Introduction to Japanese Candlestick Formations

As long ago as the 17th century, it is known that the Japanese were using technical analysis to improve their success in the rice trade. Developing a knowledge of the signals simply through observation, they managed to hone their skills in this area and became extremely wealthy and successful. The earliest modern candlestick charts appeared around 1850 when a famous rice trader called Homma from Sakata created the system. Over the following years, these signals were developed further and the psychology behind their development was analysed. Today, these patterns are now used as a tool to project future price movement.

The guiding principles of Japanese candlestick formations are roughly the following:

• The price action, or “what”, has more importance than the earnings, news etc, or “why”.
• All of the known information should be reflected in pricing.
• Sellers and buyers move the markets based on emotions and expectations.
• Markets always fluctuate.
• The underlying value may not always be reflected in the price.

With their long history, these candlestick formations are one of the most convincing types of signals that can be used, and when they are understood and used correctly to inform trading, they can allow traders to make great profits simply by recognising the signs that a market trend is reversing and acting on those signs.

How do Japanese Candlestick Formations Develop?

A candlestick chart is created using a data set with open, low, high and close values for every time period you wish to display. The “real body” of the candlestick is the filled or hollow portion, while the long narrow lines below and above the body are representative of the low/high range and are given the name “shadows”. Sometimes, they are also known as “tails” and “wicks”. Highs are demarcated by the top of the shadow on the upper part of the chart and lows are represented by the base of the lower shadow. Should the stock close higher than the price that it opened at, the charter draws hollow candlestick, the bottom of its body representing its opening price while the top is representative of the price on closing. Should the stock close at a lower price than its opening price, the charter draws a filled candlestick, the top of its body representing its opening price and its bottom representative of its price on closing. When compared to the more traditional bar chart, the candlestick chart is generally believed to be easier to interpret as well as being more visually appealing as every candlestick supplies a simple-to-decipher image of price action. Traders can immediately compare the vital information relating to the relationship between opening and closing prices as well as the highs and lows. A hollow candlestick with a close that is greater than the open indicates that there is buying pressure while a filled candlestick with close that is less than the open indicates selling pressure.

What are Bullish Engulfing Patterns?

One of the most compelling candlestick signals is the Bullish Engulfing Pattern, which consists of 2 bodies – the first being the same colour as the current trend and the second being the opposite colour. The signal day will open at a lower price than the closing of the previous day however it will trade higher so at the end of the day it closes above the opening price of the previous day. It is called a engulfing pattern as the new white candle formed engulfs the candle of the previous day. When an investor sees a white bullish candle that engulfs the black candle of the previous day and follows a series of black candles, it is a clear indicator of a change in investor sentiment. The larger the black candle being engulfed, the more effective this new signal will be.

What is a Bearish Engulfing Pattern?

A Bearish Engulfing Pattern reflects the opposite of a Bullish pattern and occurs at the top of an uptrend in the market indicating a price reversal. Easy to see on a chart, the Bearish pattern consists of a minimum of two candlesticks, with the first being a bullish candlestick. The following candlestick must engulf the entire body of the first candlestick, closing either at or below the opening price of the first candlestick. The second candlestick can wither open below or above the closing price of the first candlestick but it must completely engulf the first candlestick’s real body. Once this pattern forms, it is very obvious on a chart as the black candle stops the white bodies of the uptrend.

Other educational articles

• Japanese Candlestick Formations – Bullish And Bearish Engulfing Patterns
• Gain Using Wedges In Binary Options
• Fibonacci Retracements To Identify Potential Reversal Levels
• Morning And Evening Stars Patterns
• Support/Resistance Levels Analysis
• Ascending Triangle Strategy In Binary Options

Recommended reading

• Japanese Candlestick Charting Techniques (book) (Prentice Hall Press)
• Chart Analysis (StockCharts – ChartSchool )
• Trading Tools and Tactics: Reading the Mind of the Market (From the founder of the leading online trading education company, a simple technical method to trade or invest)