A stock chart is a simple chart that has the stock price of a company plotted alongside time. The stock price of a company rises, loses, or trades sideways with each trading session. This change is reflected in a stock chart.
However, in a simple line chart, only the market-closing of each stock is plotted. The market closing is simply the price at which the stock traded in the last transaction for the day. Although this information is useful to track the historical performance of a company, we could certainly benefit from more information about the stock price’s intraday action. This is where candlestick charts have their importance.
A candlestick chart gives more information than an ordinary stock chart
A stock has hundreds of transactions in a single day. We can’t track them all as a chart reader. It is also worthless to do that. Rather, if we can know the opening, high, low, and closing of the stock for the day, we get the overall picture.
This is a single candle of a candlestick chart:
The opening price is the price at which the stock opens, i.e. the price at which the first transaction took place for the day. The high is the highest price at which the stock traded and the low is the lowest price. Finally, the closing is the price at which the stock traded in the last transaction for the day. All four values can be represented in a candlestick chart. Reading candlestick charts is simple and fun.
If the stock price loses on a trading day, the closing price will obviously be lower than the market open. This is seen in the candle for that day. Furthermore, the candle is now red to symbolize that the stock has lost for that day.
Personally, these are the main reasons I love to read candlestick charts:
a) Like I already said, it gives more information about a stock’s intraday action than a simple line chart.
b) The candles are easy to understand and need very little interpretation. You understand the market trend and psychology immediately after looking at a candlestick chart.
c) Candlestick patterns help investors to predict the next movement. Investing is a game of probability, and the way to keep probability in your favor is to learn to read candlestick patterns.
d) Candlestick patterns have fun, memorable names. The patterns can be identified easily in a candlestick chart.
You will learn about candlestick patterns in the next article. For now, let me just give a brief introduction about candlestick patterns and why they work.
Technical analysis looks very mathematical. All the trendlines, indicators, fancy terms make it look hard to understand. However, if technical analysis were to be distilled in a few words, it is just a study of investor psychology. Technical analysis is not a scientific field. It is vague, deep, and beautiful, just like art.
All the indicators and charts are studied to gauge market sentiment. Fundamental analysts believe that company fundamentals and profitability drives stock prices. However, technical analysts are of the opinion that company fundamentals do not buy or sell a stock. Investors do. And investors are inherently irrational because they are humans. Greed and fear have a lot of say in a decision that investors make. Thus, the most profitable way is to know what the investors think and capitalize on that information.
Candlestick patterns work for the same reason. We always study candlestick patterns alongside the volume (number of shares traded). The shape and color of the candle gives us the market movement. The volume gives us the strength of that movement, i.e. how many investors brought that change. These two pieces of information is enough to understand where the investors want to take the company’s stock price.
Although we can study candlestick patterns at every instance of a trend, they are most profitable when they tell whether the trend is going to reverse. Thus, reversal patterns are of most importance for an investor.
These are the most important and profitable candlestick patterns: