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Investing Tools: The Basics of Candlesticks

By  May 26, 2011

Topics: Finance & Investing

Spotting trends quickly and easily is a goal of most technicians. This is why candlestick charting is so popular. A single candlestick reveals everything you need instantly: high and low range, open and close, and direction of price movement. Candlesticks are the perfect analytical tool, but ironically, many are not sure what to look for in the patterns candlesticks create.

Candlesticks contain several valuable features:

1. The “real body” is a rectangle that is white (for days that move up in price) or black (for days that move down in price). The top and bottom of the rectangle are the opening and closing prices.

2. The “shadows” appear above and below the real body. Also called “wicks” or “tails,” these show you the day’s complete trading range above and below the opening and closing prices.

3. Day-to-day changes are very important in the patterns that candlesticks form over two or three trading sessions. These various patterns are excellent for predicting reversals or for confirming a current trend.

The size and extension of candlesticks are important by themselves. So the very long session or the very narrow may serve as reversal or continuation indicators. When the shadow is exceptionally long --- especially on a narrow-range day, or doji -- it also signifies declining momentum on the side of the shadow (above for buyers or below for sellers).

With any system, candlesticks included, you need to confirm anything that appears to be about to happen. Candlestick formations are great confirmation tools for other, traditional patterns, and can strengthen what you conclude from observing chart patterns. So combining candlestick formations with patterns involving resistance and support, price gaps, relative strength, money flow, volume spikes, and moving averages, makes technical analysis more accurate and helps improve entry and exit timing.

No system works 100% of the time. Candlesticks do not substitute for analytical methods, but they do provide one more strong confirmation tool that is valuable for short-term trading. For the pure speculator, day or swing trader, and even for the long-term value investor, using candlestick charts just makes sense.

Many sites offer free candlestick charting. One of the most flexible is www.stockcharts.com, which lets you design your chart to include as many accompanying technical indicators as you want; trading session duration; and even colors. For example, you can vary analysis daily charts, or weekly summaries for a full year.  Since everyone has their own systems and preferences, the free online charting services are exceptionally valuable. Coupled with the ability to interpret candlesticks and what they mean in a series of sessions, any trader’s analytical skills can be improved greatly.

There are over 100 distinct candlestick patterns of one session or longer, so mastering candlestick charting takes practice and study.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE blog and to the Seeking Alpha blog.