Candlestick Patterns

Explained [Plus Free Cheat

Sheet]

Trading without candlestick patterns is a lot like flying in

the night with no visibility. Sure, it is doable, but it
requires special training and expertise. To that end, we’ll be
covering the fundamentals of candlestick charting in this
tutorial. More importantly, we will discuss their significance
and reveal 5 real examples of reliable candlestick patterns.
Along the way, we’ll offer tips for how to practice this time-
honored method of price analysis.

Also, feel free to download our Candlestick Pattern Quick

Reference Guide!
Why Do Candlestick Patterns Matter?
After all, there are traders who trade simply with squiggly
lines on a chart. Astonishingly, some don’t even look at the
charts! Instead, they pay attention to the “tape” — the bids
and offers flashing across their Level II trading montage like
numbers in The Matrix.

A Level II montage. Source: CenterPoint Securities

No doubt, there are countless ways to make money in the stock
market. In fact, there is no right or wrong way to read a
chart. But unless you are just a gambler, you need some form
of data to make informed decisions.

We believe the best way to do this is by understanding

candlestick patterns.

For newer traders, even reading candlestick charts can seem

like an insurmountable learning curve. There appears no rhyme
or reason, and no end to the amount of price and volume data
being thrown your way.

It’s daunting, for sure. Especially when you’re just getting

started.

But be of good cheer! There is a method to the madness. The

method is in the patterns. The patterns reveal probabilities.
And the right probabilities create opportunities.

More importantly, the right opportunities can create profits.

This is where candlestick patterns come in handy. They help us

to decipher the patterns of the market. They’re like little
road signs on crowded streets. And with enough repetition,
enough practice, you just might find yourself a decent chart
reader.

That’s why you’re here, right? To learn to navigate the murky

waters of the market?

Trust us, it is a worthwhile endeavor.

Who Discovered the Idea of

Candlestick Patterns?
Munehisa Honma, 1724-18031
According to Investopedia.com, it is commonly believed that
candlestick charts were invented by a Japanese rice futures

trader from the 18th century. His name was Munehisa Honma.2

Honma traded on the Dojima Rice Exchange of Osaka, considered

to be the first formal futures exchange in history.3

As the father of candlestick charting, Honma recognized the

impact of human emotion on markets. Thus, he devised a system
of charting that gave him an edge in understanding the ebb and
flow of these emotions and their effect on rice future prices.

Honma actually wrote a trading psychology book around 1755

claiming that emotions impacted rice prices considerably.4

When all are bearish, there is cause for prices to rise.

Munehisa Honma5
In recent history, Steve Nison is widely considered the
foremost expert on Japanese candlestick methods. After all, he
wrote the book that catapulted candlestick charting to the
forefront of modern market trading systems.

Beyond Candlesticks: New Japanese Charting Techniques

Revealed, is one of his most popular books and a definitive
resource for candle patterns.

Since the 90s, this method of charting has become pervasive

throughout all financial markets: equities, futures, forex,
and more.

In his books, Nison describes the depth of information found

in a single candle, not to mention a string of candles that
form patterns. It truly puts the edge in favor of a skilled
chartist.

The Story That Candlesticks Tell

Emotions and psychology were paramount to trading in the
1700s, just as they are today. This is the foundation of why
candlesticks are significant to chart readers.

How so?

Every candle reveals a battle of emotions between buyers and

sellers.

As the great trading psychologist Brett Steenbarger notes,

“proper training is the best source of discipline and the most
effective safeguard against intrusive anxiety and
impulsivity.”

With this in mind, understanding the emotional story within

candlesticks is a great place to start that training.
How are Candlesticks Formed?
There are three types of candlestick interpretations: bullish,
bearish, and indecisive. This is painting a broad stroke,
because the context of the candle formation is what really
matters. But for all intents and purposes, we’ll stick with
these three categories.

The elements of a candlestick

What Is a Candlestick?
The formation of the candle is essentially a plot of price
over a period of time. For this reason, a one minute candle is
a plot of the price fluctuation during a single minute of the
trading day. The actual candle is just a visual record of that
price action and all of the trading executions that occurred
in one minute.

Similarly, a daily or weekly candle is the culmination of all

the trading executions achieved during that day or that week.

The open tells us where the stock price opens at the beginning
of the minute. The close reveals the last recorded price of
that minute. The wicks (also known as shadows or tails)
represent the highest and lowest recorded price from the open
and close.

According to Nison, the Japanese placed much less emphasis on

the highs and lows of individual candles. For them, as it is
for modern technicians, the opening and closing prices were

more relevant.6

Essentially, the broader context of candles will paint the

whole picture.

What Is a Bullish Candle?

A bullish candle is formed when the price at the closing of
the candle is higher than the open. This can be on any time
frame: from a 1-minute candle to a 1-month candle. It will all
be the same.

A bullish candle opens low and closes high.

Typically these candles close with a green or white body
color, though most charting platforms allow for customization
these days.
What Is a Bearish Candle?
Conversely, a bearish candle is assumed when the closing price
is lower than the opening price. In other words, the price
dropped in the amount of time it took for the candle to form.

A bearish candle opens high and closes low.

By default, most platforms will show a red or black candle as
bearish.

What Does the Candle Formation Tell

Us?
This is the real question we need to ask ourselves. It isn’t
enough to know that the candle opened and then closed lower,
or vice-versa.

As renowned trader and best-selling author Dr. Alexander Elder

explains, “The main advantage of a candlestick chart is its
focus on the struggle between amateurs who control openings

and professionals who control closings.”7

Dr. Elder may be referring to daily candles, but his point is

still important. The candle represents a struggle between
buyers and sellers, bulls and bears, weak hands and strong
hands.

Armed with that knowledge, let’s dig in and see what picture
those little candles are trying to paint for us.

The High of the Candle

The high of each candle, whether it is the tip of the wick at
the top, or if the body closes at the top, represents the
maximum effort of bulls. If it is a daily candle, buyers could
not push the price of the stock one cent more during that day.

Why is that important? There are two reasons:

1. This could represent a near term level of resistance

which will have to be broken for the price to move
higher.
 2. In order to find enough demand to push through that
resistance, the stock may need to consolidate lower
until enough shares are accumulated.

The Low of the Candle

Just as the high represents the power of the bulls, the low
represents the power of the bears. The lowest price in the
candle is the limit of how strong the bears were during that
session.
Why is this important? Again, two reasons:

1. This could represent a near term level of support where

bulls were able to stop the downward momentum
2. To move lower, more supply may need to enter the market
at higher prices.

The Closing Price of Each Bar

This is where the story gets interesting.

When a candle closes above its opening price, we can assume

that the bears won in some form or fashion. How much it closes
above the open tells us with what intensity the bulls were in
control during that session.

Let’s look at few examples to better understand this:

In this chart, we see the “Three White Soldiers,” which is a

candlestick pattern describing three bullish candlesticks in a
row. What can we interpret from this?

Three White Soldiers candlestick pattern

It is clear to see that the candles open low and close high.
Bulls were clearly in control during each session with very
little energy from the bears.

Now contrast that with what we see in the next example. Ask
yourself, who was in control during this session?

Apparently there is indecision as to who is in control. How do

we know? Think about the story behind this “Spinning Top”
candle:

The stock opens, proceeds lower as bears are in control from

the open, then rips higher during the session. But after
putting in a decent high, the bulls settle back and give the
bears some control into the close.

Are you beginning to see how the story unfolds?

These are the stories that candles tell us on charts. Who is

in control (greed), who is weak (fear), to what extent they
are in control, and what areas of support and resistance are
forming.

The Range between the Open and Closing

Price
This is one of the most important aspects of interpreting
candles. As Dr. Elder notes, the range between open and close
8
“reflects the intensity of conflict between bulls and bears.”

In day trading, momentum is everything. On this token, the

character of the candles can tell us if there is demand or if
a stock is sleepy and uninteresting — whether we are about to
launch, fall off a cliff, or just grind sideways.

Additionally, the nature of the candles can tell us when to

enter with tight risk. Or, when to take profits into climactic
candles.

In the end, it all boils down to context and the story of

buyers and sellers behind the tape.

5 Real Examples of Reliable Candle

Patterns
Without practice, none of this information really matters. It
takes screen time and review to interpret chart candles
properly. There are no free lunches in the markets.

With that being said, let’s look at some examples of how

candlestick patterns can help us anticipate reversals,
continuations, and indecision in the market.

1. The Hammer / Hanging Man

The Hanging Man is a candlestick that is most effective after

an extended rally in stock prices. The story behind this
candle tells us that there were extensive sellers in the
formation of the candle, signified by the long wick.

It is usually accompanied by heavy volume.

The Hanging Man appears at the top of an extended uptrend

before reversing.
The Hammer is another reversal pattern that is identical to
the The Hanging Man. The only difference is the context. The
Hammer occurs at the end of a selloff, signifying demand or
short covering, driving the price of the stock higher after a
significant selloff.

Like the Hanging Man, you want to see a solid volume signature
associated with these candles.
Hammer candles appear at the bottom of a downtrend before a
reversal

2. Engulfing Patterns
Engulfing patterns offer a great opportunity to go long while
keeping risk defined to a minimum. As you can see in the
example below, the prior bearish candle is completely
“engulfed” by the demand on the next candle.
A bullish engulfing candle at the market open.
Another example of engulfing patterns is the Bearish Engulfing
Sandwich. Here we have what appears to be a bearish reversal,
but the next candle completely swallows the supply from that
red candle:
A bearish engulfing sandwich pattern, also know as a stick
sandwich

3. The Morning Star

The Morning Star is yet another reversal signal. It can be
found at the end of an extended downtrend or during the open.
It takes 3 candles to confirm the setup.

1. The first candle must be a strong downtrending candle.

 2. The second candle is the star. It’s usually a narrow
body candle that, ideally, does not touch the body of
the prior candle.
3. The third candle is a strong bullish candle confirming
the new uptrend.

The morning star candlestick pattern at the open

4. The Evening Star

Similar to the Morning Star, the Evening Star is its bearish
cousin. It forms at the top of parabolic or extended bullish
runs. Much like the Morning Star, the body of the candles
should not touch.

Here are three criteria for spotting the shooting star:

1. The bodies do not overlap

 2. The third candle is a strong bearish candle closing into
the body of the first candle
3. Volume should increase from left to right in the pattern

The Evening Star candlestick pattern on GME

As with all of these formations, the goal is to provide an
entry point to go long or short with a definable risk. In the
example above, the proper entry would be below the body of the
shooting star, with a stop at the high.

5. Indecision Candles
The doji and spinning top candles are typically found in a
sideways consolidation patterns where price and trend are
still trying to be discovered.
Indecision candlestick patterns
The “doji’s pattern conveys a struggle between buyers and
sellers that results in no net gain for either side,” as noted
in this great article by IG.com.

Will it continue upward? Go sideways? Or reverse?

With indecision candles, we typically need much more context

to answer these questions.

The Gravestone Doji is a perfect example of this:

Gravestone Doji candles can represent indecision on a chart.
Note the trend is mostly sideways in this first circled
example. For this reason, waiting for the reaction to these
candles is usually best for risk management.

Eventually, the price falls in this particular case as the

trend becomes more extended into the rally. Correspondingly,
the Shooting Star that occurs just beyond the Gravestone Doji
is confirmation of that falling price action.

The Best Way to Practice with

Candlestick Patterns
As always, it is best to practice a strategy before putting
money to work in the market. There is no better way to do this
than with a simulator.
One of the best methods to train your “chart eye” to see these
patterns is to simply replay the market, noting each time you
see a particular candle.

As you put in deliberate practice, ask yourself the following

questions:

What candle formation is this?

What is the context? Uptrend? Down trend? Sideways?
Does this candle meet the criteria for a proper
reversal?
Where could I enter with the least amount of risk?
What would confirm the pattern?

We have a wealth of knowledge on many different candlestick

patterns, so be sure to check out those lessons, too!