So now that you’re here, you would like to know how to trade stocks and know when to enter a trade and when to exit. For that particular reason, technical analysis is used. Technical analysis gives you a good idea when it is the right time to buy and sell a stock. Technical Analysis (TA) is among the most popularly used method to do that. TA gives you a general idea about your risk exposure, and what could be your expected gains in a limited time frame (suppose 1 week or 1 month).
However, one of the biggest con of Technical Analysis (TA) is that it is viable for short term trades or investment and is not suitable for long term investments. A long term investment is best suited for Fundamental Analysis (FA) which involves understanding the business and finding the intrinsic value of a stock or asset by analyzing information which is made available in a company’s annual reports such as balance sheet, profit and loss statement, cash flow statement, revenues, earnings, future growth, PE Ratio, the effectiveness of a company’s management, etc. Fundamental analysis is a whole new topic and explaining it here will not do it justice, so we will cover it in another guide.
So what exactly is a Candlestick?
Now that you are well acquainted with the beginning, let’s get into technical analysis. A candlestick helps you to read and understand a chart in a better way.
To explain that, we first have to get into the basics of the market.
The Indian stock market(BSE & NSE) operates from 9:15 am to 3:30 pm. During that period, millions of trades take place in the exchange. If we plot each of these trades on a piece of paper, we will not be able to fit all the millions of trades taking place and let’s be honest, it will be total gibberish.
From the image above, we can see a few numbers of trades which take place at different points of time throughout the day. However, it is not the case for the millions of trades that take place during the active hours of the stock market. Now imagine if we try to put all the prices of a stock traded during a time, the whole chart will be filled full of dots and we will not be able to make anything out of it.
Thus, to solve this exact problem, candlesticks are used which originated from Japanese rice merchants and traders who used it to track everyday market prices back in the 18th century. It gained popularity and momentum in the United States only recently back in the 1980s.
A candlestick provides a summary of an asset during a fixed time frame, ex – hourly, daily, weekly, monthly, etc. The basic components of a candlestick are –
- The body – It connects the opening price of an asset to its closing price in a fixed time frame
- The upper wick – A line which connects the highest price of an asset to the opening/closing price in a fixed time frame
- The lower wick – A line which connects the lowest price of an asset to the opening/ closing price in a fixed time frame
- The color – If the body of the candlestick is red, it implies that the asset closed lower, and if the body of the candlestick is green, it implies that the asset closed higher.
Let us further understand this concept with the help of a live example.
So when we look at the daily chart of Reliance Industries, we find that the asset closed lower than its opening today on 27th July 2020 which is shown with the help of a red candle.
Let us look at the important price points throughout the day –
Open – Rs 2179.75
Close – Rs 2156.20
Highest Price – Rs 2200.35
Lowest Price – Rs 2126.20
The table above shows different types of time frames. Credits – Zerodha
Now that the concept of candlesticks is clear to all, we will get into some candlesticks pattern which will help you identify trades in a better way.
Bullish candlestick patterns
These patterns usually signal an uptrend or a bullish market where bulls have more buying power and bears are losing selling power.
A hammer candlestick contains a small body with a long lower wick and generally appears at the bottom of a downtrend. It shows that even though bears were able to push the price lower, the bulls managed to push back the price higher with their buying pressure and shows the strength of bulls over the bears. The color can vary between green and red, however, a green candle shows more buying strength.
2. Inverse Hammer
An inverse hammer is similar to a hammer, but instead of a lower wick, there is an upper wick. It implies a buying pressure which got overpowered by selling price at higher prices which drove down the prices down but the bulls still managed to close the price above the open price.
3. Bullish engulfing
A bullish engulfing pattern is formed when the first candle is a short red body that gets completely engulfed by the second green candle which is larger than the first candle.
4. Morning star
Morning star is a 3 candlestick pattern where the first candlestick is a long red candle followed by a small body candle and the third candlestick is a long green candle. It shows that after a bearish market, the bulls regained their strength to push the price higher.
5. Three white soldiers
This pattern occurs over 3 consecutive candlesticks where each candlestick is longer than its previous one with no wicks in their real body and closes progressively higher than its predecessor.
Bearish candlestick patterns
These patterns usually signal a downtrend or a bearish market where bears have more selling power and bulls are losing buying power.
1. Hanging man
It is the opposite of a hammer which appears at the end of an uptrend. A hanging man has a small red body with a long lower wick. It signifies that there was a big sell-off but the bulls were able to push the price higher but the sell-off implies profit-booking after a bull run and that the bears are gaining strength in the market.
2. Shooting star
A shooting star forms at the end of an uptrend and is similar to a hanging man such as a small red body but the main difference is that instead of a lower wick, it has a higher wick which shows that the bulls were able to push the price higher but were unable to sustain it and the bears took over the control.
3. Bearish engulfing
This pattern is the bearish equivalent of Bullish engulfing where the first candle is a small green candlestick but the second candle is a long red candlestick that completely engulfs the first green candle. It appears at the end of a bull rally and signals a downtrend market where profit booking takes place.
4. Evening star
It is the opposite of morning star. Evening star signals the reversal of the market trend from bullish to bearish. It is a 3 candlestick pattern where the first candle is long green, the second candle is small and the third candle is a long red.
5. Three black crows
This pattern occurs over 3 consecutive candlesticks where each candlestick is longer than its previous one with no wicks in their real body and closes progressively lower than its predecessor signifying the bears have taken control of the market with their selling pressure.
Continuation candlestick patterns
Patterns that do not fall into bullish or bearish candlestick patterns fall into this category. These patterns don’t indicate any change in the trend of a market but show indecisiveness of the market.
A doji contains a small or non-existant real body with both long higher and lower wicks. It shows that neither bulls nor bears were able to take control of the market and the asset closed near its opening price. It looks similar to a “Plus sign (+)”. These patterns generally appear in reversal patterns such as morning star or evening star.
2. Spinning top
A spinning top has a small real body but contains equal-sized wick towards both directions. Once again, it is a neutral sign where neither bulls nor bears were able to take control of the market because bulls managed to push the price higher but at the same time, bears managed to pull the price lower. On its own, a spinning top signifies nothing but combined with other patterns, a larger picture can be visualized.
With the help of the understanding of candlesticks, you will be able to gauge and time your trades better because you will be able to understand the charts in a way that you did not before. If you have any doubts that you would like to resolve regarding, you can comment on this post and we would try to solve it.