Candlestick PatternsExplained [Plus Free CheatSheet]

Trading without candlestick patterns is a lot like flying inthe night with no visibility. Sure, it is doable, but itrequires special training and expertise. To that end, we’ll becovering the fundamentals of candlestick charting in thistutorial. More importantly, we will discuss their significanceand reveal 5 real examples of reliable candlestick patterns.Along the way, we’ll offer tips for how to practice this time-honored method of price analysis.

Also, feel free to download our Candlestick Pattern QuickReference Guide!

Why Do Candlestick Patterns Matter?After all, there are traders who trade simply with squigglylines on a chart. Astonishingly, some don’t even look at thecharts! Instead, they pay attention to the “tape” — the bidsand offers flashing across their Level II trading montage likenumbers in The Matrix.

A Level II montage. Source: CenterPoint Securities

No doubt, there are countless ways to make money in the stockmarket. In fact, there is no right or wrong way to read achart. But unless you are just a gambler, you need some formof data to make informed decisions.

We believe the best way to do this is by understandingcandlestick patterns.

For newer traders, even reading candlestick charts can seemlike an insurmountable learning curve. There appears no rhymeor reason, and no end to the amount of price and volume data

being thrown your way.

It’s daunting, for sure. Especially when you’re just gettingstarted.

But be of good cheer! There is a method to the madness. Themethod is in the patterns. The patterns reveal probabilities.And the right probabilities create opportunities.

More importantly, the right opportunities can create profits.

This is where candlestick patterns come in handy. They help usto decipher the patterns of the market. They’re like littleroad signs on crowded streets. And with enough repetition,enough practice, you just might find yourself a decent chartreader.

That’s why you’re here, right? To learn to navigate the murkywaters of the market?

Trust us, it is a worthwhile endeavor.

Who Discovered the Idea ofCandlestick Patterns?

Munehisa Honma, 1724-18031

According to Investopedia.com, it is commonly believed thatcandlestick charts were invented by a Japanese rice futures

trader from the 18th century. His name was Munehisa Honma.2

Honma traded on the Dojima Rice Exchange of Osaka, considered

to be the first formal futures exchange in history.3

As the father of candlestick charting, Honma recognized theimpact of human emotion on markets. Thus, he devised a systemof charting that gave him an edge in understanding the ebb andflow of these emotions and their effect on rice future prices.

Honma actually wrote a trading psychology book around 1755

claiming that emotions impacted rice prices considerably.4

When all are bearish, there is cause for prices to rise.

Munehisa Honma5

In recent history, Steve Nison is widely considered theforemost expert on Japanese candlestick methods. After all, hewrote the book that catapulted candlestick charting to theforefront of modern market trading systems.

Beyond Candlesticks: New Japanese Charting TechniquesRevealed, is one of his most popular books and a definitiveresource for candle patterns.

Since the 90s, this method of charting has become pervasivethroughout all financial markets: equities, futures, forex,and more.

In his books, Nison describes the depth of information foundin a single candle, not to mention a string of candles thatform patterns. It truly puts the edge in favor of a skilledchartist.

The Story That Candlesticks Tell

Emotions and psychology were paramount to trading in the1700s, just as they are today. This is the foundation of whycandlesticks are significant to chart readers.

How so?

Every candle reveals a battle of emotions between buyers andsellers.

As the great trading psychologist Brett Steenbarger notes,“proper training is the best source of discipline and the mosteffective safeguard against intrusive anxiety andimpulsivity.”

With this in mind, understanding the emotional story withincandlesticks is a great place to start that training.

How are Candlesticks Formed?There are three types of candlestick interpretations: bullish,bearish, and indecisive. This is painting a broad stroke,because the context of the candle formation is what reallymatters. But for all intents and purposes, we’ll stick withthese three categories.

The elements of a candlestick

What Is a Candlestick?The formation of the candle is essentially a plot of priceover a period of time. For this reason, a one minute candle isa plot of the price fluctuation during a single minute of thetrading day. The actual candle is just a visual record of thatprice action and all of the trading executions that occurredin one minute.

Similarly, a daily or weekly candle is the culmination of allthe trading executions achieved during that day or that week.

The open tells us where the stock price opens at the beginning

of the minute. The close reveals the last recorded price ofthat minute. The wicks (also known as shadows or tails)represent the highest and lowest recorded price from the openand close.

According to Nison, the Japanese placed much less emphasis onthe highs and lows of individual candles. For them, as it isfor modern technicians, the opening and closing prices were

more relevant.6

Essentially, the broader context of candles will paint thewhole picture.

What Is a Bullish Candle?A bullish candle is formed when the price at the closing ofthe candle is higher than the open. This can be on any timeframe: from a 1-minute candle to a 1-month candle. It will allbe the same.

A bullish candle opens low and closes high.

Typically these candles close with a green or white bodycolor, though most charting platforms allow for customizationthese days.

What Is a Bearish Candle?Conversely, a bearish candle is assumed when the closing priceis lower than the opening price. In other words, the pricedropped in the amount of time it took for the candle to form.

A bearish candle opens high and closes low.

By default, most platforms will show a red or black candle asbearish.

What Does the Candle Formation TellUs?This is the real question we need to ask ourselves. It isn’tenough to know that the candle opened and then closed lower,or vice-versa.

As renowned trader and best-selling author Dr. Alexander Elderexplains, “The main advantage of a candlestick chart is itsfocus on the struggle between amateurs who control openings

and professionals who control closings.”7

Dr. Elder may be referring to daily candles, but his point isstill important. The candle represents a struggle between

buyers and sellers, bulls and bears, weak hands and stronghands.

Armed with that knowledge, let’s dig in and see what picturethose little candles are trying to paint for us.

The High of the CandleThe high of each candle, whether it is the tip of the wick atthe top, or if the body closes at the top, represents themaximum effort of bulls. If it is a daily candle, buyers couldnot push the price of the stock one cent more during that day.

Why is that important? There are two reasons:

This could represent a near term level of resistance1.which will have to be broken for the price to movehigher.

In order to find enough demand to push through that2.resistance, the stock may need to consolidate loweruntil enough shares are accumulated.

The Low of the CandleJust as the high represents the power of the bulls, the lowrepresents the power of the bears. The lowest price in thecandle is the limit of how strong the bears were during thatsession.

Why is this important? Again, two reasons:

This could represent a near term level of support where1.bulls were able to stop the downward momentumTo move lower, more supply may need to enter the market2.at higher prices.

The Closing Price of Each BarThis is where the story gets interesting.

When a candle closes above its opening price, we can assumethat the bears won in some form or fashion. How much it closesabove the open tells us with what intensity the bulls were incontrol during that session.

Let’s look at few examples to better understand this:

In this chart, we see the “Three White Soldiers,” which is acandlestick pattern describing three bullish candlesticks in arow. What can we interpret from this?

Three White Soldiers candlestick pattern

It is clear to see that the candles open low and close high.Bulls were clearly in control during each session with verylittle energy from the bears.

Now contrast that with what we see in the next example. Askyourself, who was in control during this session?

Apparently there is indecision as to who is in control. How dowe know? Think about the story behind this “Spinning Top”candle:

The stock opens, proceeds lower as bears are in control fromthe open, then rips higher during the session. But afterputting in a decent high, the bulls settle back and give thebears some control into the close.

Are you beginning to see how the story unfolds?

These are the stories that candles tell us on charts. Who isin control (greed), who is weak (fear), to what extent theyare in control, and what areas of support and resistance areforming.

The Range between the Open and ClosingPriceThis is one of the most important aspects of interpretingcandles. As Dr. Elder notes, the range between open and close

“reflects the intensity of conflict between bulls and bears.” 8

In day trading, momentum is everything. On this token, thecharacter of the candles can tell us if there is demand or ifa stock is sleepy and uninteresting — whether we are about tolaunch, fall off a cliff, or just grind sideways.

Additionally, the nature of the candles can tell us when toenter with tight risk. Or, when to take profits into climacticcandles.

In the end, it all boils down to context and the story ofbuyers and sellers behind the tape.

5 Real Examples of Reliable Candle

PatternsWithout practice, none of this information really matters. Ittakes screen time and review to interpret chart candlesproperly. There are no free lunches in the markets.

With that being said, let’s look at some examples of howcandlestick patterns can help us anticipate reversals,continuations, and indecision in the market.

1. The Hammer / Hanging Man

The Hanging Man is a candlestick that is most effective afteran extended rally in stock prices. The story behind thiscandle tells us that there were extensive sellers in theformation of the candle, signified by the long wick.

It is usually accompanied by heavy volume.

The Hanging Man appears at the top of an extended uptrendbefore reversing.

The Hammer is another reversal pattern that is identical tothe The Hanging Man. The only difference is the context. TheHammer occurs at the end of a selloff, signifying demand orshort covering, driving the price of the stock higher after asignificant selloff.

Like the Hanging Man, you want to see a solid volume signatureassociated with these candles.

Hammer candles appear at the bottom of a downtrend before areversal

2. Engulfing PatternsEngulfing patterns offer a great opportunity to go long whilekeeping risk defined to a minimum. As you can see in theexample below, the prior bearish candle is completely“engulfed” by the demand on the next candle.

A bullish engulfing candle at the market open.

Another example of engulfing patterns is the Bearish EngulfingSandwich. Here we have what appears to be a bearish reversal,but the next candle completely swallows the supply from thatred candle:

A bearish engulfing sandwich pattern, also know as a sticksandwich

3. The Morning StarThe Morning Star is yet another reversal signal. It can befound at the end of an extended downtrend or during the open.It takes 3 candles to confirm the setup.

The first candle must be a strong downtrending candle.1.

The second candle is the star. It’s usually a narrow2.body candle that, ideally, does not touch the body ofthe prior candle.The third candle is a strong bullish candle confirming3.the new uptrend.

The morning star candlestick pattern at the open

4. The Evening StarSimilar to the Morning Star, the Evening Star is its bearishcousin. It forms at the top of parabolic or extended bullishruns. Much like the Morning Star, the body of the candlesshould not touch.

Here are three criteria for spotting the shooting star:

The bodies do not overlap1.

The third candle is a strong bearish candle closing into2.the body of the first candleVolume should increase from left to right in the pattern3.

The Evening Star candlestick pattern on GME

As with all of these formations, the goal is to provide anentry point to go long or short with a definable risk. In theexample above, the proper entry would be below the body of theshooting star, with a stop at the high.

5. Indecision CandlesThe doji and spinning top candles are typically found in asideways consolidation patterns where price and trend arestill trying to be discovered.

Indecision candlestick patterns

The “doji’s pattern conveys a struggle between buyers andsellers that results in no net gain for either side,” as notedin this great article by IG.com.

Will it continue upward? Go sideways? Or reverse?

With indecision candles, we typically need much more contextto answer these questions.

The Gravestone Doji is a perfect example of this:

Gravestone Doji candles can represent indecision on a chart.

Note the trend is mostly sideways in this first circledexample. For this reason, waiting for the reaction to thesecandles is usually best for risk management.

Eventually, the price falls in this particular case as thetrend becomes more extended into the rally. Correspondingly,the Shooting Star that occurs just beyond the Gravestone Dojiis confirmation of that falling price action.

The Best Way to Practice withCandlestick PatternsAs always, it is best to practice a strategy before puttingmoney to work in the market. There is no better way to do thisthan with a simulator.

One of the best methods to train your “chart eye” to see thesepatterns is to simply replay the market, noting each time yousee a particular candle.

As you put in deliberate practice, ask yourself the followingquestions:

What candle formation is this?What is the context? Uptrend? Down trend? Sideways?Does this candle meet the criteria for a properreversal?Where could I enter with the least amount of risk?What would confirm the pattern?

We have a wealth of knowledge on many different candlestickpatterns, so be sure to check out those lessons, too!