What Do Candlestick Patterns Indicate?

The Japanese candlestick, hereafter simply referred to as candlestick or candle, conveys the open, high, low, close price points for the period in question. For the sake of this article, letís consider the daily period (using end of day historical data) which is suitable for active and short-term traders.

Candlestick patterns can embrace 1, 2, 3 or even more days. Examples of 1-day candlestick patterns include doji, hammer and harami; 2-day patterns include counterattack, engulfing and separating lines; 3-day patterns include morning star and evening star.

In general terms, the essence of candlestick pattern formations is that they indicate continuance or reversal of an up-trend or a down-trend. This is the basic answer to ďWhat do candlestick patterns indicate?Ē.

For example, a doji is a candlestick pattern where the open and close prices are at the same level. Following a trend in which the stock price has risen or dropped for a duration of many days, the appearance of the doji is a signal that the trend may be coming to an end, with an ensuing reversal of the stock price direction. Therefore, the trader must take the signal and observe what happens on the next trading day and react accordingly.

Letís look at that example in more detail. Suppose a doji appears after a 10-day run-up in the price of a stock in which the trader is holding a long position. With the appearance of the doji, the trader should take note of this signal and look for a closing price below the doji level on the next trading day. If that happens, the trader would be well-advised to close the long position and take the profit because it is likely that the up-trend is in reversal progression.

This is only one example from the multitude of candlestick patterns. There are entire books and web sites dedicated to the study and discussion of candlestick patterns, what they mean, the interpretation of the candlestick pattern formations, and the trading decisions to be taken.

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