Technical Analysis – What is a Candlestick?

Technical analysis as a way of charting the markets started in the Western world with some classical patterns that we’re going to show here on the Trading Academy: head and shoulders, rising or falling wedges, ascending or descending triangles, bullish or bearish flags, pennants, etc. These patterns are designed to show either continuation or reversal of prices to come. Lately, more and more people are seeing the benefits of the Japanese approach to technical analysis: the candlesticks approach. So powerful are these candlestick techniques that they are widely used now around the world, and market technicians cannot ignore these formations. There are multiple possibilities for setting up a trading chart, and, besides a line or a bar chart, candlesticks can be chosen as well. Exactly like a bar, a candlestick shows the opening and closing prices, but it offers something more in between. Japanese candlestick techniques as part of technical analysis are a powerful trading tool. They can show either reversal or continuation patterns, but mostly reversal ones. In this Trading Academy project, we will treat the Japanese approach to technical analysis as well; but before going into more detail, it is necessary to explain what a candlestick is, and above all why it is important to use a candlesticks chart, as there are only advantages to doing so.

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Defining a Candlestick’s Elements

When talking about a candlestick, the starting point should be the timeframe we’re referring to. The principle of a candlestick and its elements are the same whatever the timeframe, and only the interpretation should be different. A perfect example is a comparison between the monthly and the hourly timeframes. If the candlestick chart is selected on both timeframes, the candles will look the same, in the sense that they are formed out of the same elements, but the interpretation is different: one candle will close in 1 hour, and the other in 1 month. This is important because a candlestick should be interpreted only after it is closed. During the opening time, it can take various shapes and forms – it can be bullish or bearish, or even show continuation patterns – but nothing should be considered until the candle is closed.

The Body of the Candle

The body of the candle can take any colour possible, but the standard ones are green and red. A green body shows a bullish candle, while a red body shows a bearish one. By way of a definition, the body of a candle is the difference between the opening and closing price. If this difference is positive, the body is green, and the candle bullish. If it is negative, the bearish candle is shown as a red one. The bigger the difference between the opening and closing price of a candle, the bigger the body, and hence the whole candle.
Candlesticks - 1
The image above shows red and green candles and how they represent bearish and bullish conditions during their formation. In this case, the timeframe is the hourly one. The body is the thick area in a candle. However, not all candles travel from the absolute high to the absolute low, and, as such, the body shape of a candle varies.

The Shadow of the Candle

The shadow of the candle is the line above or below its body, and it can be either bullish or bearish (respectively green or red). As a rule of thumb, the shadow of a candle always has the same colour as its body. The reason why candles have shadows is that, again, it is not mandatory for them to close at their highest or lowest point; in fact, it is rarely that this happens. A shadow shows the fact that the price, sometimes during the candle’s formation, reached a specific value, even though that level was retraced before the candle closed. Shadows can be small or short, and usually, they represent violent fake moves. The Forex market is well known for its fake moves and the ability to attract traders on the wrong side, only for the price to make a V-shaped recovery and retrace the previous move completely. In terms of candlestick charts, candles have a big shadow when this happens.
Candlesticks - 2
The same chart as the one above shows on its right-hand side the shadows of two candles: one bullish and one bearish. The shadows respect the nature (colour) of their candles, and a quick look at the other candles there shows that shadows are different for every other candle. These are the two elements that make up a candlestick: the body and the shadow of a candle.

When treated as continuation or reversal patterns, one or a group of candles are considered. Different types of shadows and bodies have different meanings for the patterns, and again it is important to wait for the candle to close. This is the same thing as when trading with indicators: If you don’t wait to see the closing value or the printing value of the indicator, how will you know what the correct one is? Trading with candlesticks leaves little room for differing interpretations, as the Japanese candlestick techniques are exact and offer great opportunities. Not only is reversal spotted, but the set-up gives powerful risk/reward ratios, which are a crucial part of any sound money management system.

It is not possible to trade the Forex market, or any other market, and have only winning trades. The idea is to have more win than losses, as this is the only way the account will grow in time. Discipline is key here, and that discipline is given by technical analysis. Fundamental analysis may give the reason why the market is moving, but the direction is always given by both technical and fundamental factors. On top of that, the technical analysis gives the risk-to-reward ratio, and this is what differentiates a good strategy from a bad one. We will use the concept of candlesticks as described here in further articles in our project, so do make sure you understand the importance of it.

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