If you’ve spent any amount of time reading analysis of the forex markets (or even playing around with trading software for yourself), you’ll no doubt have come across these mysterious yet ubiquitous graphs known as ‘candlestick charts’.
Though they may look intimidating and complex to decipher, with the right know-how they’re actually quite straightforward to read and can offer you a lot of useful information at a glance.
In this article, we’ll give you a quick guide on how to read these colourful little charts so you can begin analysing market movements for yourself — but first, where did they come from?
A Brief History of Candlestick Charts
Candlestick charts are generally agreed to have originated in Japan during the 1700s, having first been used by a Japanese rice trader named Munehisa Homma — referred to by some in his era as the ‘god of the markets’.
After getting his start as a humble rice merchant, Homma later became a prominent figure on the rice futures trading scene on the Dojima Rice Exchange in Osaka, which was founded in 1697 and is thought to have been the world’s very first commodities futures exchange.
During his trading activities, Homma eventually realised that whilst supply and demand were indeed a key contributor to the movement of the markets, investors’ emotions and sentiment towards the product in question also played a large part in the process.
Consequently, he began charting the shifts in bullish or bearish momentum alongside pricing information on rudimentary versions of the candlestick charts we know today — hundreds of years before modern Western traders picked up the practice — with other Japanese traders soon joining him.
In fact, candlestick charts didn’t truly take off in the Western world until the 1990s, thanks in large part to trader and finance author Steve Nison who learned the technique off a Japanese colleague and later authored several books popularising the discipline.
What Do the Parts of the Candlestick Represent?
Every candlestick on the chart is made up of several components, each of which can tell you a lot about the behaviour of the markets over the specific timeframe chosen (for example hourly, four-hourly, daily and so on). These parts are commonly referred to as the ‘upper shadow’, ‘body’ and ‘lower shadow’, respectively:
The longer the main body of the candlestick, the greater the buying or selling pressure during that period (in other words, either the bulls or bears of that particular instrument took control and were able to push the market price further in the corresponding direction).
Conversely, a shorter candlestick body denotes comparatively little buying or selling activity either way and therefore minimal movement in pricing overall.
Put simply:
· A long green candlestick shows a very bullish market with strong buying pressure where the closing value is notably higher than the open
· A short green candlestick shows a slightly bullish market with where the closing value is marginally higher than the open
· A long red candlestick shows a very bearish market with strong selling pressure where the closing value is notably lower than the open
· A short red candlestick shows a slightly bearish market with where the closing value is marginally lower than the open
Note: many trading applications allow users to customise the colour schemes of their charts, however green and red are the most common colours so we have chosen them for our examples in this piece.
Surrounding each of the candlesticks’ body you will also see vertical line ‘shadows’, which denote both the highest (upper shadow) and lowest (lower shadow) points reached during that period.
If the shadows extend far past the bodies, this means a lot of trading activity happened at either extremity beyond the opening and/or closing values, whilst shorter shadows show that most trading action happened close to the opening and/or closing figures.
Further reading: https://www.forex.academy/46-basic-anatomy-of-a-candlestick-chart/
What is a Doji in Forex Analysis?
Sessions where the opening and closing values are virtually identical — and so the candlestick has a very short body, resembling a cross or plus sign (‘+’) on the chart — are known as a ‘doji’.
Because these sessions show very little movement in the overall price of the instrument, they are seen as neutral phases when taken individually; however, they can sometimes be useful to note as ‘transitional’ periods during wider trends.
Depending on the positioning of the body in relation to the shadows, dojis can be split into three distinct categories:
Further reading: https://www.dailyfx.com/education/candlestick-patterns/doji-candle.html
What are the Most Common Candlestick Patterns in Forex?
Though each candlestick gives a succinct overview of the price movement within its individual timeframe, many seasoned traders also find it useful to analyse groups of candlesticks together, often looking out for certain familiar patterns on the charts that can be used as signposts to suggest where the market may be heading next based on past behaviours and trends.
There are countless examples of candlestick patterns and many free resources online to help traders identify them, but we’ll go over a few of the most prominent examples below as an introduction:
Engulfing Patterns
One of the most basic and commonly discussed candlestick movements, engulfing patterns — as the name suggests — show a large main-bodied candlestick reversing its direction from the previous few candlesticks’ trajectory, with the body of the latest candlestick being larger than the whole of the previous stick’s body (i.e. the previous marker is ‘engulfed’ by the current, larger candlestick that has more widely spaced open and closing values).
In a bullish market, this means three descending red candlesticks followed by a green that engulfs the penultimate period’s real body, indicating the buyers have regained momentum and are now back in charge of the market movements and suggesting a rising price in the near term.
Conversely, a bearish engulfing pattern would comprise three rising green candlesticks followed by a larger, red real body engulfing the previous green, showing that the sellers have exerted new pressure on the market and so the price could continue to decline.
Harami/Harami Cross
Harami patterns tend to denote a kind of ‘pausing’ of the previous trend, with the trajectory of the past few movements being followed by a reversal in the sentiment similar to an engulfing pattern.
However, the difference here is that the latest body will be shorter than the final candlestick of the earlier movement, with the open and closing prices within the boundaries of the previous period. In some instances, the latest candlestick will show a virtually equal open and close value (i.e. a doji); this is known as a ‘harami cross’:
Both standard harami and harami cross patterns involve no significant movement in price either way during the current phase, which is why they are seen as a break period before the next movement; if they interrupt a decline, they’re considered bullish, whilst if they stop a rise they’re considered bearish.
Typically, if a bullish harami is followed by another period of upwards movement, it could signal further appreciations are in store as buyers take charge, whilst a bearish harami followed by more dropping suggests the potential for further decline.
Rising/Falling Three
The rising three pattern — a classic bullish movement — begins with a strong upwards period, followed by three consecutive declines that stay within the margins of the preceding bullish real body, after which another dramatic upwards movement takes place.
Despite the drops in the middle period, the pattern is considered bullish as no new lows are recorded during that timeframe and the final period shows the price appreciating overall.
The bearish equivalent — the falling three — simply takes the opposite trajectory, with a notable decline followed by three short upward bursts (staying within the original drop’s opening and closing parameters) and ending with a further depreciation that brings the value down in the end, signalling that the sellers have regained control for the time being.
Further reading: https://www.investopedia.com/articles/active-trading/092315/5-most-powerful-candlestick-patterns.asp
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