While investing in the stock markets, an investor is always on the lookout for the best stocks, which can help in maximising returns on investments. Profit-making through stock trading requires knowledge of stock analysis and identifying potential of different stocks. Intraday trading, especially, can be tricky for new investors who may not know when exactly they can book profits and when to cut losses. In this type of trading, the buying and selling of shares happens on the same day, and there are no open positions to be left at the end of the day.
To gain expertise in intraday trading, investors can leverage certain strategies which involve the use of data to learn about market trends, changing market sentiments, and overall momentum. One such strategy is technical analysis. It can help investors assess a stock’s price movements by looking at historical patterns to further predict its future prices. Technical analysis involves the usage of tools like Candlestick patterns. Read on to find out the meaning of technical analysis and all the details that beginners should know about Candlestick patterns.
What is technical analysis?
Technical analysis uses statistics to gauge the performance of a stock. This type of analysis focuses on:
- historical performance of a stock
- price movements and
- trading volumes
Technical analysis differs from fundamental analysis since the former makes use of historical and statistical data for predicting stock price trends.
While technical analysis focuses on various kinds of charts and patterns, one of the most commonly used tools is candlestick patterns.
What are candlestick charts?
Candlestick charts are graphs that represent the volume and direction of stock price movements.
The below-given picture of a candlestick chart shows its two main components:
- the wick and
- the main body
The wick / upper shadow
The wick of a candlestick chart is also called upper shadow. This is a thin line at the top of the candlestick’s body. It represents the highest and the lowest stock prices during a given period. The length of the wick or upper shadow reflects the range of stock price movement.
The main body
The candlestick’s main body shows the range between the opening and closing price of a stock. The upper end of the body is the opening price and the lower end is the closing price. The length of the body depicts the range of movement between opening and closing prices.
Different types of candlestick patterns
Stock price movements often create specific patterns which can be represented on candlesticks. Candlestick patterns help in assessing whether the stock price may increase or decrease and further make trading decisions.
Candlestick patterns are broadly categorised into bullish and bearish candlesticks to reflect market movements. Here, we will discuss both of these and further explore sub-categories of candlestick patterns.
These reflect rising stock prices and are usually green or white. Let’s understand some of the common bullish candlestick patterns:
This candlestick indicates bullish patterns with a short body and a long lower shadow. It is seen at the bottom of a downward market trend, signaling a bounce back of prices. This uptrend in prices is caused by a buying surge. A green body indicates a stronger bull market as compared to a red body.
Image Source – Dailyfx
A bullish engulfing candlestick pattern indicates bullish markets and a possible up move. It shows two candlesticks with the second candle’s body (large green) completely engulfing the first candlestick (shorter red).
The pattern shows that the bullish market condition is pushing the prices up despite a lower opening on the previous day. Such patterns are mostly seen at the end of a market consolidation phase.
Image Source – Howtotradeblog
The Morning Star pattern is made up of 3 candlesticks:
- Bearish candle (long red body) – it shows the continuation of the downtrend
- Doji (short red body) – this indicates indecision prevailing in the market
- Bullish candle (long green body) – shows return of the bulls in the market and indicates possible reversal
This pattern is formed after a downtrend, indicating bullish reversal.
It usually does not see an overlap between the three candles. This indicates a reduction of selling pressure and the start of a bull market.
Image Source – Learnstockmarket
These patterns reflect declining stock prices and are mostly in red or black. Here are the common types of patterns under this category:
Hanging Man pattern
Hanging Man is a single candlestick seen at the end of an uptrend. It indicates bearish reversal with a small body and a shadow that is twice the real body. This candlestick pattern shows no or little upper shadow.
The market sentiment seen through this candlestick pattern is that the prices are being pushed down by the sellers. As the buyers enter the market, they push the prices up but with little success. This results in the prices closing below the opening price.
Image Source – Dailyfx
Evening Star pattern
The Evening Star pattern involves multiple candlesticks formed after an uptrend. This indicates bearish reversal. The 3 candlesticks in this pattern are:
- a bullish candle (long green) – this shows continuation of an uptrend
- doji (short red) – indecision in the market
- bearish candle (long red) – indicates arrival of the bears and reversal is expected
There is generally no overlap between the short and the long candles, indicating a reversal of an upward trend. This is further highlighted if the third candle exceeds the gains of the first candle.
Image Source – Chart formations
‘Harami’ in Japanese means ‘pregnant’. This pattern comprises two candlesticks:
- tall bullish candlestick (reflects continuation in bullish trend)
- small-bodied bearish (return of the bears)
In this pattern, the small bearish candlestick is seen enclosed under the tall candlestick’s body. This pattern is seen at the peak of an uptrend and indicates a reversal in the stock price trend.
Source – Learnstockmarket
How can a beginner analyse candlestick charts?
- Price range:
Every candlestick pattern body reflects the opening and closing stock prices during the selected trading period. Those starting off newly in the stock markets can look at the price range of a selected stock using these patterns.
- Rise or fall in prices:
The colour of a candlestick tells investors whether the stock prices are on the rise or falling down. Consecutive reds indicate that prices have been continuously falling, whereas consecutive greens indicate rising prices for the said period.
- Price highs and lows:
The upper and lower body of the candlestick are vertical lines that reflect the highs and lows of the stock price. Here is how to read the price highs and lows through these lines:
- A short upper line on a red body indicates that the opening stock price was near the day’s high.
- A short upper wick on a green body indicates that the stock price closed near the day’s high.
Thus, a combination of the size and colours of the candlestick reflects market sentiment of the said stock.
Once an investor knows how to read candlestick patterns, it’s easy to identify market movements, specifically for the selected stock. While technical analysis comprises a lot more than just candlestick patterns, it is important for a beginner to learn such basic methods of analysing a stock for improved and informed decision-making.
Yes, you can use a combination of both fundamental and technical analysis to identify undervalued stocks. While fundamental analysis tells you about the company and its industry, technical analysis helps in evaluating the fair value of an undervalued stock.
The time required on technical analysis of stocks depends on your investment horizon, quantum of investment, and return expectations. If investing for the long term, it is advisable to also spend time on fundamental analysis to know better about the company.
There is no perfect timing to enter the markets and depends on your investment strategy. While investing in stocks during rising market scenarios, you must be careful about the stock selection to ensure that you do not end up paying more for the stocks.
Candlestick patterns are best used in combination with other measures of technical analysis. This helps in covering all aspects while analysing a stock to ultimately make an informed investment decision.
The three main features of every candlestick pattern are its size, colour, and wick or shadow.