Candlestick Charting Explained

Candlestick charting is a method of stock price technical analysis that uses visual candlestick charts to identify bullish and bearish stock trends, and stock trend reversal points. Like other methods of technical analysis, candlestick charting assumes that future stock price action can be predicted based on the assumptions that all that is known about a stock is already priced into a stock’s price and that trading momentum will dictate the near term price movement of a stock.

As can be seen by the figure above, candlestick charting produces a chart of a stock’s trading data that visually displays the daily trading action of a stock as white and black blocks that look like candlesticks. A white candlestick indicates a close higher than the opening price, which is bullish. A black candlestick indicates a close lower than the opening price, which is bearish. The lines (wicks) on either end of the candlesticks are called shadows, and represent the lowest and highest trading level for the stock for the trading day.

In order to use the information provided by candlestick charting, a stock trader has to look at the chart over a period of time longer than a single trading session and a single candle. When looked at more broadly, a candlestick chart reveals bullish, bearish, and reversal indicators that traders can use to make trading decisions. Successive white candles indicate strong buying pressure and are bullish, while successive black candles indicate strong selling pressure and are bearish. A change in candles from white to black or black to white can indicate a reversal in trend, especially candles that have long wicks that indicate a surge in selling or buying occurred during a trading day, which then reversed before the close. Many traders use candlestick charting to identify possible stock reverse points, then wait for a confirmation of a trend reversal by the candlestick that appears on the chart the following trading day.

The Limitations of Candlestick Charting

While candlestick charting can be a very useful technical analysis and trading tool, it does have some limitations. Since candlestick charting assumes that all is known about a stock and momentum will dictate a stock’s future near term trading direction, it fails to account for external factors that can affect a stock’s price, such as unexpected news or an overall stock market trend reversal that affects many stocks.

The best way to protect trading capital when using candlestick charting to make trading decisions is to use stop losses or call and put options to protect against unexpected news events. That way, if the candlestick charting technical analysis does not work out as expected, the trade can be exited without substantial losses.

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