What are candles in the stock market

Trading candles: the 7 most important candle patterns

Day traders and swing traders use candle formations in trading for entry and exit. Get to know the 7 most important candlestick patterns.

 

There are many candle formations, but only a few of these trading candles are really noteworthy. Here are 7 trading candles that are worth paying attention to in the context of chart technology or trading indicators.

First, a quick look at the origins of the candle charts.

A Japanese rice trader named Munehisa Homma developed the candle formations based on his records of prices on the Japanese rice exchange over several years.

It was very clear to him that with the help of this visualization he was able to make fairly accurate forecasts of future price developments.

This procedure has also manifested itself in the stock market world since the 1980s.

The nice thing about the candle representation is that I can read the price development in the observed time unit from the candle formation. I also learn a lot about volatility and the current trend.

Let's see how that works now.

What does this candle body tell me about the course of the course?

We now want to take a look at what a closed candle reveals to me about the price trend.

Before that, however, I would like to point out that I can display a candle in any time unit (depending on the chart software).

The candle then represents exactly this selected period.

Each chart software will show the candles in two different colors. Here I have chosen green and red, privately I sometimes use blue and white or black and white.

The different colors show me whether the price of the underlying asset has risen or fallen in the period under review, or whether it has closed positively or negatively.

First of all, let's take a look at the left, i.e. the red candle.

The candle opens in point 1. Here the first course of the new period is determined. The price then finds its high point in this period (point 2) and then falls back to point 4, where it finds its low point in this period.

From this he can recover a bit and finally closes at point 3. The candle is negative, which means that the closing price of the period is below the opening price.

Now let's look at the right one, i.e. the green one.

You can see that the range and the highs and lows for the left candle are identical. The difference lies in the opening and closing prices.

The candle here closes positively, so the closing price must be above the opening price. This difference to the previous candle is only revealed by the different color.

 

How can I trade on the basis of the trading candles?

In order to be able to trade on the basis of the candle formations, you have to set your chart software accordingly in the first step. The chart of an underlying asset is shown as a line by default and we can't do much with that.

Remember, these patterns are only useful if you understand what is happening in each pattern.

I can display the candles in different time units. When I look at a 4h candle, I can see the opening price, closing price, high and low point, but I don't know much about the course within the 4 hours.

Day traders and scalp traders in particular therefore use lower time units such as the 5-minute or 15-minute chart.

The following picture illustrates the relationship.

Here you can see that the upper 10-minute chart shows us a downward trend that we cannot directly see in the 4-hour chart of the identical underlying.

Now that we have developed a basic understanding of trading candles and time units, let's look at individual candle formations.

But why are we actually doing this?

Very easily. Like the Japanese rice trader mentioned above, we traders also want to be able to anticipate the future price development of a security or derivative.

Expressed differently:

If we knew where the price of an underlying asset would be in a minute, an hour, a week, etc., we would have taken care of tomorrow ... Well, the good old subjunctive.

Since none of us knows where the prices will move in the future, we want to at least guess the approximate direction using the candles and thus improve our risk-reward ratio for a trade.

So make it clear to yourself that one of the following candle formations should never be the sole reason for a trade.

To increase the likelihood of a winning trade, you need to combine the interpretation of the trading candle with other forms of charting technique such as support and resistance or Fibonacci retracements.

It also makes sense to compare the individual time units.
The rule of thumb applies here:

The higher time unit (e.g. hourly chart) is more valuable than the lower time unit (e.g. minute chart).

In the minute chart, there are more fakes than in the hourly chart. That's why I compare the current trend in the 1-hour chart from the 15-minute chart before every trade. Only if both point in the same direction (long or short) do I enter the trade.

 

Which candle patterns are there in trading?

The following candle formations are divided into two parts: Bullish Trading Candles and Bearish Trading Candles.

Their respective shape should give us clues as to whether the price is likely to rise or fall in the near future.

We start with the first bullish candle formation.

Bullish engulfing

This pattern consists of two candles. The first candle tells us nothing about the pattern, other than that the downtrend is still intact. The second candle then practically "devours" the previous candle. The buyers have overwhelmed the sellers (demand is greater than supply) and now want to initiate an upward trend.

So here we see a potential trend reversal, from short to long. Traders who want to trade on the basis of the pattern position themselves long after completing the second candle (i.e. with the third or fourth candle).

Bearish engulfing

Bearish engulfing is the exact opposite of bullish engulfing. It marks the potential end of an uptrend and initiates a downtrend.

The second candle opens with a gap up, encloses the first candle again and then ends in the negative area.

hammer

The hammer should also signal an impending trend reversal. The hammer appears at the end of a downtrend. Ideally, this candle has high momentum and a long wick. This means that volatility was high during this period and many buyers came in at the low point who pushed the price back up.

Note: a hammer is sufficient to provide this signal. In the picture I took a second hammer with me to show that both a positive closing price and a negative closing price (red) count as a hammer.

For example, hammers can occur in significant support areas. Various stop losses are then triggered there, which the big boys use for a long entry due to the healthy liquidity. In this post here you can examine the topic of Stop Loss Fishing.

Inverted hammer

The inverted hammer has the same requirements as the "normal" hammer. However, the trend direction is exactly the opposite. The Inverted Hammer occurs at the end of an uptrend and signals a possible reversal to a downtrend.

Again, a hammer candle is sufficient to deliver the signal, but both candle types shown (red or green) can occur.

Hanging Man

Caution: risk of confusion! The Hanging Man looks exactly like Hammer and Inverted Hammer, but the trend is different.

The following picture illustrates the difference between Hanging Man and hammer Candle. The hanging man marks the end of an uptrend, while the hammer marks the beginning of an uptrend. The reverse is also true for the Inverted Hammer.

Doji

The (or that?) Doji is also a reversal formation. The doji is probably the most popular candle pattern in stock market trading.

The underlying does not really want to move in the period under review and closes directly at or near the opening price. It represents indecision on the part of the market participants and possibly a low trading volume. Some traders have doubts about the continuation of the current trend, which in the case of a large majority then leads to a trend change.

The formation shown is also known as the Morning Doji Star and symbolizes a potential turnaround.

Kicker

A "kicker" is sometimes referred to as the strongest candle pattern of all. You can see in the graphic above why this pattern is so explosive. Like most candle patterns, there is a bullish and a bearish version.

In the bullish version, the underlying moves down and the last red candle closes at the bottom of the range. Then the next period begins with a clear gap up and closes above the last candle.

;

This "shock event" forces small sellers to hedge or sell and bring new traders to the long side. Often times, market-moving news released after the market closes is the key to this candlestick pattern. This is exactly the opposite in the bearish version.

 


 

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When is the best time to start the trade?

Now that you have gotten to know some trading candles and will now “screen” the charts of DAX, Dow and Co full of euphoria, I would like to go back to the meaning of the candle formations.

We often see a trend change based on these patterns. Of course, as traders, we want to be there as early as possible and anticipate the change in trend.

A mistake that I made very often at the beginning is trading a “possible” candle formation. This means that I did not wait for the closing price and entered the market much too early (often without comparing the time units).

For example, I once recognized a hammer at the end of a downtrend in the 1-hour chart at 2:20 p.m., but at 2:59 p.m. it became a very long red candle. It could hardly be more bearish.

So it makes sense to wait for the end of the period and, if necessary, for the follow-up candle. The danger of course is that the course will have run away from you by then.

So it is important to be as patient as possible and still not miss half of the upcoming movement.

I can also use the candle formations as an exit signal. If I have traded a downward trend and after a while a Doji appears, then it may be a good idea to make a (partial) sale. The stop loss can also be adjusted based on the trading candles.

Remember again that you shouldn't use the candle formations alone as a trade reason. Depending on the underlying, you can combine the fundamental data and the sentiment or indicators from chart technology with the candlestick patterns.

I wish you every success!

Tim Grueger

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