Candlestick formations – The display of price information
There are many different ways that a trader can have access to the price of an asset. In the Forex market, the most common ways that traders monitor the movements of exchange rates are by using line graphs, bar charts, Renko charts, tick or ticker tape charts. And one of the most popular ways of deciphering price movements is the Japanese candlestick.
Let’s look at some examples of exchange rate price action via three commonly used technical analysis tools.
Example ‘A’ is a basic line graph of the daily time frame of the GBPUSD pair, as denoted in the top left-hand corner of our chart. Time frames are shown here too. At the bottom of the chart along a horizontal axis, we can see time and the date, and the exchange rate of this pair is shown in the vertical axis on the right-hand side of the chart.
The line graph converts the price action of a currency pair onto a continuous line on a chart. As you would expect, the line goes up and down and sideways. However, just by looking at the line graph alone, it would appear to be almost impossible to try and ascertain future movements by this tool.
Example ‘B’ is the same daily time frame of the GBPUSD pair, but this time we are looking at a bar chart. Each bar opens at the beginning of the given timeframe, and in this case, opens and closes every 24 hours. Each bar consists of three lines: A vertical line to the left of the horizontal line, which denotes the opening of the bar; the vertical line which tells the trader the up-and-down movement of price action during this time frame; and another horizontal line to the right of the vertical which tells the trader where price action finished.
Let’s now turn our attention to example ‘C’: The Japanese candlestick. Each candlestick opens and closes along a vertical line. Again, this is the daily time frame of the GBPUSD pair. The candlestick offers a much greater visual representation of the exchange rate and therefore presents many opportunities to a trader with regard to potential future trends. The Japanese candlestick is the most widely used technical tool used by traders across the globe.
Japanese candlesticks were invented in the early 15th century by the Japanese government of the time. They were used to record price movements on Japan’s rice exchange. At this time, rice was not only the primary dietary staple, but it was also a unit of exchange.
Example ‘D’ is a typical candlestick shape that traders see regularly on their charts. We have marked the points where the candlestick opened and closed. If the candlestick closes above the exchange rate at the point of which it opened, it is considered to be a bullish candlestick. If it closes below the exchange rate at the point of opening, it is considered to be bearish. Candlesticks can also open and close at the same exchange rate.
However, in this example of a bullish candlestick, we can see a wick at the top of the candlestick and also one at the bottom. Therefore, a trader can determine that after opening, price action initially falls before reversing and rising to the top of the time frame, before falling again back to the close. In this case, we have two wicks, one at the top and one at the bottom. A trader can tell the total exchange rate covered by the candlestick by measuring between the low and the high points and also see pullbacks and reversals. The same principle applies to a bearish candlestick where price action is measured over the whole length of the candlestick, but where traders easily identify the opening and closing of price action for each time frame.
Each candlestick will have a different sized body and wicks dependent on the amount of volume going through at any given time. The basic principle is that the longer the body and the shorter the wicks, the stronger the volume. Traders are able to read the many different types of candlesticks, which are all given names, in order to depict the strength of a trend and volume in the market at any given time, and these will help them to predict trend formations, reversals, and consolidation of the exchange rate of any particular pair.
Diagram ‘E’ provides us with a snap-shot of a 1-hour chart of the GBPUSD pair, where candlesticks are used to show price action. In section ‘A’ of the diagram, we can see that the price action is fairly flat and trading in a sideways motion. However, candlestick number 1 pushes below the trend line and forms the basis of a downward move. The candlestick is also bigger than those preceding it, and the wick at the bottom is small, denoting strong volume to the downside.
After a period of uncertainty, price action becomes stronger to the downside, as denoted by the large candlesticks numbered 2 and 3. Price action continues the downward trend, however buyers push up price action at number 4, which is called a reversal hammer, and where indeed price action reverses to section ‘B.’ We now have a series of smaller candlesticks which denotes a thinning in volume, and where we can see some candlesticks open and close at the same exchange rate, telling traders that neither the buyers or sellers are in control at this particular moment in time.
Candlestick number 5 tries to push the trend to the downside, but reverses and forms a reversal hammer shape, and where we subsequently see price action move to the upside as per candlestick number 6 and 7. But we then see a trend reversal in candlestick number 8, which becomes an engulfing candlestick because it is larger than both 6 and 7. The strength of this candlestick denotes a potential increase in price action to the downside by taking out the previous two candlesticks, and we see further movement to the downside before price rises again. Incidentally, we have another price reversal hammer in section A where we have placed an X.
Here at Forex.Academy, we strongly recommend that you learn as many candlestick formations as possible because they are very commonly used within the trading community, and therefore this will give you an edge in your trading.