision.
Three Black Crows
Three black crows consists of three consecutive red candlesticks, with each opening price within the body of the previous candlestick and each closing price below the low of the previous candlestick.
Three black crows is the bearish equivalent of three white soldiers. Typically, the candlesticks have short upper wicks, indicating that sustained selling pressure is driving the price lower. Traders can judge whether the downtrend is likely to continue based on the size of the candlestick bodies and the length of the wicks.
Bearish Harami
A bearish harami consists of a long green candlestick followed by a shorter red candlestick, with the entire body of the red candlestick contained within the body of the green candlestick.
A bearish harami can form over two or more periods (e.g., two or more days on a daily chart), usually appearing at the end of an uptrend. It may indicate that buying momentum is weakening and a reversal is imminent.
Dark Cloud Cover
Dark cloud cover consists of a green candlestick followed by a red candlestick, where the opening price of the red candlestick is above the closing price of the previous green candlestick, but the closing price of the red candlestick is below the midpoint of that green candlestick.
This pattern is usually accompanied by high trading volume, indicating that the market may quickly turn from bullish to bearish. Some traders use a subsequent third red candlestick to confirm the market direction.
Three Consolidation Candlestick Patterns
Rising Three Methods
The rising three methods candlestick pattern is commonly seen in an uptrend, where three consecutive short red candlesticks are followed by a continuation of the rally. Ideally, the length of these three candlesticks does not exceed the body of the preceding candlestick.
This bullish consolidation pattern is marked by a long green candlestick, signaling a renewed bullish move in the market.
Falling Three Methods
The falling three methods is the inverse of the rising three methods, typically signaling a continuation of a downtrend.
Doji Candlestick Pattern
A doji pattern forms when the opening price and closing price are the same (or very close to each other). This means the price fluctuated above and below the opening price but ultimately closed at or near the opening level. For this reason, a doji signals indecision between buyers and sellers. However, the interpretation of a doji pattern is highly dependent on the specific market context.
Depending on the position of the opening/closing level, a doji can be classified as a gravestone doji, long-legged doji, or dragonfly doji.
Gravestone Doji
This is a candlestick pattern signaling a bearish reversal, with a long upper wick and an opening/closing price near the lowest point of the range.
Long-Legged Doji
This is a candlestick pattern signaling market indecision, with both upper and lower wicks and an opening/closing price near the midpoint of the body.
Dragonfly Doji
This is a candlestick pattern that can signal either bullish or bearish price action (depending on the context), with a long lower wick and an opening/closing price near the highest point of the range.
By the original definition of a doji, the opening and closing prices should be exactly the same. But what if the opening and closing prices are not identical, but very close? This is called a spinning top. However, the cryptocurrency market is highly volatile, and pure doji patterns are quite rare. For this reason, spinning tops are often used interchangeably with dojis.
Candlestick Patterns Based on Price Gaps
A price gap occurs when the opening price of a financial asset is higher or lower than the previous closing price, creating a gap between the two candlesticks.
While many candlestick patterns include price gaps, patterns based on these gaps are not common in the cryptocurrency market, as crypto trading takes place 24/7. That said, price gaps can still occur in low-liquidity markets, primarily indicating low liquidity and a wide bid-ask spread, and are not reliable actionable patterns for traders.
How to Use Candlestick Charts in Crypto Trading
When using candlestick patterns in cryptocurrency trading, traders should keep the following tips in mind:
Learn the Basics
Before making trading decisions based on candlestick patterns, cryptocurrency traders should thoroughly understand the fundamentals related to candlestick patterns, including learning how to read candlestick charts and identify different candlestick formations. Never take impulsive risks if you are unfamiliar with the basics.
Combine Multiple Indicators
While candlestick patterns can provide valuable insights for traders, they should be used in conjunction with other technical indicators to form a more comprehensive forecast, including moving averages (MA), Relative Strength Index (RSI), and Moving Average Convergence Divergence (MACD).
Use Multiple Time Frames
Cryptocurrency traders should analyze candlestick patterns across multiple time frames to gain a full understanding of market sentiment. For example, if a trader is analyzing a daily chart, they should also look at the hourly and 15-minute charts to see how the patterns perform across different time horizons.
Implement Risk Management Techniques
As with all trading strategies, using candlestick patterns comes with inherent risks. Traders should always implement risk management techniques, such as setting stop-loss orders, to protect their capital from significant losses. In addition, traders should avoid overtrading and only enter trades with a favorable risk-reward ratio.
Even if a trader does not incorporate candlestick charts into their trading strategy, they can still benefit from a solid understanding of candlestick charts and their patterns.
Candlestick charts play a vital role in market analysis, as they fully capture the buying and selling pressure that ultimately determines the direction of the market. It is important to note, however, that they are not infallible analytical tools. Combining them with other tools and proper risk management measures can help reduce potential losses.