What are Japanese Candlesticks?

A ‘candlestick’ is a chart that displays the high, low, opening and closing prices for a security for a single day. Candlestick charting is based on a technique developed in Japan in the 1700s when Homma, a Japanese trader in the futures market, discovered that although there was  a connection between price and the supply and demand of rice, the markets were intensely swayed by the emotions of traders. He understood that when emotions were factored into the equation, there was a vast difference between the value and the price of rice. This difference between the value and the price is as pertinent to trading today as it was to rice in Japan centuries ago. In fact, the principles established by Homma are the basis for the candlestick chart analysis, which is used to measure market emotions surrounding a stock, commodity currency or any other financial instrument.

Japanese candlesticks are used in technical analysis in order to determine when to enter and exit trades. The middle part of the candlestick is the body and indicates to investors whether the closing price was higher or lower than the opening price. A bearish pattern will appear in black and red if the stock closed lower while a bullish pattern will be white and green if the stock closed higher. A Japanese candlestick shape differs based on the relationship between the day's high, low, opening and closing prices.

There are three main parts to a candlestick--The Upper Shadow is the vertical line between the high of the day and the close (bullish candle) or open (bearish candle). The Real Body is the middle colored portion of the candlestick and represents the difference between the open and close prices. The Lower Shadow is the vertical line between the low of the day and the open (bullish candle) or close (bearish candle).

Charts

Candlestick charting and analysis is an effective tool and a powerful method for Forex trading; they provide visual insight into current market psychology. The use and interpretation of candlesticks in technical analysis is based on the following premises:

• Price action is more important than the reports on news, earnings, etc.
• All the known information is reflected in the current price,
• Emotions of fear, greed and hope drive buyers and the sellers to move markets.
•  The actual price may not reflect the underlying value.

The candlestick charting technique is very popular among traders, mostly due to the fact that the charts reflect only short-term outlooks only, often lasting less than eight to 10 trading sessions.

Although traders can use either fundamental analysis or other methods of technical analysis in addition to candlesticks before making a trade, the actual message inherent in the candlestick pattern is what is most important since it provides us with the insight to what the market is thinking and this information is key to a profitable interpretation. In addition, candlesticks offer us the opportunity to identify reversals early enough to enable the system to establish the stop loss and confirmation levels in good time.

Candlestick charting is a very multifaceted and is not an easy system to understand.