Anyone who has been on a cryptocurrency exchange will have seen a candlestick chart. It is by no means a chart exclusive to cryptocurrency, but it is an extremely powerful tool because of the amount of information shown in a concise manner.
For anyone looking to invest and trade in cryptocurrencies, learning how to read a basic candlestick chart is a vital skill.
A Brief History
Back in the 16th century, Japan did not have an official currency to buy or sell products and/or services. Instead, they used rice as a medium for exchange. Citizens were also taxed in terms of rice, rather than ‘income’ as we are familiar with today.
However, it was impractical to lug around bags of rice; the rice was instead stored in a warehouse in Osaka in exchange for a ‘rice receipt’. This rice receipt became a medium for exchange for buying and selling.
However, rice was heavily dependent on weather conditions — poor weather would lead to a poor harvest, and the value of rice would increase as the supply was scarce. Good weather would lead to an abundant harvest, and the value of rice would decrease as the supply went up.
As a countermeasure, futures options were used. Simply put, a buyer and seller would agree on a price, but the product would only need to be delivered at a future date. In this way, the seller is assured of a certain sum, and buyer is able to protect himself/herself from a sudden inflation in price.
In the 17th century, a rice trader called Homma Munehisa began studying the rice futures market, from the weather and fundamentals to the market sentiments. Using this knowledge, he created the candlestick method; a method which he reputedly use to make 100 consecutive winning trades.
This method was adopted in the 19th century for the Japanese stock exchange, and many technical analysts began to use the candlestick trading method.
In the mid 1980s, it was brought into the West by Steve Nison, and has since evolved to become one of the most popular and successful charting methods used for trading in any market. With the advancement of technology, such as computers, the candlestick chart more accessible to traders; they were able to make use of programs to analyze the charts and extract the information much more easily.
The history of candlestick charting reaches back more than 300 years, and has established an excellent record in Japan long before it as adopted by the West in the past 30 years. It is a versatile and powerful tool that every trader is strongly encouraged to learn.
Understanding the Candlestick
To begin understanding candlestick charts, it is necessary to understand what each candlestick means. Each candlestick consists of two main parts, namely the body and the shadow.
This refers to the ‘fat’ part of the candlestick. The body shows the opening and closing prices of the candlestick for the time period specified. The opening price is the first price traded during the candlestick, while the closing price is the last price traded.
The position of the open and close is dependent on the movement of the candlestick. Upward candles are usually green, and the opening price will be at the bottom of the body, while the closing price is at the top. This is known as a hollow bar. In simple terms, the price of the cryptocurrency has risen during the candlestick.
For a downward candle, it is usually colored red; in this case the opening price is at the top of the body, and the closing price is at the bottom. This is known as a filled bar. This indicates that the price of the cryptocurrency has fallen during the candlestick.
Do note that the colors may differ from chart to chart, and traders themselves can customize it to something they prefer, such as black (filled) and white (hollow) candlesticks.
The Shadow (also known as Wick)
This refers to the thin lines at the top and bottom of the body. The thin lines show the highest and lowest prices traded during the candlestick.
Other than showing the highest and lowest price, the length of the shadow also serves as an indicator of volatility. If the upper and lower shadows are long, it means that the cryptocurrency is extremely volatile — the prices have fluctuated greatly. On the other hand, shorter shadows are an indication of a more stable cryptocurrency.
When a candle is forming, the candle will be constantly changing as the price moves. The only area that remains unaffected during its formation is the opening price. Other than that, the color of the candle may change from red to green, or vice versa, multiple times as the price fluctuates. Only when the candle is closed will the fluctuations stop, and the next candle begins.
Common Candlestick Patterns
Now that you know how to read a candlestick, the next step is spotting trends in the charts. The candlestick chart is much more than just information about the prices; it can give savvy investors an idea of what the market is going to do next. While no one can predict the future, knowing some of the basic trends will help you to understand why the market moves the way it does.
A Bullish Engulfing candlestick pattern refers is when a small filled candlestick is immediately accompanied by a much larger hollow candlestick — it completely ‘engulfs’ the previous candlestick.
The shadow of the previous filled candlestick is short, and is completely covered by the body of the subsequent hollow candlestick. This pattern is usually indicative of a bullish trend, with the prices going upward.
A Bullish Engulfing pattern indicates that there is a great buying interest in the market; the opening and closing price exceeded the previous candlestick’s highs and lows.
If the candlestick closes with little or no upper wick, it is indicative that the buying frenzy will likely spill over into the next candle. If the candlestick following this closes higher than the bullish engulfing pattern, there is a higher chance that the upward trend will continue.
A Bearish Engulfing candlestick pattern is the opposite of a Bullish Engulfing candlestick pattern. In this case, the first candlestick (body and shadow) is completely engulfed by the body of the following candlestick.
Often seen as the end of an upward trend, the filled candlestick typically opens at a higher price than the previous hollow candlestick. This is followed by a sharp drop, causing the price to fall below the previous low.
Just as with the Bullish Engulfing pattern, if the lower shadow of the filled candlestick is short or non-existent, it is a strong sign that the bullish pattern will continue and spillover into the subsequent candlestick.
Hammer and Inverse Hammer Formation
A Hammer candlestick formation is often viewed as a sign of bullish reversal, and is usually seen at the bottom of a downtrend.
There are 2 key requirements for the Hammer formation.
1. The opening, closing and high price are almost the same price
2. There is a long lower shadow, about twice the length of the body
Regardless of a downward or upward candlestick, the Hammer formation is considered a bullish sign. However, the hollow candlestick is considered a ‘stronger’ bullish sign.
The long lower shadow is an indication that the market’s support and resistance levels were being tested. When the price fell to the support levels, it rebounded upward close to the opening price.
If the opening price and the highest price are the same (filled candlestick), it indicates that the bullish sentiments were enough to fend off the bearish sentiments, but were insufficient to bring the closing price back to levels of the opening price.
A stronger bullish sign would be if the closing price and highest price were about same (upward candlestick), as it would indicate that the bulls were not only able to fend off the bears, but were able to close above the opening price.
The Hammer formation is not just useful as a bullish indicator; the lower shadow is a good indicator of the support and resistance levels of the market.
Like the name suggests, an Inverted Hammer candlestick is the opposite of the Hammer. It is often viewed as a sign of bearish reversal, and is usually seen at the top of an uptrend.
There are 2 key requirements for the Inverse Hammer.
1. The opening, closing and high price are almost the same price
2. There is a long upper shadow, about twice the length of the body
The opposite of the Hammer, it is indicative of a bearish trend. If it is a hollow candlestick, it indicates that the bulls had tried to raise the price, but the bears in the market were able to push the closing price down, close to the opening price.
A filled candlestick is an even stronger bearish sign. The bulls tried to raise the price, but the bears were able to rally and bring the closing price even lower than the opening price.
In either case, there is a significant chance of a downward trend beginning.
While the previous three formations were indicators of bullish or bearish trends, the Doji formation is indicative of indecisiveness in the market. While there are a few kinds of Doji formations, in here we cover the basic one.
Shaped like an addition sign, the Doji formation is formed when the opening and closing prices are almost the same, which gives it an extremely small body. It does not matter much if the body is hollow or filled. When the opening and closing prices are almost the same, it indicates that the buyers and sellers are at an equilibrium; neither side is sure if the market is going to become bullish or bearish.
This conundrum can be seen from the relatively long upper and lower shadows — during the formation of the candlestick, there were attempts to push the price in both a bullish and bearish direction, with neither side gaining an advantage.
On its own, the Doji does not indicate which direction the market is moving toward. It has to be taken in the context of when it appears.
Candlestick charts are an amazing tool for trading and investment. Not only do they show the necessary information, such as opening and closing price, each candlestick tells a story about market sentiments.
However, candlesticks cannot be analyzed in isolation; they have to be viewed with the proper context. In the next article, we will cover how to look at candlestick formations, is the basis of educated investment. A solid foundation in candlestick analysis can differentiate between a career trader/investor and a gambler.
23 March 2018