Does candlestick chart analysis work?

Many people new to the short-term/day-trading arena assume that technical analysis is a relatively recent phenomenon. However, you would be surprised when it comes to systems such as the candlestick charting analysis method!

 

Where did the candlestick charting system originate?

 

This is a system which originated in 18th century Japan. It was created by Munehisa Homma, who was considered a "lowly" merchant. At the time, rice was an essential commodity and one which the hierarchy in Japan used to store their wealth. Stored in massive warehouses, they would release rice into the market to replenish their riches as and when convenient. Homma created the candlestick analysis method and went on to immense fame and fortune, with his strategy still relevant today.

 

What is the candlestick chart system?

 

While many people discount graph systems such as the candlestick chart, they do so at their peril. This is an extremely useful and innovative way to gauge price movements and sentiment. Here is a basic candlestick:-

 

 

To recap, a candlestick can represent any period you choose. For example, as a day trader, you may choose a five minute period with multiple candlesticks represented in graph form. The body represents the opening and closing share prices. If the closing price is higher than the opening price, the body will be coloured green; if the closing price is lower than the opening price, the body will be red.

 

The lower shadow extends to the lowest trading price, and the upper shadow has the highest trading price over the period. Therefore, in an instant, you have a visual and easy to understand snapshot before you!

 

Reading a candlestick graph

 

While some forms of technical analysis will identify one point at which a trend changed, and there was a buying/selling opportunity. When using candlestick graphs, each candlestick needs to be taken in context with those immediately prior. This helps to strengthen signals and avoid what can be a trader's nightmare, a false flag.

 

There are many different candlestick chart patterns to consider, which include:-

 

Hammer candlestick

 

This is one of the strongest indicators and can often identify the turning of a downtrend after a significant sell-off. This candlestick will have a green body, indicating a rise on the day, but an extended lower shadow which indicates a sell-off and recovery. The longer the shadow, the stronger the indicator - ideally, the shadow should be at least two times the length of the body. The lower shadow should be a new low for the downtrend.

 

Shooting star candlestick

 

The exact opposite of a hammer candlestick, the shooting star candlestick, following several green candles, will often indicate the top of an uptrend. This is a scenario where sellers have been waiting for the price to fall, without success, beforefinally giving in and overpaying. The spike represents frenzied buying and would typically be at least twice as large as the body. In this instance, the closing share price would be below the open, signalling a change in sentiment.

 

Bullish engulfing candlestick

 

The bullish engulfing candlestick represents a significant change in sentiment. This pattern is dominated by a substantial green body demonstrating a powerful upward movement on the day. The size of the green body would be many times greater than the previous red body, the greater the difference, the more significant the event. In this situation, trading volume tends to be at least twice the normal, and the pattern is confirmed if the next candlestick exceeds the previous high.

 

Bearish engulfing candlestick

 

The bearish engulfing candlestick is the opposite of the bullish one, indicating further potential upside only to be hit by enormous selling pressure. The red body of this candlestick will engulf the previous green candlestick, the size difference showing the strength of the sell signal. Those investors who bought in on the way up will join in the sell-off, banking a profit and moving on. Typically, trading volume for the period would be double the average, indicating the strength of the sell-off.

 

Fast-moving charts

 

The beauty of the candlestick chart strategy is that the candles can be adjusted to a timeframe of your choice. Consequently, if you are a day trader, you could adapt each candlestick to represent a five minute period, monitoring changing trends throughout the day. 

 

At Global Investment Strategy Ltd, we offer an exceptional trading service with low latency facilities and a competitive charging structure, allowing you to maximise your profits.


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