In this article, we’ll cover everything you need to know about Japanese Candlesticks, plus how to recognize the various patterns they create.
Technical analysis is a trading discipline that calculates investments and identifies trading opportunities. It closely analyzes statistical trends that draw from trading activity, like price movement and volume. Technical analysts’ primary focus is on patterns of price movements, trading signals, and various other analytical charting tools. The purpose of this is to determine the strengths and weaknesses of a security.
In technical analysis, there is a popular tool that goes by the name of ‘candlestick’. This is a specific type of price chart analysts use that display an array of security prices. To be specific, these prices are the high, low, open, and closing prices of a security for a particular period. Its origins trace back to Japanese rice merchants and traders, allowing them to record market prices and daily momentum. All of this was possible hundreds of years before it would become popular in the United States.
This tool condenses data for an array of time frames into a series of single price bars. Thus, it makes them considerably more useful. This is especially true if you compare them to traditional open-high, low-close bars. Moreover, they are more useful than lines that connect the dots of closing prices. Japanese candlesticks effectively create patterns that forecast price direction upon completion.
The wider section of the candlestick is the ‘real body’. It informs investors as to whether the closing price was higher or lower than the opening price. Speaking in visual terms, it is black/red if the stock was lower upon closure. Conversely, it is white/green if the stock was higher.
Its basic shape and its Japanese origins give this tool the name ‘Japanese Candlesticks’.
Breaking down the basics of Japanese Candlesticks
The shadows of the candlestick display the high and low points of the day. In addition, they show how they compare to the open and close. A candlestick’s shape will vary depending on the relationship between the high, low, opening, and closing prices of the day.
Japanese candlesticks are indicative of the overall impact that investor sentiment has on security prices. What’s more, technical analysts find them to be useful when determining when exactly to enter and exit trades.
Candlestick charting draws its foundation from a technique that came to be in Japan in the 1700s. At this point in time, it was utilized for keeping track of the price of rice. Candlesticks are an applicable technique when it comes to trading any liquid financial asset. These assets can be anything from stocks to futures to foreign exchange.
Candlesticks that are long and white/green indicate that there is a strong buying pressure. Therefore, the price is bullish. However, one should look at them in the context of the structure of the market rather than individually.
For instance, a long white candle is more likely to possess comparatively more significance should it form at a major price support level. Candlesticks that are long and black/red are indicative of significant selling pressure. Therefore, it suggests that the price is bearish.
A conventional bullish candlestick reversal pattern (aka. a ‘hammer’) assembles whenever price moves lower following the open. Afterward, it mobilizes to a close near the high. The bearish candlestick equivalent to this is a ‘hanging man’. These particular candlesticks have a very similar appearance to a square lollipop. Moreover, traders frequently use them when trying to pick a top or bottom in a market.
From here, let’s transition into going over the primary candlestick patterns.
The main patterns
Drawing from prior research and back-testing, there are a total of five notable candlestick patterns. These patterns provide exceptional performances when functioning as harbingers of both price direction and momentum. The patterns of Japanese candlesticks operate within the context of surrounding price bars in high or low price predictions.
Probably the most accurate of candlestick patterns fall into two categories: reversals and continuations. Candlestick reversal patterns forecast a change in price direction. Conversely, candlestick continuation patterns predict expansion in the current price action.
Most of the time, cryptocurrencies have a tendency to possess a strong upside bias. This is important to remember, especially for traders wishing to use candlestick formations to improve their trading skills. These traders should focus on chart patterns that are prone to predicting either bottoms or a continuation of the uptrend.
The five bullish Japanese candlestick patterns that investors should concentrate on during, for example, Bitcoin’s historic bull market rally, are:
- The Hammer
- The Bullish Engulfing Pattern
- The Piercing Line
- The Morning Star
- The Three Soldiers
1 – The Hammer
A hammer occurs whenever a security trades significantly lower than its opening. However, it rallies within the closing period near the opening price. This pattern creates a candlestick in the shape of a hammer. The basic formation is that the lower shadow is, at the very least, twice the size of the real body. The body of the candlestick as a whole is representative of what differentiates the open and closing prices. The shadow, meanwhile, illustrates the high and low prices for the period.
2 – The Bullish Engulfing Pattern
The bullish engulfing pattern is a two-candle reversal pattern. The intent of the second candle is to ‘engulf’ the real body of the first one. It does so without any regard to what the length of the tail shadows may be.
The bullish engulfing pattern makes itself visible in a downtrend. Furthermore, it is a combination of one dark candle and then by a larger hollow candle. On the pattern’s second day, the price will open lower than the previous low. However, buying pressure will push the price up to a higher level than the previous high. This will effectively culminate in a complete win for those who are purchasing.
3 – The Piercing Line
Similar to a bullish engulfing pattern, a piercing pattern is a two-candle pattern. It’s a two-day formation that identifies a potential short-term reversal from a downward trend to an upward trend. The pattern includes the first day opening near the high, as well as closing near the low. Moreover, it closes with an average or much larger trading range. It also contains a gap down following the first day.
This is where the second day commences trading, opening near the low and closing near the high. The close needs to be a candlestick that covers at least half of the upward length of the previous day’s red candlestick body.
4 – The Morning Star
A morning star is a visual pattern that consists of three candlesticks. It is largely seen as a bullish sign in the eyes of technical analysts. The formation of a morning star occurs after a downward trend and it’s indicative of an upward climb. It functions as something of a sign that there will be a reversal in the previous price trend.
Traders keep an eye out for a morning star’s formation before seeking validation that a reversal is occurring. They do so by utilizing additional indicators. To put simply, this pattern is a sign of hope during a particularly gloomy downtrend.
5 – The Three Soldiers
Alternatively ‘The Three White Soldiers’, this is a bullish candlestick pattern helps predict the reversal of the current downtrend. The pattern largely consists of three consecutive long-bodied candlesticks.
These candlesticks open within the previous candle’s real body and a close that surpasses the high of the previous candle. They should not have long shadows and they should ideally open within the real body of the preceding candle. This pattern is typically detected either following a downtrend period or in price consolidation.
Fibonacci Retracement Trading
There is an array of ways to use Japanese candlesticks in charting techniques. Among the more frequently used techniques is combining candlestick patterns with Fibonacci retracements.
The levels in Fibonacci retracements in the context of trading are not actually numbers in the sequence. In lieu of this, they derive from mathematical relationships that exist between numbers in the sequence. The foundation of the ‘golden’ Fibonacci ratio of 61.8% stems from dividing a number in the Fibonacci sequence by the previous number.
The depiction of Fibonacci retracement levels is done so by identifying high and low points on a chart. From there, you mark the key Fibonacci ratios of 23.6%, 38.2%, and 61.8% horizontally. Doing so will effectively produce a grid. These horizontal lines are useful when it comes to establishing potential price reversal points.
Fibonacci retracements often function as part of a strategy in trend-trading. In this particular scenario, traders monitor a retracement taking place within a trend. They will then attempt to make low-risk entries in the direction of the initial trend by utilizing Fibonacci levels. Traders that employ this strategy generally anticipate a specific outcome. That being that the price will likely bounce from the Fibonacci levels back into the direction of the original trend.
Fibonacci retracements are a common strategy on a variety of financial instruments. These include – among others – stocks, commodities, and foreign exchange. They are also frequently used on several time frames. Be that as it may, similar to other technical indicators, the predictive value is comparable to a specific time frame. Moreover, with greater weight given to time frames that are longer.
Support & Resistance
Another powerful Japanese candlesticks charting technique is trading support and resistance. It is important to note that this technique is also beneficial when you combine it with other techniques.
Keep in mind, though, that your success rate with trading support and resistance depends on one particular thing. That being your ability to select significant levels. Choosing support and resistance levels is far and away one of the most subjective aspects when it comes to trading. In a way, the selection is more of an art than it is a science.
For contextual purposes, let’s briefly go over what exactly support and resistance are.
‘Support’ is indicative of the price level that an asset does not drop below for a period of time. The creation of an asset’s support level is thanks to buyers entering the market whenever the asset’s price declines. In technical analysis, one can chart the support level by way of drawing a line alongside the lowest lows for a certain time period.
‘Resistance’ refers to the price point where the rise in the asset price comes to a halt. The reason for this halt is the emergence of a growing number of sellers who want to sell at that price. Resistance levels can often have a short lifespan if new information comes along to change the market’s attitude toward the asset. There are times, however, when they can be enduring.
To learn more about support and resistance, check out “A Practical Guide to Support and Resistance.”
An oscillator is another common tool in technical analysis. A technical analyst bands an oscillator between two extreme values. Following this, they then construct a trend indicator by drawing from the results. The analysts will use the trend indicator as a means to identify short-term overbought or oversold conditions.
‘Oscillator divergence’ is an occurrence in which the price is moving in the opposite direction of a momentum oscillator. A better way to describe this is with the application of physics terms and a familiar setup. By throwing a ball up in the air, it will lose momentum before it inevitably reverses direction.
This is basically how reversals can transpire in the stock market. Momentum will slow down prior to a stock price reversal. Divergence may present itself when the momentum is starting to slow and a potential reversal is imminent. While not all price reversals are forecast by divergence, many still are.
Divergence is an ideal starting point when it comes to conducting a trade. Divergence does not always have to be present. However, if divergence is present, the candlestick patterns will likely be exceptionally more powerful. Moreover, there is a high chance that it will lead to better trades.
Besides using oscillators for trading divergence, you can use some of them for an additional reason. If you remember, you can use them to determine whether or not the current price is overbought or oversold. This in and of itself is a simple Japanese candlestick charting technique. Still, it can be quite sufficient in distinguishing strong candlestick patterns.
All in all, Japanese candlesticks are an incredibly beneficial tool for cryptocurrency traders. Their general appeal stems from just how reliable they are and their ever-growing success rate.