Technical analysis is one of the most powerful weapons in a trader’s arsenal to grasp market opportunities. It allows you to predict price moves of the asset of your choice by studying past price patterns and current market conditions. One of the most popular ways to do this is with Japanese candlesticks. In this article, Fxview analysts take a deep dive into the origin of candlesticks, candlestick patterns and how they can help traders understand trends.
The Origin of Candlestick Analysis
Although Steve Nison’s book, Japanese Candlestick Charting Techniques, popularised using candlestick patterns for trading, he wasn’t the creator of this technical analysis tool. Homma Munehisa, a Japanese rice trader, pioneered the technique as far back as the 18th century. Candlestick patterns are considered the oldest price charting technique today.
Munehisa recorded the price of rice every day for 15 years. He would compare the price of the previous day and assess whether it had increased or decreased. He also discovered that trader psychology influenced prices. Using his knowledge, he created a trading system. Munehisa’s system was based on assessing whether the price had moved up or down during a certain period, which led him to create candlesticks. He used candlesticks to assimilate the entire range of price movement through opening and closing prices. Candlesticks formed patterns that he used to assess trends (‘Yin’- uptrend or ‘Yang’ – downtrend) and rotations (retracements).
While other traders were merely buying and selling rice, Munehisa was tracking and understanding how the price moved. He worked with 3 principles.
- Price Considers Everything
Homma Munehisa believed that price changes were the result of several factors. These factors include supply, demand, traders’ fear or greed, news or rumours, politics and weather (critical for agricultural products like rice). For this, he used a team of about 100 messengers between Osaka and Sakata to learn how prices changed from one place to another.
- Price Movement Creates Trends
Regular gains or declines in prices result in the formation of trends. Any disruptions due to news events, supply/demand changes or any other factor may cause the trend to change. Munehisa also identified factors that could lead to trend reversal.
- History Repeats Itself
The Japanese rice trader also understood that markets are cyclical. This helped him add important dates and times of the year as critical parametres to his price speculation. He used available records of price history over the past 100 years to discover more patterns and cycles.
Munehisa’s technique benefited him and he became one of the greatest market analysts of his time. He is known for introducing the Sakata Rules, the principles used to develop his trading techniques and strategies based on clear candlestick patterns. These rules gained so much attention that the then-Japanese government recognised his success and hired him as a financial aide. He was also awarded the honourable position of a Samurai and is still often referred to as the “Father of Price Action Trading” among Japanese trading communities.
Homma Munehisa’s system forms the basis of present-day technical analysis using candlesticks. A trader can gauge complete price action with a single glance at candlesticks. There are two types of candlesticks – bullish and bearish.
A bullish candlestick is green or black in colour, indicating that the price rose during the chosen period. The width of the candlestick is the duration of the price action. The bottom of the bullish candle is the opening price and the top is the closing price. The top and bottom wicks or shadows of the candle indicate the maximum and minimum price points for the period.
A bearish candlestick is either red or white in colour. The top of the bearish candle is the opening price and the bottom is the closing price. The width and the wicks represent the same duration of price action and maximum and minimum price points, just like bullish candles.
Benefits of Using Candlestick Charts for Technical Analysis
- Candlesticks are the simplest-to-read price indicators to identify entry and exit points.
- Using candlestick patterns gives traders a comprehensive view of the price movement for the time frame under consideration.
- Candlestick charts can be easily combined with other indicators for greater accuracy.
Bullish Candlestick Patterns
Candlestick patterns can be single, double, triple and multi-stick patterns. These patterns help traders discover trends and predict reversals. Based on their prediction, these patterns are also classified as bullish or bearish patterns. Traders identify bullish patterns to take long positions. Some of the most popular bullish multi-candlestick patterns are:
Head and Shoulders
Head and shoulder chart is widely used for reversal patterns. The normal head and shoulders is a bearish reversal pattern, indicating, with varying degrees of accuracy, that an uptrend is about to end. Comparatively, an inverted head and shoulders is a bullish reversal pattern, which signals that the downtrend is approaching an end.
The inverted head and shoulders pattern is formed when the price makes three consecutive valleys after a downtrend. This pattern forms when a security’s price reaches three consecutive lows separated by temporary rallies. The main characteristics of the inverted head and shoulders are:
- An initial price decline to a trough (left shoulder) followed by a rise
- A second price decline below the previous trough followed by another rise
- A third price drop, yet not as low as the previous trough (right shoulder)
- Once the last trough is reached, the price will start climbing towards the resistance point (neckline), which usually forms near the top of the previous troughs.
The trend reversal is confirmed when the next candle after the right shoulder breaches the resistance and the price begins to rally, as shown below.
A wedge pattern is formed when two trendlines converge. It indicates that the strength of the price movement is fading and could lead to a pause or reversal of the current trend. A falling wedge is considered a bullish candlestick pattern that occurs during a downtrend. Here, the price hits consecutive lower highs and lower lows, such that the trendlines for the high and low prices slope downwards to converge.
Triangle patterns are used to identify trend continuation or reversal. When the trendlines form an ascending triangle, it is considered a bullish signal, regardless of whether it occurs during an uptrend or a downtrend. For an ascending triangle to form, the asset price needs to make higher lows, indicating that the number of buyers is increasing. As buyers take control of the market, the former resistance level becomes the new support level as the price continues to rise.
Candlestick charts are one of the most popular tools for effective technical analysis. Mastering these charts can help traders build a robust trading strategy and a decision-making system to discover and act on entry and exit points. To learn all about technical analysis and trading candlestick patterns, head to Fxview’s rich library of video tutorials.