How to Read Candlestick Charts: Improve the Accuracy of Your Trades and Avoid False Signals

How to Read Candlestick Charts: Improve the Accuracy of Your Trades and Avoid False Signals

Hello traders! Today I want to make some considerations about how to read candlestick charts. Which are the main aspects we should take care when analyzing candlesticks graphs?

Study candlestick charts means study pure price action.

That’s why this technique has acquired an ever more importance, since its introduction to the occidental world by Steve Nison in 1991.

Today, I don’t want to discuss about specific patterns like engulfings or hammers; rather, I would like to introduce the major elements we should investigate to understand possible future market direction.

Before to start, I will recall some basic concepts about candlestick constructions for who don’t know this technique. Feel free to skip this part if you already master these concepts.

How to read candlesticks charts: what are Japanese candlesticks?

We build Japanese candlesticks using the OHLC data (Open, High, Low, Close). They are similar to price bars except for the part called “body” among the open and the close:

bull and bear candlestick for forex and stock markets

This main difference, the body, is the true innovation that granted this charting method to establish itself as the market standard. It provides a better and more impactful indication about market conditions, especially if the body is quite wide (I’ve talked about size in the paragraphs below).

Wicksare also of critical importance: they represent price rejection, showing how the battle between buyers and sellers developed in the market.

Why this technique is so popular?

Candlestick patterns are easy to be learned: most of them are formed by 1 or 2 candles. Furthermore, we can combine them with other technical studies like support and resistance trading, or in proximity of upwards or downward trendlines. You can see an example about FTSE 100 index:

An evening star nearby an upward trendline

Lastly, they provide clear entry and exit points in the market: each pattern has specific characteristics that help traders to insert orders in the right point.

How to read Candlestick charts: the multi-timeframe approach

General rule:

The higher the timeframe in which a formation develop, the greater the influence of this on price action.

This consideration is true also for candlestick patterns.

Bearing in mind this, we can say that the sentiment (bearish and bullish) of a specific formation, is amplified if on a higher timeframe, there is another patterns with a similar sentiment.

Look at this visual example to have a better understanding:

Use different timeframes to improve your Japanese candlestick analysis
Use different timeframes to improve your Japanese candlestick analysis (part 2).

Let’s suppose that our operating timeframe is the 4h. We notice a doji of inversion (bearish sentiment) after a protracted uptrend. We then look at a higher timeframe, searching for additional confirmation. The manifestation of an evening star (bearish bias) on a daily timeframe, corroborate our believes about a possible inversion in the 4h chart.

Elements you must know if you want to learn how to read candlestick charts

Whatever is your goal, you must know some basic characteristics of Japanese candlesticks. We will discuss about:

  • Intrinsic vs Extrinsic biases
  • Candlestick Size
  • Candlestick Colour
  • Location
  • Preceding Price Action

Intrinsic vs Extrinsic biases

Candlestick patterns have an intrinsic bias, which could be both bullish or bearish.

There isn’t a general rule for determine which is the intrinsic bias. Thus, the only thing we can do is to study the characteristics of each pattern we would like to trade.

There are three possible intrinsic biases:

  • Continuation (bullish or bearish) – is the example of the rising three method;
  • Bullish reversal – like the hammer for example;
  • Bearish reversal – like the shooting star for example.

Even though intrinsic biases are crucial for candlestick pattern, we must remember that not all the similar formations have the same biases.

Look at this example on the forex market, EUR/USD 1h:

How to read candlesticks charts - the intrinsic and extrinsic biases

We can see two equal pattern, both bearish, named tweezer top. Even if they are similar, in one case (A) we can notice that they appear after a downward phase; instead, in the other case (B) we can see this formation at the end of an upward trend phase.

Clearly, a bearish formation assume less importance if spotted at the bottom of a downtrend; in this case in fact, point A wasn’t a good entry point for a short trade. Point B instead, provided an amazing signal to enter in the market.

We can conclude that external factors influence the intrinsic bias connected with a specific pattern. We talk about extrinsic bias.

If extrinsic and intrinsic biases are in agreement, this increase the overall sentiment connected with a pattern.

External factors affecting intrinsic bias

According to Mark Andrew Lim, external factors that can overwhelm intrinsic bias are:

  • Location – a bullish pattern has a powerful bias at the end of a downtrend;
  • Overextension – a bearish formation is more reliable nearby long standing resistances than on support levels;
  • Relative proportionality – if the range of the candles start to decrease, this could be an initial sign of change in price action;
  • Prior activity – if there are signs of weakness or strength in the market, the manifestation of a reversal pattern acquire more importance.

Candlesticks Size: Body and Overall Range

You cannot learn how to read candlestick charts if you don’t consider pattern’s size.

Think about it: the larger is the size of a pattern, the more evident it is and so the higher it’s the influence on trader’s decisions.

Let’s consider the EUR/USD cross on Forex market:

How to read candlesticks charts - candlestick size

After a long period of consolidation, price break above a market structure. Then it consolidates: we can see a number of narrow-range candles.

Then, a continuation pattern (three white soldiers), appear: 4 wide candles push price higher, moving it into the main direction of the market.

These big candles clarify which is the actual condition in the market, showing buyers’ strength.

Candlesticks’ colour: does it matter?

Well, it depends.

Usually, for small formations like doji, spinning tops/bottoms and similar we don’t pay attention about the specific colour of the pattern.

Nevertheless, sometimes colour is not important even for wider formations like for example bearish or bullish harami or tweezer tops/bottoms. In these cases in fact, the intrinsic sentiment is the same whatever the colour.

Patterns’ Location: a key aspect to understand how to read candlestick charts

Candlestick patterns work best nearby structures of price, like support, resistance or trendlines.

That’s why location is crucial if you want to learn how to read candlestick charts. More in details:

  • bearish reversal candlesticks – like tweezer tops, evening star, shooting star, bearish harami or bearish engulfing – work best nearby resistance levels;
  • bullish reversal candlesticks – like tweezer bottoms, morning star, Hammer, bullish harami or bullish engulfing – work beast nearby support zones.

Here below you can find two examples, both about forex market, JPY/GBP cross:

How to read candlesticks charts - a bearish shooting star nearby an upward trendline
How to read candlesticks charts - a bullish tweezer bottom nearby a support zone

Look at preceding price action! Think about the context in which you are

Think about it: if price show strength, and an evening star suddenly appear, you would likely to short the market?

Well, I hope you answered no to this question.

Prior market action should support your decisions based on candlestick patterns recognition.

If there is agreement between market conditions and candlestick intrinsic and extrinsic biases, you can increase the accuracy of your trades:

How to read candlesticks charts - trade in the context

The above example concern Microsoft. Price has broken an upward channel, showing signs of strength. A tweezer top suddenly appear, providing a signal for a bearish entry, in contrast with previous price action.

We should avoid this trade, looking instead for a buying opportunity in the market.

The outcome is this: you should pay attention to the context!

Conclusions

I hope you will now understand how to read candlesticks charts.

I’m sure that if you will includes these considerations in your everyday trading, you will be able to increase the accuracy of your trades, avoiding more false signals than before.

If you liked this article, please consider to share it and help us keep growing. Check out the other free resources of the blog and have a look to our beginner’s guide to price action trading! See you next time!

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