One of the oldest graphical tools that have been used effectively by traders for a number of years is something called a Japanese candlestick. These are helpful as they contain so much information about the graphical components of the price.
They are also really helpful for spotting trends in the price of the asset and what the next candle is likely to be. There are a number of patterns that people can observe from the candles which helps them determine what direction the price is heading in.
In this post we will go over some of the most important aspects of the candlesticks that can help improve your trading returns over the long run.
What is a Japanese Candlestick
Japanese candlesticks are a graphical representation of what has happened to the price of an asset over a period of time. They have the open, close, high and low prices on them. As such, the trader is able to get the best of the range that spread over the trading period.
They were initially introduced in 17th century Japan by rice traders who wanted to be able to plot the progression of the price. However, they only really started being applied to Forex trading in the 1950s in the US. They were studied by traders on the floor of the Chicago Mercantile Exchange.
How to Read a Japanese Candlestick
In the image below we have a picture of a Japanese candlestick. As you can see, there are two different types of candles. You have a bullish candle and a bearish candle. The bullish candle is green and the bearish candle is red.
A Bullish candle occurs when the closing price of the asset is above the opening price. This shows that the bulls in the market had more power in that period. The opposite can be said about the red candle.
Above and below this candle “body” you have something called the “wick”. This is essentially the difference between the closing /opening price and the max / min of the asset. This will give you an idea of the range that the asset has traded in.
Candlestick Formation Patterns
Of course, a single candlestick cannot give you the best guidance of what is likely to happen to the price of the asset over a certain period of time. This is where formation patterns can be the most helpful. These are a collection of two or more candlesticks in a time period.
They can either give an indication that the asset is likely to increase in price or the other direction. For example, in the image to the right we have something called a Bullish engulfing pattern. This is a small red candle that is completely engulfed by the green candle immediately after it. When the bullish engulfing pattern is observed the trader should try and enter a long trade. This is because the next candle is likely to also be green candle.
Of course, the opposite of this can be the bearish engulfing pattern where a small green candle is immediately overtaken by a large red candle. This will require the opposite trade.
Another really simple candlestick formation is that of the “Harami”. Essentially, a Harami formation will be small candle followed immediately after by a large candle. If you first have a large red candle and then a small green candle, this is a bullish Harami. If you have a large green candle and then a small red candle this is a bearish Harami. You can also have something called a “Haram cross”. This is just a simple Harami formation where the second candle is a star and not a full candle.
A Combination of Strategies
One cannot just use the candlestick indicators in isolation without studying the underlying trends and how they will impact the price of the asset. You will need to take a look at the other technical indicators such as Bollinger bands and the moving average lines. You can also use a range of option based strategies with these candlesticks.
It also helps to monitor how the candlesticks are behaving around important support and resistance levels of the asset. These could give a great indication as to how the price is likely to react by either breaking through the level or maintain the current status quo.
Irrespective of what indicators you are going to use to confirm your trading strategy you have to have the adequate risk controls in place that will allow you to either lock in your gains or stop your losses.