Deciphering the Candlestick Charts - For Intermediates (Maybe?)

Updated: Dec 29, 2019

Disclaimer: The charts displayed are meant for educational purpose. None of the content contained here constitutes a recommendation to make any investment. I am not responsible for any loss arising from any investment based on any information contained here. Readers are expected to perform their own due diligence before venturing in any investments.

A candlestick chart tells a huge tale about what is going on behind the scenes. If you do not have any knowledge on candlesticks charts, please refer here to help you get started.

Let's take a look at the anatomy of the "hammer" & "inverted hammer" candlesticks below.

Fig 1. Anatomy of the hammer & inverted hammer candlesticks

As shown at the top left of Fig 1, the hammer candlestick has a thin body at the top with a long tail at the bottom. On the right, it shows the derivation of the candlestick over time. When the market opens, the bears(sellers) are pushing the price down. As price goes lower, the bulls(buyers) took notice about the lower price and a tug of war begins. Eventually, the bulls(buyers) won the bears(sellers), pushing price up to close above the market open. Three key messages can be derived from this candlestick:

  1. This is a bullish signal because it shows that there are buyers willing to get in

  2. Price is supported at the low, signalling a potential reversal point

  3. The longer the tail, the stronger the price rejection is at the low

The opposite is true for the inverted hammer candlestick which has a thin body at the bottom with a long tail at the top as shown at the bottom left of Fig 1. The price first declines slightly when there are some bears(sellers) in the market. As market progresses, the bulls(buyers) flooded into the market to push the price higher. The bears(sellers) saw the high prices and began to sell (or short). This creates a competition which was eventually won by the bears(sellers) pushing the price right down below the market open. Three key messages can be derived from this candlestick:

  1. This is a bearish signal because it shows that there are sellers willing to cash out or go short

  2. Price faces resistance at the high, signalling a potential reversal point

  3. The longer the tail, the stronger the price rejections is at the high

Do note that it doesn't matter if the price closes above or below the market open to be considered a hammer or and inverted hammer. The more important signal is the existence of the long tail (or wick). Fig 2. below presents the variations of the candlesticks.

Fig 2. Variations of Hammer & Inverted Hammer Candlesticks

Let's take a look at some examples. I have marked out (in boxes) some of the hammers and inverted hammers that distinctively caught my eye in the charts below. Look at how they coincidentally marks the reversal points on the charts.

Facebook (Ticker: FB)

Tesla (Ticker: TSLA)

Crude Oil Futures (Ticker: /CL)

Euro Futures (Ticker: /6E)

Macdonalds (Ticker: MCD)

Cool isn't it? But wait, this isn't a holy grail or a secret to riches. I wish it was this easy.

While the hammer and inverted hammer candlesticks present opportunities for a potential reversal (turning points) of the trading asset, it can't be traded singularly. (I.e. You see a bullish hammer, you go long or if you see a bearish inverted hammer you go short.) It doesn't work like this and you might probably blow your account sooner or later. As you can see in the charts that there are several occasions where using the candlesticks alone to identify reversals wouldn't work. Therefore it is imperative that a trader uses this in conjunction with other strategy filters to achieve higher probability trades with good risk reward ratio.

Always remember that trading is a probability game. Do you know that even if you are only right about the direction of trade 50% of the time, you can still be profitable? If you don't, please refer to this earlier post for more information about risk reward ratio and trade expectancy.

I hope that you have learnt something form this post. The information presented in this post is quite basic and can be found easily online. I just hope to present it to you (especially the beginners) on a platter.

Stay tuned for more advanced use of the candlesticks in my future posts by connecting with me via Facebook to receive the latest updates. If you have any questions, feel free to ask me in Facebook as well.

If you wish to see my trading journal, click here for more. Thanks for viewing!

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