A candlestick is composed of three parts, including the body, shadows, and color. These parts provide four data points — the highest, lowest, opening, and closing prices.
We can gain information from a candlestick by checking three features: the size of the body, the lengths of shadows, and the volume.
Candlestick charting is widely used in various financial markets because it is visually appealing and easy to interpret.
Understanding a Candlestick
A candlestick is a type of chart that displays the high, low, open, and closing prices of a financial asset within a certain timeframe.
This form of charting was created in the 18th century by a Japanese rice merchant named Munehisa Homma. In the 1990s, American Steve Nison published his book "Japanese Candlestick Charting Techniques", introducing candlestick charts to the western world.
Munehisa Homma's idea on candlestick charting was believed to be further modified and adjusted through the ages to become more applicable to current financial markets.
The graphic above shows how candlesticks are constructed.
A candlestick is typically composed of three parts: its body, shadows, and color.
There are four data points in every candlestick: the open, high, low and close price for the time period displayed.
The open is the very first trade price for the specific period and the close is the very last trade price for the period. The rectangle drawn by connecting the open and close is considered the real body of the candlestick.
The line drawn from the highest price and the body is called the upper shadow of a candlestick, also known as the wick. And the part drawn between the lowest price and the body is called the lower shadow, also known as the tail.
If the close is higher than the open, the body is colored green to form a bullish candlestick representing a net price gain. Conversely, if the closing price is lower than the open, it is usually colored red to represent a bearish candlestick.
When the open and the close are virtually equal, the candlestick is usually called a "Doji," which could be interpreted as a neutral candlestick.
The body shows the day's open and close, the shadows show the day's high and low, and the color tells the direction of movement during the candlestick's formation.
How to interpret a candlestick
Every candlestick tells a story of the showdown between the bulls and the bears. To become a professional trader, the first thing you need to learn is to analyze a candlestick.
Generally, traders get insight from a candlestick by checking the following three aspects:
1. The size of the body
A bullish candlestick with a large body tells that the buyers are in strong control. Conversely, a bearish candlestick with a large body indicates the sellers are in strong control.
2. The lengths of shadows
A long shadow indicates that the price has moved a lot, showing a sign of uncertainty. On the other hand, short shadows indicate a relatively moderate market. Generally speaking, the longer the shadow, the higher the possibility that the price would move in the opposite direction of the shadow.
3. Price with volume
A key indicator worth noting when analyzing a candlestick is the accompanying volume. If a price rise is accompanied by rising volume, traders may infer that the trend is associated with greater trading participation. However, if the price rises by a significant amount and the volume shrinks, traders may deduce that there could be something abnormal behind the price change.
The depth of information and the easy-to-understand components have made candlestick charting very popular in financial markets. It is now widely used in forex, commodities, treasuries, and the stock market.