According to Steve Nison, candlestick charting first appeared sometime after 1850. Much of the credit for candlestick development and charting goes to a legendary rice trader named Homma from the town of Sakata. It is likely that his original ideas were modified and refined over many years of trading eventually resulting in the system of candlestick charting that we use today.
In order to create a candlestick chart, you must have a data set that contains open, high, low and close values for each time period you want to display. However, the best way to explain way to explain is by using a picture.
The hollow or filled portion of the candlestick is called "the body" (also referred to as "the real body"). The long thin lines above and below the body represent the high/low range and are called "shadows" (also referred to as "wicks" and "tails"). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow. If the stock closes higher than its opening price, a hollow candlestick is drawn with the bottom of the body representing the opening price and the top of the body representing the closing price. If the stock closes lower than its opening price, a filled candlestick is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price.
You can learn more about candlesticks at http://www.altavest.com/candlesticks.html.
Long and Short Shadows
The upper and lower shadows on candlesticks can provide valuable information about the trading session. Upper shadows represent the session high and lower shadows the session low. Candlesticks with short shadows indicate that most of the trading action was confined near the open and close. Candlestick with long shadows show that traded extended well past the open and close.
Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session, and bid prices higher. However, sellers later forced prices down from their highs, and the weak close created a long upper shadow.
Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower. However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow.
Candlesticks with a long upper shadow, long lower shadow and small real body are called spinning tops. The color of the real bodies is not very important. The pattern indicates the indecision between the buyers and sellers
The small real body (whether hollow or filled) shows little movement from open to close, and the shadows indicate that both buyers and sellers were fighting but nobody could gain the upper hand.
Even though the session opened and closed with little change, prices moved significantly higher and lower in the meantime.
If a spinning top forms during an uptrend, this means there aren’t many buyers left and a possible change or interruption in trend could occur.
If a spinning top forms during a downtrend, this means there aren’t many sellers left and a possible change or interruption in trend could occur.
Hammer and Hanging Man
The Hammer and Hanging Man are very strong reversal signals. Both consist of identical candlesticks with small bodies and long lower shadows. The Hammer and Hanging Man look exactly alike, but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower shadows and short or non-existent upper shadows. As with most single and double candlestick formations, the Hammer and Hanging Man require confirmation before action.
The Hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom.
When price is falling, Hammers signal that the bottom is near and price will start rising again. The long lower shadow indicates that sellers pushed prices lower, but buyers were able to overcome this selling pressure and closed near the open.
Note that just because you see a Hammer form in a downtrend doesn’t mean you automatically place a buy order! More bullish confirmation is needed before it’s safe to pull the trigger. A good confirmation example would be to wait for a white candlestick to close above the open of the candlestick on the left side of the Hammer.
On the other hand, the Hanging Man is a bearish reversal pattern where it signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of selling pressure raises the yellow flag. As with the Hammer, a Hanging Man requires bearish confirmation before action.
Inverted Hammer and Shooting Star
The Inverted Hammer and Shooting Star look exactly alike, but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or nonexistent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action.
The Inverted Hammer occurs when price has been falling suggests the possibility of a reversal. Its long upper shadow shows that buyers tried to bid the price higher. However, sellers saw what the buyers were doing and attempted to push the price back down. Since the sellers weren’t able to close the price any lower, this is a good indication that everybody who wants to sell has already sold. And if there’s no more sellers, who is left? Buyers. However, bullish confirmation is required before action. An Inverted Hammer followed by a few long white candlestick could act as bullish confirmation.
The Shooting Star is a bearish reversal pattern that looks identical to the Inverted Hammer but occurs when price has been rising. Its shape indicates that the price opened at its low, rallied, but pulled back to the bottom. This means that buyers attempted to push the price up, but sellers came in and overpowered them. To indicate a substantial reversal, the upper shadow should relatively long and at least 2 times the length of the body. Bearish confirmation such as a few black candlestick is required after the Shooting Star before any action is taken.
Double (or Multiple) Tops or Bottoms
A double top is a reversal pattern that is formed after there is an extended move up. The “tops” are peaks which are formed when the price hits a certain level that can’t be broken. After hitting this level, the price will bounce off of it slightly, but then return back to test the level again. If the price bounces off of that level again, then you have a double top!
In the chart, you can see that two peaks or “tops” were formed after a strong move up. Notice how the 2nd top was not able to break the high of the 1st top. This is a strong sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.
Note that double tops are a trend reversal formation. You’ll want to look for these after there is a strong uptrend.
Railroad tracks are a chart pattern which comes to a halt with a tall bar that has little or no shadow and is followed by an equally ( or nearly equally) tall bar going the other way, also with little or no shadow. Someone has called off the hounds and is galloping back to the barn! This two bar pattern shows that a lot of traders have suddenly decided that the market should go the other way, and they are reversing as fast as possible.
Railroad tracks are one of the strongest reversal pattern, and while no indicator is infallible, you want to get into the trade.