Technical analysis introduces various trading indicators and tools to assist in identifying trends and predicting reversals. In addition to technical indicators, another effective method for analyzing price movement is through candlestick charts and their patterns.
As you may be aware, there are multiple ways to depict the historical price of an asset, whether it's a forex pair, company stock, or cryptocurrency. Among the most prevalent chart types are the line chart, bar chart, and candlestick chart. Many traders favor the use of candlestick charts due to their ability to highlight patterns that offer a certain level of accuracy in predicting trend continuations or reversals.
A candlestick pattern embodies a price movement of an asset illustrated visually on a candlestick chart, serving to evaluate or forecast a specific market behavior. With time, traders noticed that price movements exhibited similar tendencies when particular patterns were present on the candlestick chart before those movements occurred. Consequently, these patterns were isolated and organized into various categories to serve as tools for technical analysis. But what precisely does a candlestick signify?
A candlestick chart is a technique used to visualize the past price fluctuations of an asset within a specific time frame.
Several widely recognized candlestick patterns include the hammer, three white soldiers, and spinning top.
What Are Candlesticks?
A candlestick chart is a technique used to illustrate the historical price changes of an asset across a duration of time. Each candlestick corresponds to a specific timeframe, based on the interval chosen by the trader. For instance, when using a 1D (daily) chart, each candlestick represents one day.
Historical accounts attribute the conceptualization of candlesticks to a Japanese rice trader, while the broader adoption of candlestick techniques in the Western world was propelled by Steve Nison's 1991 book, "Japanese Candlestick Charting Techniques."
Several essential elements contribute to making candlestick analysis easily understandable, allowing for a clear grasp of the candlestick's significance.
The candlestick body reflects the opening and closing prices of an asset. The placement of the open and close points is determined by whether the candlestick is bullish or bearish during a specific period. In a bullish market, the close will be higher than the open, and in a bearish market, it will be the opposite.
Typically, each candlestick features two shadows, referred to as wicks, although this isn't a strict rule. These wicks represent the highest and lowest prices within a given period. The upper shadow signifies the peak price, while the lower shadow indicates the lowest point reached by the price. Occasionally, only one shadow may be visible, particularly when the other shadow coincides with the open or close price and aligns horizontally with the body.
The color of the body signifies the direction of price movement. Generally, a green (or white) body suggests a price increase, while a red (or black) body signifies a price decrease. Most platforms use green and red bodies. Consequently, if the body is green, its upper boundary represents the closing price.
How Are Candlesticks Utilized in Trading?
The candlestick chart stands out as the most comprehensive graphical format for illustrating an asset's price movement. This charting method was adapted to cryptocurrency trading from its usage in stocks and forex markets. Unlike the line chart, which only depicts the closing price, the candlestick chart offers a wealth of historical price information due to its structured representation (explained earlier).
Successive candlesticks align chronologically, allowing traders to perceive the overall trend, as well as resistance and support levels, even without relying on technical indicators. Furthermore, they have the ability to reveal specific patterns that function as signals for buying or selling. The application of candlestick charts is particularly pertinent in the context of cryptocurrencies, given their high volatility and the need for in-depth technical analysis.
Top 16 Candlestick Patterns
Among the numerous candlestick patterns, we'll outline the most renowned and dependable ones. We'll begin with bullish patterns, which emerge following a downtrend and indicate an impending upward reversal. Cryptocurrency traders commonly initiate long positions upon the emergence of these patterns.
The hammer candlestick is characterized by a brief body and a notably elongated lower shadow. Its name originates from its resemblance to an upright hammer. Typically observed at the bottom of a downtrend, this pattern signifies that bulls have withstood the selling pressure during a specific timeframe and have propelled the price upward. While hammer patterns can appear with either green or red candles, the former indicates a more robust uptrend than the latter.
Similar to the standard hammer pattern, the inverted hammer boasts a considerably lengthier upper shadow, accompanied by a very short lower wick. This pattern suggests initial buying pressure followed by unsuccessful attempts from bears to pull the price down. Consequently, buyers re-enter with even greater force, propelling prices upward.
Differing from the preceding two patterns, the bullish engulfing pattern involves two candlesticks. The first candle should have a short red body and is engulfed by a larger-bodied green candle. Despite the second candle opening lower than the preceding red one, heightened buying pressure triggers a reversal of the downtrend.
The piercing line, a two-candlestick pattern, may emerge at the downtrend's bottom near the support level or during a pullback, hinting at an upcoming bullish movement. It comprises a long red candle followed by a lengthy green one. A critical feature of this pattern is a substantial gap between the red candle's closing price and the green candle's opening price. The green candle's closure should also encompass at least half the length of the prior day's red candlestick body. The pronounced difference between the green candle's closing and opening prices indicates buying pressure.
The morning star pattern, slightly more intricate, encompasses three candlesticks: a long red candle succeeded by a short-bodied candle and a lengthy green candle. This pattern suggests a waning of the initial period's selling pressure and the formation of a bull market.
Three White Soldiers
The three white soldiers, another three-candle pattern, comprises three consecutive long green candles with minimal shadows. A crucial requirement is that each of these three greens must open and close higher than the previous period. This robust bullish signal typically emerges after a downtrend.
Moving on to a set of bearish patterns that predict an impending reversal in an uptrend, often appearing at resistance zones. These patterns typically prompt traders to either close their long positions or initiate short positions.
The hanging man materializes as either a green or red candlestick featuring a short body and an extensive lower shadow. This pattern generally arises at the uptrend's conclusion and hints at an imminent substantial sell-off. However, bulls might briefly rally prices higher before eventually relinquishing control.
The shooting star stands in contrast to the inverted hammer. It consists of a red candle with a short body and a lengthy upper shadow. Typically, the market experiences a slight upward gap during the candlestick's opening, surges to a local peak, and then concludes just below the opening level. The body can occasionally be nearly non-existent.
The bearish engulfing pattern is the inverse counterpart of the bullish engulfing. The initial candle has a small green body and is entirely overshadowed by the subsequent lengthy red candle. This pattern arises at the uptrend's peak and signifies a potential reversal. The greater the continuation of the second candle's descent, the more momentum the bearish movement is likely to possess.
The evening star presents a specific three-candle formation. It involves a short-bodied candle positioned between a lengthy green candle and a sizable red candle that concludes below the midpoint of the initial green candle. Typically emerging at the uptrend's zenith, this pattern serves as a signal for a possible reversal.
Three Black Crows
The three black crows pattern encompasses three consecutive long red candles with minimal or nearly absent shadows. Each new candle opens around the same level as the previous one but concludes significantly lower. This pattern is viewed as a potent bearish signal.
Dark Cloud Cover
The dark cloud cover pattern mirrors the piercing line but in an inverse manner. It anticipates a bearish reversal and comprises two candlesticks: a red candle that opens above the preceding green body and closes below its midpoint. This pattern implies that bears have seized market control, resulting in lower prices. If the candle shadows are short, traders can anticipate a robust downtrend.
In addition to the bullish and bearish patterns that predict trend reversals, there are candlestick patterns that remain neutral or suggest the continuation of a trend, whether bullish or bearish.
These patterns include Doji, Spinning Top, Falling Three Methods and Rising Three Methods.
The doji candlestick displays an extremely small body and an elongated shadow. Although often interpreted as a pattern indicating the continuation of a trend, traders need to exercise caution, as it might also signify an upcoming reversal. To avoid confusion, consider opening a position a few candles after a doji when the market situation becomes clearer.
Similar to the doji, the spinning top is characterized by a candlestick with a concise body. However, in this pattern, both shadows are of equal length and are situated on either side of the body. This formation also points to indecision and could suggest a period of consolidation or rest following a notable price rally or decline.
Falling Three Methods
The falling three methods pattern is composed of five candles arranged in a specific manner, signaling the continuation of a downtrend. It encompasses an extended red body, followed by three successive small green bodies and another extended red body. The bodies of the green candles are all encompassed by the bearish reds, illustrating that bulls lack the strength to reverse the prevailing downtrend.
Rising Three Methods
Conversely, the rising three methods pattern is the antithesis of the preceding one and typically emerges during uptrends. This pattern involves an extended green candle, followed by three minor red candles, and then culminates with another long green candle.
How to Interpret a Candlestick Chart
Candlestick charts become more understandable with practice, as they offer a wealth of information about historical price movements. In addition to the previously discussed candlestick patterns, there are chart formations composed of multiple candlesticks arranged in specific ways. Examples include double tops and double bottoms, flags and pennants, among others.
Whether you're a novice or an experienced trader, reading a candlestick chart involves visually assessing the overall trend. These visual cues generally provide enough insight to help traders recognize particular patterns within the candlesticks and their configurations, particularly at resistance and support levels.
Common Terminology in Candlestick Charts
Here are several terms associated with candlestick charts to review whenever you engage in trading:
Emerging patterns: These are candlestick patterns that are still in the process of forming.
Completed patterns: These refer to patterns that have already materialized and can be seen as either bullish or bearish signals.
Open: The opening price of a candlestick.
Close: The closing price of a candlestick.
High: The highest price level reached during the candle's timeframe.
Low: The lowest price level touched during the candle's timeframe.
Advantages of Utilizing Candlestick Patterns
Candlestick patterns offer cryptocurrency traders enhanced clarity regarding potential market movements. Essentially, they serve as signals that assist traders in determining when to initiate long or short positions, as well as when to enter or exit the market. For instance, swing traders heavily rely on candlestick charts to identify indicators for swing trading, aiding in the recognition of reversal and continuation trading patterns.
Candlestick charts and their patterns assist traders in identifying trends, grasping momentum shifts, and gauging the prevailing market sentiment in real-time.
Strategies for Swiftly Memorizing Candlestick Patterns
To swiftly identify candlestick patterns, traders should familiarize themselves by closely observing charts and engaging in trades with small amounts of capital. A productive approach involves focusing on individual candle formations and analyzing them to recognize two-stick patterns.
Starting with one pattern and thoroughly mastering it will build confidence in swiftly identifying it amidst fluctuating prices.
Candlestick patterns should be a fundamental tool in the toolkit of every cryptocurrency trader, including those involved in day trading, due to their proven effectiveness, akin to their application in forex or stock markets.
While these patterns can provide valuable standalone trading signals, we recommend supplementing them with technical analysis indicators to either validate or invalidate their indications.