Trading strategy: 4 Candlestick Patterns you should know

Candlestick patterns are valuable tools for forecasting future price movements. Explore 16 of the most common candlestick patterns and learn how to leverage them to spot potential trading opportunities.

What Are Candlesticks?

Candlesticks are graphical representations that consist of a "body," indicating the area between the opening and closing prices, and "wicks," which denote the high and low prices. The terms "candles" and "candlesticks" are often used interchangeably, and the colors of the candles typically indicate whether the price has moved up or down. For a comprehensive guide on reading candlestick charts, refer to "How to Read Stock Charts."

Many analysts believe that the shapes of individual candles or specific candlestick patterns can provide insights into market sentiment. Steve Nison's book, "Japanese Candlestick Charting Techniques," introduced this practice to Western investors and is a must-read for anyone looking to master candlestick chart analysis.

Candlestick Patterns

One of the advantages of candlestick patterns is their fixed rules, making them well-suited for automated recognition by computers. As a result, many brokers and charting platforms now offer tools for automated candlestick pattern detection.

However, before relying on these apps, it’s beneficial to practice identifying patterns on your own. This hands-on experience will help you understand how candlesticks fit into the broader context of market indicators and allow you to determine if this approach resonates with you.

While trading solely based on candlestick patterns may not lead to substantial wealth—since few opportunities are truly risk-free—these patterns can be effectively combined with other techniques, such as volume analysis and moving averages. Ultimately, candlesticks serve as just one valuable tool in your trading toolkit.

What are some must-know candlestick patterns?

The four patterns we’ll look at here are the bullish engulfing pattern, the bearish engulfing pattern, umbrella lines, and dojis.

1. Bullish Engulfing Candlestick
A bullish engulfing candlestick pattern occurs when a candle's body—the difference between its opening and closing prices—is larger than that of the preceding candle, with the current candle opening lower and closing higher. This pattern effectively "engulfs" the previous candle. Typically, a bullish engulfing pattern indicates that the price has found support, and it often signals the potential for a sustained upward movement or a change in trend.

2. Bearish engulfing candlestick
The opposite of a bullish engulfing candle, a bearish engulfing candle pattern will open higher than the previous bar’s close, then after finding selling volume will move sharply downwards, breaking the previous day's open. This can foreshadow a sharp sustained drop in price or trend change.

3. Umbrella Lines
An umbrella line forms when market participants sharply reject support or resistance levels. These patterns feature small bodies with long lower wicks. A hammer, for instance, suggests a potential reversal of a downward trend. Below is an example of a hammer amidst market activity.

4. Doji Candles
A candle without a real body is referred to as a “doji.” This pattern occurs when the opening and closing prices are the same. Many traders interpret a doji as a sign of a battle between bulls and bears for market direction. Doji candles may have long wicks extending above and below, indicating that both sides tested those levels but were pushed back. This pattern signifies uncertainty, suggesting that the market is poised for a shift in control. Often, the subsequent price movement will result in a sustained upward or downward trend as the stock breaks out of the doji.

Conclusion:

Understanding four key candlestick patterns provides significant advantages for traders. Firstly, it enhances market timing by pinpointing potential entry and exit points, crucial for optimizing profits. Secondly, these patterns help identify trends and reversals, allowing traders to align their strategies with market conditions.

This alignment fosters informed decision-making and mitigates risk. Additionally, familiarity with candlestick patterns boosts traders' confidence, as they can rely on visual signals rather than intuition alone. Lastly, when combined with other technical analysis tools, candlestick patterns offer a more comprehensive view of market behavior, empowering traders to navigate the financial landscape more effectively.

When considering shares, indices, forex (foreign exchange) and commodities for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss.

Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.