Japanese candles are a most useful tool for predicting price movements. They are one of the most widely used tools by traders today.
What are Japanese candles?
Anyone, even a trading novice, will have already heard of Japanese candlesticks. So-called candlestick trading is a real system of analyzing market charts by means of a particular representation of prices called, precisely, candlesticks.
It is commonly referred to as Japanese candlesticks because candlestick analysis reportedly originated in feudal Japan between the 17th and 18th centuries. It is, in all likelihood, the oldest methodology for graphical analysis of financial markets.
Studying Japanese candlesticks has immediate advantages even for novice traders in that this type of graphical representation of prices immediately visually highlights the imbalance of forces between buyers and sellers in any given trading session.
And this is probably why so many traders use Japanese candlestick trading.
The Japanese candlestick chart is simple to construct and does not require any additional information compared to the classic bar chart, the so-called bar chart.
In fact, to construct Japanese candlesticks and identify the main figures of this methodology, the four summary prices of the trades (opening, high, low, and close) are sufficient.
The construction of the candlestick chart
The construction of the chart by means of Japanese candlesticks offers, compared to the bar chart, additional information based on the relationship between the first and last prices traded, that is, between the opening and closing figures.
In fact, each individual candlestick consists of:
Main or real body ('jittay' in Japanese): this is the body of the candle, which is obtained by combining the opening price with the closing price.
Shadow ('kage'): these are the thin lines connecting the session high and low (High and Low) to the body, referred to as 'upper shadow' ('uwakage') and 'lower shadow' ('shitakage') respectively
Each candlestick can take on a different color (generally the most commonly used ones are red and green, or black and white) depending on whether the market close is greater ('positive session') or less ('negative session') than its opening.
In 'default' graphical analysis software, the convention of 'filling' the body of the bearish candle (coloring it black) is often used, while leaving the body of the bullish candle empty (drawing only its outline), as we can see in the image below.
Current software now allows candlestick bodies to be colored in the preferred way in order to distinguish at a glance the positive ones from the negative ones, that is, bullish candles from bearish ones.
As already mentioned within this guide, it is now common to use the color green for uptrend candles and red for downtrend candles.
bullish- bearish candle
Thanks to well-defined colors, reading Japanese candles is very easy. When we use a Japanese candlestick chart, in fact, we can clearly see within a bullish trend a predominance of positive green candles while conversely in a bearish trend we will notice the predominance of red or rather negative candles.
How to interpret the Japanese candlestick chart in trading
Candlestick analysis allows us to identify, as a starting point, nine different types of Japanese candles, each of which represents a different market movement within the trading session.
Each of them gives rise to a true Japanese candlestick strategy, which can be exploited operationally in the way we shall see.
The meaning of Japanese candles and their interpretation concern first and foremost how they appear at the end of the session, that is, what shape the individual candle under consideration took in comparison with the previous one.
Indeed, the shape the candle takes at the end of the session provides us with a great deal of information about the course of the stock market session as a whole. Such information can be exploited from an operational point of view.
Candlestick trading includes several candlestick patterns based on a single candle or on several candles to be evaluated as a whole.
The 13 most important bullish and bearish trending Japanese candlestick patterns and continuation patterns
Now that we have seen what the main types of Japanese candles are let's go on to look operationally at what are the most important figures we can use to build our strategy with Japanese candles. Here are which ones we will cover:
Shooting Star: This is a typical candlestick pattern that finds its physiological place in an uptrend.
The pattern consists of a small real body (candlestick body) and a long shadow (shadow) at the top, while it has little or no shadow at the bottom.
Evening Star: This figure in candlestick chart analysis, falls among the three-candle reversal figures and is a bearish pattern that develops in an uptrend.
The first day (the figure is also valid for an intraday analysis) is represented by a wide-range white candle followed by a Star.
The middle candle (the star, precisely) records a gap up from the body of the previous candle, which we said must be wide-range and bullish, thus with the close greater than the open.
Hammer: The hammer is a bearish trend reversal pattern in candlestick analysis, consisting of a single candle.
It falls among the patterns that do not need to be confirmed by subsequent candles, except for certain limitations.
It is a pattern easily identified by the presence of a very small body and a long shadow that must be at least twice as long as the body.
This pattern can be identified after a downtrend (a bearish trend) and often heralds an impending market reversal, i.e., it identifies an area of price where buyers begin to confront and resist sellers until they eventually take over.
Inverted Hammer: Since this is a bullish reversal pattern we will find it after a bearish trend.
It consists of a small body located on the lower part of the range and a long upper shadow that should be at least twice the size of the real body; the color of the body is not relevant.
In the classic figure, the lower shadow should not be present at all, or in any case, should be insignificant.
For this type of pattern, it is prudent to wait for confirmation, which could be given by an opening, of the next candle, higher than the real body.
Hanging Man: The Hanging Man is a candlestick pattern with bearish implications and exactly mirrors the hammer analyzed above.
We can find this pattern after a prolonged uptrend or, as we shall see, even after a correction phase.
In contrast to the hammer, the hanging man has a considerably higher probability of success, at least according to statistics reported by candlestick treatises.
In fact, this pattern would turn out to have a 69 percent probability of success, compared with 41 percent for its opposite.
Moreover, its recurrence, although fairly frequent, is far less than that of the hammer.
Engulfing: The Engulfing pattern consists of two consecutive candles with a real body of opposite color.
The body of the second candle completely encloses the body of the previous candle.
The first candle of the Engulfing pattern has a narrow range body, while the next one has a wide range body, this is because the movement of the second candle is much wider than the previous one, as it may reflect the possible exhaustion of the current trend.
The width of the two candles that make up the pattern may have some significance, the narrower the range of the first candle and the wider the range of the second, the more reliable the pattern.
The formation of this pattern is quite frequent and has a success rate of around 45 percent.
Harami: The candles that make up the Harami pattern are the same candles that also form the Engulfing pattern, but arranged inversely. In practice we have a two-candle formation, the second of which is 'inside' that is, entirely contained in the one that precedes it, within the limits we will immediately discuss.
We find the bearish Harami at the end of an uptrend or after a bullish correction in a downtrend.
It consists of a wide-range candle that totally encloses the candle that follows it, the latter of which must be narrow-range.
It is a kind of inside day, as mentioned, with the difference that in the Harami only the body of the narrow range candle is referred to and not the lows and highs.
In other words, it is only the body that has to be enclosed in the previous candle, while the shadows have no significance.
From the most authoritative manuals on Japanese candles, we know that this pattern has a 50% success rate. However, even here the probability of success increases if we wait for confirmation, which occurs when prices violate the low of the pattern.
Doji: There are certain types of Japanese candles that can often identify important market turning points.
One such pattern is undoubtedly the Doji line.
On daily charts, Doji lines often indicate the beginning of a minor or intermediate trend, so recognizing this type of pattern can prevent us from making common mistakes such as entering bullish on market highs or bearish on lows, or conversely it can provide us with valuable indications to take a position just on the eve of a major trend reversal.
There are as many as 4 types of Doji candles: the classic Doji figure that has coincident closing and opening and fairly narrow range and indicates considerable indecision.
The second version and the long-legged Doji figure, again characterized by coincident opening and closing but a considerably wider range than the classic Doji.
This pattern indicates a marked upward run of prices, then pushed back down to the opening level by strong profit-taking. Behavior of traders, which, returned graphically by our candlestick pattern, indicates extreme indecision.
The third type of Doji is the Gravestone Doji, a candle with coincident opening and closing and a long upper tail. Literally 'tombstone' from the name we can deduce what its implications are.
Again we have a notable rise in quotations then pushed back strongly downward to the opening price by profit-taking.
The latest version of this type of pattern is the Drangonfly Doji which is the opposite version of the Gravestone Doji.
In this case we have a strong price decline immediately after the opening and then significant profit-taking that pushes the price back to the opening level.
Piercing Line and Dark Cloud Clover: The Piercing Line pattern is a two-candle reversal pattern that forms after a downtrend or at the end of a correction in an uptrend. The first candle is black (i.e., negative) confirming the downtrend, while the second, which opens on a new low (gap), is white and closes above the middle of the previous candle.
The probability of success of this pattern is 47%, consequently it is advisable to wait for confirmation, which can be given as always by the breaking of the high of the reversal candle
Tweezers Top and Tweezer Bottom: This pattern of candlestick trading consists of two candles with coincident highs or lows.
The term "tweezer" is used precisely because this pattern is likened to the two ends of a tweezer.
In an uptrend a tweezer pattern is formed when two highs coincide; conversely, in a downtrend it is formed when two lows coincide.
The candles that form this pattern can take various shapes, can have a longer or shorter body, shadows of various sizes, and even the presence of a Doji candle could contribute to the creation of a Tweezer pattern.
This formation acquires more value when it occurs at the end of a strong bullish or bearish movement and also when a reversal candle is present in its formation, which can give rise to another two-candle pattern.
Morning Star: The Morning Star pattern is a bullish reversal candlestick pattern.
The pattern consists of a bearish wide range candle, followed by a narrow range candle that registers a negative opening gap.
The third candle is represented by a bullish candle that, again, has an opening gap, this time positive, compared to the narrow range candle.
Contrary to what one might think, the probability of success of this pattern does not exceed 50 percent (a percentage taken from Gregory Morris statistics), consequently in my many years of trading experience I have devised some tricks aimed at avoiding some of the most frequent false signals generated by this albeit interesting chart pattern.
Before moving on to some examples drawn from the real market, I would like to clarify what might seem all too obvious: when moving from theory to practice, that is, from candlestick manuals to the real market, finding the perfect pattern is not so common.
This is, of course, a general statement that applies with regard to any chart conformation, even those in classical technical analysis.
Consider, for example, heads and shoulders, which, in real markets, very rarely form as per the textbook.
In the case of the Morning Star, the perfect pattern would involve a gap both makes the first and second candle and between the second and third.
Homing Pigeon: We find this figure in a downtrending market and it is a pattern that, like its bearish counterpart Discending Hawk, this Japanese candlestick strategy highlights a weakening of the current trend to the point of often forming as a true reversal figure.
The Homing Pigeon is formed by an initial bearish wide-range candle (close < open), which is followed by a candle, also bearish, within the wide-range candle that precedes it.
In the figure the pattern is shown in its optimal configuration, the one that in traditional technical analysis corresponds to the so-called 'inside'.
Moreover, the Homing Pigeon differs from the traditional inside in that in this candlestick pattern only the body of the second candle needs to be included within the first candle, while the shadows need not remain within the range of the previous candle.
Descending Hawk: This pattern, with a singular name (descending hawk) like so many other figures in the candlestick, consists of a positive (close>open) wide-range candle followed by a candle, also positive, with a smaller range than the first.
As a result, we have a day when the trend was broadly positive followed by a day when prices, while always having a positive excursion remained within the previous candle.