How to understand charts like pro traders
Candlestick charts are one of the most popular charts used in analysing price movement and overall investor emotion when looking at stocks, forex and cryptocurrencies. They can be used to quickly determine the key price information of an asset in a certain time period and overall direction of the price.
To understand how the candlestick charts show us key price data, we must first understand what these key components are. Traders and Investors who are interested in analysing short term sentiment or emotion are interested in four main components:
- The Opening price — This is the price of the asset when the time period first begins. For example, If we’re interested in looking at daily price movements (so the time period we’re looking at is 1 day) then the opening price would be the price of the asset at the beginning of the day.
- The Closing price — This is the price of the asset when the time period ends. Again using the daily price movement example, this would be the price at the end of the day. If we’re looking at the 1 hour price movement, this would be the price at the end of the hour.
- The Low price — This is the lowest price that the asset reached in the specified time period between the time of open and the time of close. For the daily time period, this would be the lowest price the asset hit on that day.
- The High price — This is the highest price that the asset reached in the specified time period between the time of open and the time of close. For the daily time period, this would be the highest price the asset hit on that day.
Please note that not all markets are actively trading all the time. Unlike Forex and Crypto which can be traded 24/7, the stock market is only active within its trading times. The New York Stock Exchange (NYSE) for instance, trades on weekdays between 9:30am and 4:00pm Eastern time not including certain holidays. This means, for stocks listed on the NYSE, the times the open and close prices are taken at would be different to open and close times for Forex and Crypto.
When using the 1 day time period, stocks listed on the NYSE would show opening prices taken at 9:30am ET and closing prices taken at 4:00pm ET. There are also premarket and aftermarket hours for certain exchanges which trade outside these hours, however these are not accessible to everyone. Most traders will not use this data however for those who deem it useful, candlestick charts can in fact include these hours if you pick extended price data.
Determining price information using candles
The image above displays what these candlesticks look like, each one of these represents a time period and as shown in the diagram, we can quickly see the four key price points in that time period.
The solid rectangle in the diagram is called the candle body which, on its own, shows us whether the price increased or decreased by its colour, usually if it’s red the price decreased and if it’s green, the price increased. These colours can be changed by the trader in the platform, green/red and white/black are the most popular. The candle body also shows us the open and close prices which are on different ends of the candle body depending on whether the price of the asset increased or decreased (view image above).
The lines which come off the candle body are called wicks, or candle wicks. Regardless of candle colour, the top of the higher wick shows us the high price, the maximum price achieved in that time period, and the bottom of the lower wick shows us the low price, the minimum price achieved in that time period.
Candlestick charts as a whole
This is what a candlestick chart looks like all together, this is a candlestick chart of the Dow Jones Industrial Average Index, the time period is 1 week so each candle represents the price movement of one week. This chart makes it easy for investors to view the price movement of an asset over a prolonged period of time as well as the micro movements per time period. This is much more effective at showing overall price movement than a standard line graph.
Candle Patterns & Short Term Market Sentiment
Some investors and traders use candlestick charts to look for certain patterns or use these candles to understand market sentiment. Using a simplified approach, following three small bodied and small wicked green candles, a large red candle which engulfs the entirety of these three candles will signify that the market emotion and sentiment is currently bearish (anticipating falling asset prices).
The logic behind it, regardless of evidence to support the idea, is that if in one time period, the price movement moves greater in the opposite direction than the last three time periods, the current market expectation is that the asset price will fall.
Many traders will see these candles and deduce that in the short term (one to a few candles in the future), the general market sentiment is negative. If the candles were reversed and there were three short red candles and one large engulfing green, the general market sentiment in the short term would be deduced as positive.
Another way some traders use candles to determine short term sentiment or potential price movement is the wicks. A long top wick compared to the body with a short bottom wick can be seen as negative due to the bulls (market participants buying in hopes of the price increasing) being “weak” and not being able to have the candle close near the high price of that time period. A long bottom wick with a short top wick and short body can be deduced as the opposite case. Further a short body with long wicks on both ends can be seen as indecisiveness in the market… market participants can’t decide on the outlook in the short term.
Trading Using Candlestick Charts & Final Thoughts
Candlestick charts are often used in conjunction with other trading indicators such as moving averages and trend strength oscillators (I may cover the most popular trading indicators at a later date). When entering and exiting a trade, traders try to use candlestick patterns and other indicators to select and gauge the most profitable prices to enter and exit a trade at.
Whether these patterns can actually produce successful consistent trading results is not the point of this article and in actuality the majority of traders suffer substantial losses when trading based solely on price movement analysis. Smarter traders may use these patterns and indicators together with a fundamental catalyst* or when trading assets they believe to be fundamentally undervalued** to better manoeuvre their trades.
* A Fundamental Catalyst is something like a new piece of information or news released that changes the value of an asset, this gives price changes actual fundamental and intrinsic reasoning
** Some assets, when extensively analysed, appear to be undervalued when compared to similar assets. Many traders try to look for these assets in order to have an increased chance of profitability based on the assumption that the asset’s price in question will converge with other similar assets.
