Candlestick Charts: The Building Blocks of Price Action

One of the most important features of any trading platform is the method with which the financial movement of an instrument – currency, in the case of Forex – is plotted over a period of time, as described by the selected timeframe.

There are several ways which financial data can be plotted on our charts, but arguably the most popular and  most widely taught analysis methods use ‘candlesticks’ and the candlestick chart which were thought to be first used in Japan by rice traders back in the 1800s. 

The whole subject of candlesticks, candlestick charts and patterns is a very detailed study in itself.

In this article we are going to cover the basics of what a candlestick is, what a candlestick represents, the information contained within them and then we will look at two different types of candlestick patterns which we can use as we begin to read price action.

In the context of Forex trading, a candlestick represents the price fluctuation of a currency pair during a fixed period of time. For instance if we are on the H1 chart, each candlestick represents an hour’s worth of price movement data.

If we are on the M5 timeframe, each candlestick would represent 5 minute’s worth of data.

Each candlestick consists of a real body (the ‘body’) and wicks (or shadows) which stand out vertically top and bottom from the body, looking like the wick of a candle, the body representing the candle body. The extremities of the wicks represent the high and low of the price movement seen in that time period.

Figure 1 above outlines the main components of a candlestick. This particular candlestick happens to be a bull candlestick and the body is coloured green.

The size of the body is determined by the difference between the Open and Close levels in the time period that the candlestick represents. The difference between the Open and the Low of the candlestick is represented by the Lower shadow or Lower wick.

The difference between Closing price level and the highest price level that was reached in this time period is represented by the Upper shadow or Upper wick.

It is not until a candle closes that it is fully recorded as being a bull or bear candle.

From the point it opens, price will move up and down depending on the money flow at that time.

When price moves upwards from the Open level, it will look bullish and any candle body developing will be shown in the bull candle colour, in this case, green. If, during the time period, price drops below the Open level, any candle body developing will be shown in the bear candle colour, highlighting the fact that price is below the level that the candle opened at.

A candle closes at the end of each time period i.e. if you are on an H1 chart, each candle closes exactly on the turn of each hour and the next candle simultaneously opens. Once the candle closes, you can see exactly how much distance price travelled in the last hour – the range of the candle – as described by the difference between the tips of the Upper and Lower shadows or wicks.

The actual or ‘real’ progress made by price is shown by the size of the candle ‘real’ body. We will go into more detail about the size of candles, bodies and wicks a bit later.

Let’s look a Bear candle just to complete the comparison…

The Bear candlestick is similar to the Bull candlestick, except that the Open is always the higher limit of the candle body and the Close, the lower limit and the candle body is also therefore a different colour, in this case red.

In exactly the same way as explained above for the bull candle, price opens, moves up and down during the price period and then closes.

Since, in this case, the close is lower than the open, we call this candle a bear candle.

Once the candle is printed at the end of the time period, that is it…there is no repainting, the candle is cast in the financial history of that instrument and represents the price movement during that specific time period for ever more.

Although mentioned above, It is important to remember that until the candle closes, the size, shape and direction of the candle is completely subject to the financial forces at play in the market, even, and especially so, in the last few seconds.

You cannot fully know the exact extent of the information available for that period until it closes and prints a complete candle. 

So far we have discussed the basics of what each candlestick consist of and how it works, but what does it tell us in real time on the chart?

Well, for a start, candlesticks are a very graphic way of representing price action.

Each printed candle contains a lot of information relevant to current price action which is displayed in an easy and quick-to-read format. Candles tell us if there is strong or weak direction in the market, whether or not there is much buying or selling interest, or both at that time, whether price is trending, consolidating or ranging, they tell us if price is reversing or more likely to continue in the same direction.

There is no end to the information one might gain from just looking at the candles on a candlestick chart.

Figure 3 below shows some basic candlestick identification – Note, these are not candlestick patterns, just individual candle examples

A strong bull or bear candle represents strong buying or selling activity.

Both the upper and lower shadows – wicks – are generally small, and the candle bodies large.

In the case of the strong bull candle above, price opened and immediately moved upwards in the direction of strong buying interest. The close of the candle is right near the top which tells us that price continually moved upwards throughout the time period and that the bulls were still firmly in control at the close.

The strong bear candle shows the same but in the reverse.

In the example, the upper shadow of the bear candle does show that there was some retracement upwards before the bears regained full control, pushing price downwards throughout the rest of the time period, closing almost at the very low.

Both strong bull and bear candles with large bodies will often print on a chart at the beginning of a new trend or immediately after a price reversal.

They represent strong buying or selling interest, often initiated by banks or market makers.

The indecision candle is often a sign of balanced buying and selling interest and will often print at the end of a trend, as the market waits to make the next move, or at quiet times in the market. The bigger the wicks, the more buying and selling that went on in the period and the smaller and more centred the body, the more evenly distributed the buying and selling has been in that period.

The smaller the wicks and overall range, the lower the buying and selling activity in that period.

A price test candle is identified by a long wick on one end, a very short wick (or no wick at all) at the other end and a very small body at the short wick end.

These bars are often called pin bars because they look like exactly that – pins.

A low test candle or pin bar has the long wick below the body and prints on the chart when price comes down into a level and quickly pulls back up, usually due to both sellers profit taking and buyers buying at the level which price is testing. A high test candle or pin bar has the long wick above the body and prints on the chart when price comes up into a level and quickly pulls back down, usually due to buyers profit taking and sellers selling at the level which price is testing.

Some websites call this ‘rejection’ of a level or price gets ‘rejected’ at a level, but this is an inadequate term and does not explain what actually happens at the level when price reaches it.

Let’s have a look at candlesticks on a candlestick chart, as they describe a period of price action.

Figure 4 highlights a period of price action for the EURUSD on the H4 chart. The chart has been highlighted with numbers relating to some basic points of interest which are described below.

1) An indecision bar prints at a swing high as price rallies strongly into a level shown by the preceding strong bull candle and then reverses at the level with the indecision candle, before a strong bear candle prints and price retraces to create a swing low at 3)

2) A pin bar and series of indecision candles (dojis) print at a minor swing low before a short-term reversal occurs

3) A number of different types of candles print during a period of consolidation. There is no strong direction in force as the market waits for committed buyers or sellers to step in. Buyers eventually step back in and start a new uptrend

4) The new uptrend is marked by large, strong bull candles

5) Indecision bars print at a period of consolidation as the market takes a breath before continuing with the uptrend

6) Further strong buying activity with large bull bars

7) A very large bearish “engulfing” candle prints – a very strong bear candle which engulfs the previous green bull candle – showing very clearly that price is reversing and strong selling activity is taking place

8) Large, strong bear candles indicate continued strong selling activity

9) Even though this bull candle moved upwards strongly from it’s open, the long wick to the upside shows that there is considerable selling resistance at the level that price reached

10) Another strong bearish engulfing candle highlights another price point reversal and marks the beginning of the ensuing downtrend

11) A single indecision candle prints as the downtrend pauses and reverses momentarily after some profit taking.

12) Price moves downwards, interspersed with short profit taking rallies. Price prints generally larger red candles than green showing that sellers are in control.

It’s not just the individual candles themselves that hold great information about current price action.

There are a number of well documented and accepted patterns of candles which often appear just before or just after certain events, which can either forewarn us that certain events are potentially about to take place, or confirm that certain other events have already taken place.

It is beyond the scope of this article to discuss all of the popular patterns in detail, however, we will discuss in broader terms the main categories these patterns fall into, namely Reversal patterns and Continuation patterns.

As their names suggest, reversal patterns are those patterns which when they print on a chart, give traders the heads up that sentiment has changed and that following the pattern, we can potentially expect a change in price direction.

Price continuation patterns often occur in a chart when the market is taking a breath or consolidating after making a large or sustained move in either direction and before continuing in the original trend or price direction.  

There are generally more reversal patterns than there are continuation patterns, particularly in Forex.

Reversal patterns have to occur at significant levels of support and resistance to have real meaning and reliability. Let’s have a quick look at a few reversal and continuation patterns that you might see regularly in Forex candlestick charts.

Using the same EURUSD chart we saw earlier, figure 5 shows the chart with some reversal and continuation patterns highlighted. The Engulfing patterns, both bullish and bearish, are examples of reversal patterns and the Inside bar patterns are examples of candlestick continuation patterns.

Candlestick patterns are discussed in more detail in later articles, but in the example above you can see how often they occur and how reliable they can be to trade with. All the engulfing reversal patterns occur at key levels. Price stops at a level and then the next bar moves away in the opposite direction and ‘engulfs’ the first bar by being larger than the first bar in the pattern.

The inside bar pattern is a continuation pattern and is almost the reverse of the engulfing pattern. Price moves up to a level (in figure 5) and then the next bar fails to progress any higher and fits inside the range of the first (mother) bar.  The third bar then breaks the high of the mother bar and the trend continues.

The examples in figure 5 were just to highlight the occurrence of reversal and continuation candlestick patterns. Details on how to use candlestick patterns effectively in your trading will be discussed in more detail in later articles.

In this article we have learnt what candlesticks are, what they represent, what they look like on a chart and we have briefly discussed the main categories of candlestick patterns which can form on a chart at a time of interest to us as traders.

It is easy to see why candlestick charts are such a popular choice for financial traders.

Being able to decipher price action quickly and easily is a real advantage when you are trading live and particularly on shorter time frames when you need to make quicker decisions.

Candlesticks hold a lot of data, not only about the price action which occurred during the time period represented by the individual candlestick, but also about the trend or period of trading activity that it has printed within. The wicks give us a clear indication of the range of price activity at that time, which can lead us to understand the volatility and depth of the market.

The size of the bodies can give us information about the general sentiment, commitment and direction of the market, enabling us to make sound trading decisions as the market unfolds in front of us.

Pull up a blank chart of any instrument on any time frame and begin tuning your vision into each candle and get a feel for what was happening during that time period. Keep an eye out for repeating candlestick patterns or behaviours which may occur mid-trend or at key levels such as swing highs and lows, which will often highlight support and resistance levels.

The ability to be able to read candlesticks and the market information they contain and represent will contribute greatly to your understanding and skills in reading price action.

As you become more and more familiar with tuning into what’s really going on, your reliance on price-lagging indicators will lessen and as a result, your screens will become much cleaner and easier to read and you will find it increasingly easier to make clear and decisive trading decisions.

A definite advantage!