By Hrishikesh Menon. Edited by Arjun Chandrasekar.
What Are Candlesticks?
Candlesticks are a type of graph used by investors to determine a stock’s price movement within a given time period (ranges from 1 second to YTD). It is usually used for day trading purposes, as candlesticks give a more precise price at which either a stop loss or limit buy order must be placed.
Parts of a Candlestick
Each candlestick indicates where the price opened and closed within the time period. These 2 positions are located at the end of the body of the candlestick. If the closing price is lower than the open price, the candle will be red indicating a price drop. If the closing price is higher than the open, the candle will be either hollow or green indicating a price increase. Most of the time there are 2 lines which protrude from the body of the candle indicating the highest and/or lowest price the stock was at during that time period. These lines are called wicks or shadows. Finally, there are neutral candlesticks which look almost like a cross (with wicks) or a hyphen (without wicks) since its open and close price are at the same position.
Trading with Candlesticks
All successful day traders use candlestick patterns and indicators to precisely pinpoint when to buy a stock and when to sell it. There are 2 major categories for patterns – bullish and bearish. In a bullish pattern, there are several small red candles followed by a significant green candle indicating a possible price increase. In a bearish pattern, there are several green candles followed by a big red candle indicating price depreciation. These 2 patterns are the most basic and simple ones to identify, but it is much more complicated in real stock charts. There can be multiple bullish or bearish cycles within a day.
Since it is quite difficult to identify bullish or bearish patterns on a real stock price chart, thousands of patterns have been discovered to facilitate the process of finding the right position to enter and exit trades.. Here are some of the common patterns which are seen in charts:
- Trendline resistance/support – These are 2 almost parallel lines in a chart indicating price resistance and support. Resistance is when the price stalls at a particular price range and usually has a pullback into a support. Support is when the price consolidates at a lower price range and eventually rises and potentially breaks the previous resistance. These trendlines help investors determine when to buy or sell. They buy if the price breaks the trendline resistance and sell if the price goes below the trendline support.
- Wedges – There are 3 types of wedge patterns: wedge up, wedge down, and wedge. Wedge up is usually seen in an uptrend graph where the support line is steeper then the resistance line, indicating a steep decline in price soon. Wedge down is the opposite of a wedge up – seen in a downtrend, resistance line steeper than support, indicating a price breakout (another word for significant price increase). Finally, a wedge is when the support and resistance lines gradually or rapidly shrink the price fluctuation and cause consolidation. At this point, the candles could move in either direction. If there is an abundance of red candles, there could be a breakout with a big green candle or vice versa.
- Triangle patterns – The 2 types of triangle patterns are triangle ascending and triangle descending. In triangle ascending, the resistance line is horizontal and the support line is relatively steep and guides the graph to the resistance line where a pullback can be predicted. In triangle descending, the support line is horizontal and the resistance guides the price down to the support where there can be a breakout.
- Channels – Channels are quite similar to trendlines, they indicate either a strong uptrend (channel up) or downtrend (channel down) or just a consolidation (little to no net movement in price).
- Double top/bottom – In a double top, it starts off with an uptrend and there would be 2 peaks or tops in price which usually indicate a steep pullback. In a double bottom, it starts with a downtrend where there are 2 troughs or bottoms which usually indicate a breakout or a gradual uptrend.
- Multiple top/bottom – Same as double top/bottom but here there can be more than 2 slumps or peaks.
Although these are robust patterns used by millions of investors and proven to be quintessential in daytrading, price movements are not entirely dependent on these. There can always be an external catalyst, along with other technical factors, which can cause the graph to break its traditional movement, so it is unwise to solely rely on patterns.