Reading and Using Your Candlestick Chart to Make Decisions about Stocks

Candlestick charts are primarily for short-term trading decisions; longer-term traders or investors tend to use candlestick charts to pick entry and exit points. It is important to understand when candles matter most in stock buying and selling decisions; you also need to become familiar with some of the most common patterns.

Knowing when candles matter

Candlesticks are built based on intraday price movements, so daily candlesticks aren’t typically used with long time horizons of a year or more. For shorter-term trading opportunities, though, candlesticks can be helpful.

Investigating individual candles

Candlestick signals typically have a life of five to ten candles. As you might expect, it is easier to find hollow candles with a small top shadow in an uptrend. IIt is easier to find filled candles with small bottom shadows in a downtrend.

As each candle is interpreted to suggest bullishness or weakness, it is important to realize the next move expected may not follow through on the next candle.

Looking at groups of candles

Individual candles may not be very reliable to trade with, but looking at candles collectively can be helpful. Looking across a few months of candles gives you more information, and trading in the direction of the trend is usually more profitable.

When a stock is in an uptrend, more hollow candles are present. When a break in a trend line occurs, you may experience heavy selling. On most charts, if you can draw a multi-month trend line, the candle that closes below the trend line is usually a big filled candle. An example of a trend line break on Consolidated Edison (ED) is shown here.

Pairing two or more candles can be a little more valuable to confirm a pattern within a trending market. How is that done? The first candle sets a bullish or bearish expectation for the next day, and the next day, investors watch to see whether the move based on the directional bias starts to happen. If it does, they investigate buying the stock on that basis and go through a process to decide.

Technical analysis tools work better when stocks are trending. A stock moving sideways for years is hard to profit from. However, a stock moving sideways for a month or so also allows you the opportunity to buy near recent lows. The term for a stock with price action moving sideways is consolidating. Consolidating happens when the price of a stock stays between two price levels and moves sideways. The stock shown above consolidated for three months between $67 and $73.

Conversely, a sustainable move above a previous consolidation range will usually need to be a larger hollow candle. The thinking behind the candle size is that if the price moves above a consolidation area, the new buyer has to be willing to pay more for the stock than at any time in the consolidation period. If only a few new buyers are willing to buy into the stock at a higher level, the chart is most likely to fall back into the consolidation range. Rarely are timid moves above a consolidation zone the best ones to buy.

Buying based on bullish candlestick patterns

Candlesticks carry a lot of information. Understanding candlestick patterns can be very beneficial to see a change in trend or typical price action that supports a move in the direction of the main trend.

Above, the period from February 26 to March 2 is a great example of seeing a bullish signal on a candlestick chart. First of all, the intermediate trend was up but had consolidated in a small range between $66 and $70 for about a month. After moving down hard on February 27 to the previous low of February 17, the next two candles got very small, showing a loss of downside selling pressure.

On March 2, the stock fell hard after the market opening, but by the end of the day the price had recovered above the previous close and above the open to create a long shadow under the first hollow candle. This shape of candle is a bullish candlestick called a hammer and is often seen at the bottom of a countertrend move. This is exactly what you would look for to end a downward move. When March 3 had similar price action (another hammer) and closed higher, this was very strong price action. The stock continued higher for most of March.

One reason to use a candlestick display is to help find bullish setups. StockCharts.com runs a scan every day looking for hammer candlesticks like the one described earlier and various other candlestick patterns. Using these tools, some investors find good stocks to invest in just using candlesticks. The image below some of the other candlestick pattern names, and the number of occurrences is shown on the right side under each stock market.