Technical analysis using Japanese candlesticks

Before reading this lesson, you should have previously read through:

Japanese candlesticks can be used in conjunction to identify the current market conditions and the possible future price direction. This is done by using the information they present to show the balance between the buyers and sellers in the markets. This in turn allows you to identify the market sentiment.

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Assessing the balance between the buyers and the sellers

The longer the body of a candlestick, the more momentum there is in that direction. What this means is:

  • The longer a bullish candlestick, the more buying pressure there is in comparison to selling pressure for that period.
  • The longer a bearish candlestick, the more selling pressure there is in comparison to buying pressure for that period.

Comparing candles in practice to assess the balance

Bullish candle formation

The three candles to the right are all bullish candles; over the course of each of these time periods there were more buyers than sellers (the closing price was higher than the opening price).

Candle number_2 is larger than candle number_1. This indicates that there was more momentum to the upside in the second candle compared to the first. The buyers were able to push the price higher in the same amount of time as the first candle. Comparing the candles, it can be seen that the balance is shifting more and more in favour of the bulls.

Candle number_3 is even larger than candle number_2. This indicates that not only is the balance continuing to shift in favour of the bulls, but the momentum in buying pressure is continuing to increase as well.

Comparing bearish candlesticks in the same manner

Bearish candle formation

The candles to the right are all bearish, meaning that over the course of these time periods there were more sellers than buyers. In comparison, candle number_2 is larger than candle number_1, indicating that there was more momentum to the downside in the second candle compared to the first.

The sellers were able to push the price lower in the second candle than in the first, and it can be seen that the balance has shifted more in favour of the sellers.

Candle number_3 is much larger than candle number_2, indicating that not only is the balance continually shifting in favour of the bears, but the momentum in selling pressure is increasing too.

Observing this kind of shift in the balance between the buyers and sellers helps to determine whether the market sentiment is likely to be bullish or bearish. If the balance is shifting towards the bulls, then the direction of the market is likely to be to the upside; if the balance is shifting towards the bears, then the direction in the market is likely to be to the downside.

Interpreting the size of the candlestick wicks

Bull candle with long wick

The candlestick to the right is a bullish candle. It has a long wick at the bottom and almost no wick at the top. During the time frame of this candle forming, the bears attempted to push the price down. However, the balance shifted back towards the bulls and the buyers pushed the price back past the opening price – the candle ended up closing as a bullish candle.

Candle formation

The illustration to the right shows how the candle could have looked during its formation.

The fact that the bulls managed to push the price back up from the low of the candlestick, past the open, and up to where it closed, indicates strong momentum in buying pressure.

A long wick, such as the illustration above to the right shown as number_1, therefore indicates that during the course of the candle, a shift in balance occurred from one side to the other– in this case from the sellers to the buyers. This provides an insight into which direction the momentum is likely to continue occurring.

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The doji candlestick

Doji

A doji candlestick pattern is a candlestick in which the opening and the closing price are the same, as the image to the right shows.

If there is a difference of just a few pips between the open and the closing price, then it is generally still considered to be doji.

This type of candle is neither bullish nor bearish and indicates that the buying and selling pressure is relatively equal – there is indecision in the market. A doji can sometimes indicate a reversal if found at the end of a large price movement.

Caution with interpreting open candlesticks

A candlestick that is still open does not provide any useful information as the dynamics of that candle can still change. This means that you cannot analyse the very last candle on the price chart; you can only analyse the prior candles. This is very important to know when making decisions about trading.

Open Bullish Candle 2
Open Candle Orange 2

The illustration above and to the left shows a 4 hour chart. The last candle shown is still open and has not finished forming. The price is moving to the upside indicating a strong bullish tendency. At this point, the buyers are in control and it appears that this will form as a bullish candle.

However, the chart to the right shows that within the time period of the four hours, the candle changed completely. The balance has shifted towards the bears. It now appears that the candle will form as a bearish candle.

Until the candle closes, there is no way to tell how the candle will eventually form. You should not make assumptions, carry out analysis or enter trades based on an open candle.

Gaps between open and close of the candlesticks

Gap

You may notice that in the illustration examples provided, each candlestick opens where the previous candlestick closes. Although this is logical, it is not always the case. As the illustration to the right demonstrates, occasionally a gap number_1 is created between the close and the open of two candlesticks.

There are multiple reasons for this, the main one being that the price shifted while the normal markets were closed. Therefore, the opening price will be different to the closing price when the markets open again.

Summary

So far, you have learned that ...

  • ... the longer the body of a candlestick the further the price moved in that time period and so the more momentum there is pushing the price in that particular direction.
  • ... an increase in market sentiment can be identified by comparing the candlesticks against one another.
  • ... a bearish body means that sellers are currently in control and a bullish body means that the buyers are currently in control over the course of that period.
  • ... long wicks indicate that there has been a shift in balance between the buyers and sellers – from one side to the other – within that period.
  • ... a doji candlestick represents market indecision where neither the buyers nor the sellers were in control.
  • ... only a closed candlestick should be taken into account because the sentiment can change within the time of that candle.

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  • Great lessons guys

    edit - question 4 is fine as it is
  • Isn't it incorrect (or rather imprecise) to say that in a given period of time there were more buyers than sellers (or more sellers than buyers) as each transaction has a seller and a buyer?
  • IMO Yes it is.

    Perhaps a better way of putting it would be that the price was bid or asked at lower or higher levels and filled at these bid and asked offers. That is why the the price moved in the direction it moved.
  • this is very confusing to me but i am learning very slowly. how to use this info in a real trade will take time to fully understand and apply. i have more questions than answers so all i can do is keep studying. thanks for yopur good work. len
  • Hi Leonard,
    It can be confusing at the beginning so don't hesitate to ask questions if you have any. I'll be happy to help!
    Regards.
    Peter
  • how to determine your profit or loss as the stock price moves up or down on an option considering the affect of the greeks, the premium and brokers commision ? a second question, how to deternine the acceptible risk/reward ratio ? i am not clear about these issues which seem basic to making profitable trades. len
  • Hi Leonard,
    unfortunately i am not familiar with options and can't really help you with that.

    Regarding risk/reward generally text books talk about a 2:1 requirement but it is quite artificial and comes really down to whether your system is profitable on a series of trades. It is also called expectancy. If you have a 50% win rate you don't need a 2:1 RR, a 1.5:1 is more than enough to make money on the long run.

    Hope that cleared it up a bit!
    Regards.
    Peter
  • Hej
    It seems some typing error or misunderstanding in the explanation of the charts under the title: Caution with interpreting open candlesticks. The statements says" the illustration above and to the left shows a 4 hour chart. The last candle shown is still open and has not finished forming"........ Is that correct?
  • Hi Mosses,
    the last candles if you think about it are never closed. As soon as they are closed a new one opens (which in turn becomes "the last" and is open by definition). The illustration meant to demonstrate that a 4H candle in his 2nd hour could look bullish, but it doesn't mean much because few hours later the candle might turn completely around and become bearish.
    Hope that makes sense.
    Regards.
    Peter
  • Hello, is there any difference between using only candlestick chart and use some indicator to analyse chart?
  • Hi Fresco,
    Indicators can be used as confirmation or filter but you do not necessarily need them. Lot of people put the indicator first and then figure out how they want to use them. I suggest you try the opposite way. Have a question first and then choose an indicator to give you an answer.

    For example many people put RSI on the chart because they saw others do it and go like:
    "ok RSI is overbought so maybe that's a sell"
    "hm there's a trend line on RSI"
    "RSI divergence, that is a buy"

    ...and they use RSI to justify their random way of trading.

    Instead try the following (take these only as examples):
    RSI can be used for many things:
    -divergence
    -OB/OS conditions
    -bull/bear conditions
    -RSI trend lines

    choose one of the above and combine it with other tools to enhance your signals:

    When there's an evening star (1) at resistance (2) and RSI divergence (3) --- > sell it

    and always use it the same way and don't use the indicator for anything more than you initially decided to.

    Let me know if that makes sense to you.
    Regards.
    Peter
  • Oh, okay Peter. I will try this for a while. i will inform you later on.
  • Trading Experte, u.a. verantwortlich für Tradimo Premium
    Hi zmalik,

    rsi means Relative Strength Index and is a range indicator. You can find more about it here.
  • Great collection of lessons. A pic is worth thousand words and a video definitely worth a million.
  • i don't understand the gap, i mean if a candlestick finished ad a certain value, the next candle would be open at the same price where the previous candlestick stpped,no??

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