Japanese candlesticks represent a way to describe the price action during the given timeframe. They originated in Japan over 100 years before the Western traders developed the bar charts. The creation of Japanese candlesticks is often credited to a Japanese rice trader Munehisa Homma who discovered that markets were strongly influenced by the emotions of traders, not only by supply and demand.
To show this emotion on the chart, Homma started representing the size of price moves with different colors. Homma’s findings were refined by many traders and his approach was popular among Japanese traders. But then, a Westerner Steve Nison “discovered” this technique from his fellow Japanese broker and called it “Japanese candlesticks”. He published several books about Japanese candlesticks, and it helped the technique grow in popularity among traders around the world.
Since its creation, candlesticks have been extensively used and studied by numerous traders. As a result, they have established themselves as a major tool to facilitate the analysis of financial markets and one of the vital steps of any aspiring trader.
When you set up a timeframe for a candlestick chart, you select what period each candlestick will represent. For example, on a 1-hour timeframe, each candlestick will illustrate a market movement for every hour. Japanese candlesticks can be used to represent any timeframe, from seconds to years.
Japanese candlesticks consist of four elements:
- Open — the first trading price within a particular timeframe.
- High — the highest recorded price in a selected period (maximum).
- Low — the lowest recorded price in a selected period (minimum).
- Close — the last trading price within a particular timeframe.
Together, these four elements form a shape resembling a candle (hence, the name “candlesticks”). Depending on the price movement, candlesticks can be bullish or bearish.
A bullish candle is the one where the closing price is higher than the open. In most cases, bullish candles are shown as green on the chart.
A bearish candle is the one where the open price is higher than the closing price. They are usually displayed as red.
The price range between the open and the close is known as a body of a candle. The difference between a candle’s body and its highs or lows form the tails, also called the whisks or the shadows.
How to read Japanese candlesticks
When you look at the candlestick chart, you see a battle between bulls and bears for moving the price higher or lower. And each candlestick represents a result of this battle for a certain period.
If the body of a candle is long, then it means buyers or sellers were stronger and took control. Long candles also show intense buying/selling pressure over a certain period. On the other hand, short bodies imply little buying/selling activity or a period of indecision when buyers and sellers had almost the same strength.
The length of a candle’s tails can also demonstrate the bearish or bullish momentum during the period of the candle’s formation. There could be long tails, medium tails, or no tails at all on both or one side of a candle.
Candlesticks with long tails show that there were significant trading actions well past the open and close. At the same time, short tails tell about most trading action near the open and close.
For example, long upper tail and short lower tail indicate that bulls try to push the price higher but eventually sellers were able to drive the price back down closer to its open price.
How to use Japanese candlesticks
A big portion of Technical Analysis is dedicated to determining the price action from how candles look, individually, and more importantly, in combinations. There are a number of candlestick patterns (single, dual, and triple ones) that can signal a possible trend reversal, its continuation, or period of indecision.
Individual candlesticks and candlesticks patterns by themselves, however, should not be the only determining factor in making trades because the reliability of their signals varies. Other factors, like volume, analytics indicators, market sentiment, and news should be taken into account too.
Common mistakes when trading Japanese candlesticks
Mistakes are unavoidable when you start trading. A lot of patterns on the real price chart may look different than in textbooks, and it can confuse new traders. Furthermore, some traders may rely too much on candlestick patterns, and it could lead to potential losses.
Here are some of the most common mistakes that traders make using Japanese candlestick patterns.
Finding meaning in every candlestick
When many aspiring traders find out about candlestick patterns for the first time, they see patterns in every market move. In reality, markets can be quite “noisy”, so not every candlestick is useful for future price movements.
By itself, the candlestick can be useful in giving a general idea of price action. However, looking at candlesticks may not be enough for a comprehensive analysis. Candlesticks don’t show in detail what happens between the open and close, only the final result. Also, candlesticks don’t determine whether the lower shadow, or upper shadow happened first. That is why traders usually use other indicators to confirm their candlestick analysis.
Instead of looking at every candlestick, try to focus on the ones near important price levels for the start.
Using candlesticks without checking support and resistance levels
This mistake emerges from the previous one. If you find a reversal candlestick pattern near a random price level, it doesn’t guarantee further price movement in the opposite direction.
The easiest way to check candlestick patterns is by looking at support and resistance levels. Support and resistance levels determine where bulls or sellers may increase their pressure on the market. First identify where these levels are located, and then start looking out for candlestick patterns. If a reversal candlestick pattern occurs nearby major resistance or support, it can make the pattern more valid.
For example, let’s take a look at this chart.
The price approached the resistance level which bulls had already tried to break once. But buyers didn’t manage to consolidate the price above the resistance level. As a result, a triple candlestick pattern called Three Inside Down formed on the chart.
Since bulls failed to break resistance, it strengthened the bearish sentiment. It helped bears to change the market trend.
It doesn’t mean that candlestick patterns always work with support and resistance levels. A lot of other factors may affect the price movements as well. At least, trading candlestick patterns with support and resistance may help you make your analysis more reasonable.
Searching only for standard pattern form
If you need to make a decent zoom, or squint at the Japanese candlestick chart to “see something”, then probably there’s nothing there. Technical analysis can be quite intersubjective and self-reproducing, so if other traders don’t see the same pattern on the chart, they may not trade according to it.
Furthermore, you don’t have to always fit a textbook representation of the pattern to the chart. If a candle’s tail on the chart is a bit higher or lower than in the textbook or guide, it doesn’t always mean that this pattern is invalid. Candlestick patterns that are supposed to form after three candles may end up forming after four or even five candles.
Try to focus more on the price action behind the candlestick pattern than simply on memorizing how the pattern is supposed to look. If a candlestick pattern is a bit different than a standard one, it still may indicate a strong buying or selling pressure.
Trading without waiting for confirmation
Candlestick patterns can be “self-confirming”, but many are not. If the candlestick hasn’t been formed yet, then it doesn’t mean that it will eventually be formed.
Moreover, some patterns need an additional candlestick in a preferable direction to confirm the pattern. For example, the double candlestick pattern Piercing Line can signal a bearish-to-bullish reversal if it is confirmed with a bullish candle after the pattern formation.
Make sure to wait until the candlestick closes and the pattern is fully formed before trading following the pattern.