Candlestick Chart Definition and Basics Explained

What Is a Candlestick?

A candlestick is a type of price chart used in technical analysis. It displays the high, low, open, and closing prices of a security for a specific period. The candlestick originated from Japanese rice merchants and traders hundreds of years before becoming popularized in the United States. It was used to track market prices and daily momentum.

The wide part of the candlestick is called the "real body." It tells investors whether the closing price is higher or lower than the opening price. It appears as black/red if the stock closed lower or white/green if the stock closed higher.

The Basics of a Candlestick

The candlestick's shadows show the day's high and low and how they compare to the open and close. Its shape varies based on the relationship between the day's high, low, opening, and closing prices.

Candlesticks reflect the impact of investor sentiment on security prices and they're used by technical analysts to determine when to enter and exit trades. Candlestick charting is based on a technique developed in Japan in the 1700s for tracking the price of rice. They're a suitable technique for trading any liquid financial asset such as stocks, foreign exchange, and futures.

White/Green Candlesticks

Long white/green candlesticks indicate that there's strong buying pressure. This typically indicates that price is bullish but they should be looked at in the context of the market structure rather than individually.

A long white candle is likely to have more significance if it forms at a major price support level.

Black/Red Candlesticks

Long black/red candlesticks indicate that there's significant selling pressure. They suggest that the price is bearish.

Hammers and Hanging Men

The hammer is a common bullish candlestick reversal pattern that forms when the price moves substantially lower after the open and then rallies to close near the high. The equivalent bearish candlestick is known as a hanging man.

These candlesticks have a similar appearance to a square lollipop and are often used by traders attempting to select a top or bottom in a market.

Two-Day Candlestick Trading Patterns

Many short-term trading strategies are based on candlestick patterns.

The engulfing pattern suggests a potential trend reversal. The first candlestick has a small body that is completely engulfed by the second candlestick. It's referred to as a bullish engulfing pattern when it appears at the end of a downtrend and as a bearish engulfing pattern after an uptrend.

The harami is a reversal pattern where the second candlestick is entirely contained within the first and is opposite in color. The Harami Cross has a second candlestick in a related pattern that's a doji. The open and close are effectively equal.

Three-Day Candlestick Trading Patterns

An evening star is a bearish reversal pattern in which the first candlestick continues the uptrend. The second candlestick gaps up and has a narrow body. The third candlestick closes below the midpoint of the first candlestick.

A morning star is a bullish reversal pattern where the first candlestick is long and black/red-bodied followed by a short candlestick that has gapped lower. It's completed by a long-bodied white/green candlestick that closes above the midpoint of the first candlestick.

The Bottom Line

Candlestick charts depict the open, closing, high, and low prices of a security over a designated time. The shape can shrink or enlarge depending on the relationship between these prices. The color of the wide part of the candlestick indicates whether the stock closed higher or lower than the previous period.

As with all trading tools, you’ll want to be sure that you have a firm grasp of how a candlestick chart works before you invest money based on its interpretation and implications.