Japanese candlestick charts were invented in the 18th century by Homma Munehisa. They were designed to capture and display the forces at work in trading rice, in a simple to read way. The candlesticks tell the trader at a glance the open,high,low, and close prices for each days trading.
Due to the immense popularity and ease of use, scholars began studying patterns in the candlesticks that captured the psychology of the markets, and could accurate predict future market direction.
Why Use Candlestick patterns
The major benefit of Candlestick signals is that they are very easy to learn and identify. You do not need to learn formulas. You do not have to do extensive fundamental analysis. A Japanese Candlestick reversal signal is a visual identification of a change in investor sentiment. Of the 50 or 60 Candlestick signals, there are 10 major signals that occur at the reversals the majority of the time.
Traders can master Japanese candlestick analysis by focusing on the 10 major signals. A complete understanding of how the signals are formed, and the underlying market forces and psychology can provide traders tremendous predictive powers.
Based on hundreds of years of use within actual markets, the 10 major signals have been proven time an again in real markets. Logically speaking, if the patterns didn't work, Japanese traders wouldn't still be using them today!
Single Stick Candlestick Formations
An individual candlestick provides insight to market forces visually. Due to the predictive nature of the charts, the Japanese quickly began to identify and name individual patterns such as:
1. White candlestick - signals uptrend movement (those occur in different lengths; the longer the body, the more significant the price increase)
2. Black candlestick - signals downtrend movement (those occur in different lengths; the longer the body, the more significant the price decrease)
3. Long lower shadow - bullish signal (the lower wick must be at least the body's size; the longer the lower wick, the more reliable the signal)
4. Long upper shadow - bearish signal (the upper wick must be at least the body's size; the longer the upper wick, the more reliable the signal)
5. Hammer - a bullish pattern during a downtrend (long lower wick and small or no body); Shaven head - a bullish pattern during a downtrend & a bearish pattern during an uptrend (no upper wick); Hanging man - bearish pattern during an uptrend (long lower wick, small or no body; wick has the multiple length of the body.
6. Inverted hammer - signals bottom reversal, however confirmation must be obtained from next trade (may be either a white or black body); Shaven bottom - signaling bottom reversal, however confirmation must be obtained from next trade (no lower wick); Shooting star - a bearish pattern during an uptrend (small body, long upper wick, small or no lower wick)
7. Spinning top white - neutral pattern, meaningful in combination with other candlestick patterns
8. Spinning top black - neutral pattern, meaningful in combination with other candlestick patterns
9. Doji - neutral pattern, meaningful in combination with other candlestick patterns
10. Long legged doji - signals a top reversal
11. Dragonfly doji - signals trend reversal (no upper wick, long lower wick)
12. Gravestone doji - signals trend reversal (no lower wick, long upper wick)
13. Marubozu white - dominant bullish trades, continued bullish trend (no upper, no lower wick)
14. Marubozu black - dominant bearish trades, continued bearish trend (no upper, no lower wick)
Exmples of Major, Complex Japanese Candlestick Patterns
Harami - "Pregnant Woman", or "Body Within", the Harami is a 2 candlestick trend reversal formation
Tasuki Gap - "A sash that holds up one's sleeve", that Tasuki gap is a 3 candlestick formation that confirms the continuation of the existing trend.
Engulfing Patterns - Comprised of two candlesticks, engulfing patterns signify a pending reversal of the current market trend. The DAKI ("embracin line"), is the second candlestick that engulfs (body high and low encompass) the first days body.
Piercing Pattern - A two candlestick, bullish reversal pattern. The first candle is black, a continuation of the existing trend. The second candle is formed by opening below the low of the previous day. It closes more than midway up the black candle, near or at the high for the day
Dark Cloud Cover - A bearish reversal pattern comprised of two candlesticks. The body of the first candle is white and the body of the second candle is black. The black day opens higher, above the trading range of the previous day. The price closes below the 50% level of the white body.
Star Patterns - A symmetrical, reversal candlestick pattern. The bullish pattern, known as the Morning Star, is a three day signal consists of a long black body, usually one produced of the fear induced at the bottom of a long decline. The following day gaps down. However, the magnitude of the trading range remains small for the day. This produces an indecision type - day. The third day is a white candle day. The white candle represents the fact that the bulls have now stepped in and seized control. The optimal Morning Star signal would have a gap before and after the star day.