Summary
Candlesticks are among the most well-known and widely used tools in technical analysis, providing a clear and visual representation of price movements in financial markets. Originally developed in Japan, candlestick charts have established themselves over centuries as a valuable tool for interpreting price developments and identifying market trends.
In this first part, we explore the history, explain the basic components, and demonstrate the structure of an individual candlestick.
Key Takeaways
- Roots of Candlestick Analysis: Candlestick charts originated in the 18th century with the Japanese rice trader Munehisa Honma, who recognized the fundamental dynamics of supply and demand, as well as the emotions of market participants. His simple diagrams laid the groundwork for candlestick analysis, which is used to represent price movements in financial markets.
- Introduction to the West: Candlestick charts became popular in the West only in the 1980s, primarily due to the efforts of U.S. trader and author Steve Nison. His book "Japanese Candlestick Charting Techniques," published in 1991, made the principles of candlestick analysis accessible to a broader audience and helped establish the charts as an important tool in technical analysis.
- Structure and Significance of Candlesticks: A candlestick consists of a body that represents the price range between the open and close, along with upper and lower shadows that indicate price movements over the period. These elements help traders quickly identify market sentiment, trends, and potential reversal points, enabling them to make informed decisions.
Origin and History of Candlesticks
It begins with a journey into the depths of Japanese financial history. A rice merchant laid the foundation that would shape modern chart analysis—a legacy stretching from the rice fields of 18th-century Japan to today's global trading floors.
The Rice Merchant
Munehisa Honma, also known as Sokyu Honma or Sokyu Homma (1724-1803), was a rice merchant from Sakata, Japan. He traded at the Dojima Rice Exchange in Osaka and is regarded as a key figure in the development of candlestick charts.
Similar to today’s futures markets, the rice market was used to secure prices for future rice deliveries. Honma understood the fundamental dynamics of supply and demand but also recognized that traders' emotions significantly impacted price movements.
He aimed to document the emotions of market participants, and this work became the foundation of candlestick analysis. Honma developed rudimentary charts—simple rectangles—that marked the origins of today’s candlestick charts. The basics were simple yet profound. His rectangles evolved into the first candlesticks, showing opening and closing prices as well as highs and lows.
The Journey to the West
Candlestick charts made their way to the West many years later. In the 1980s, more analysts began learning about this form of chart analysis. Candlestick charts gained significant popularity thanks to the efforts of American trader and author Steve Nison in the 1980s and 1990s. Nison encountered the candlestick technique during his research trips and recognized its potential for technical market analysis. With the publication of his book "Japanese Candlestick Charting Techniques" in 1991, candlestick charts gained even more traction in analysis. Nison’s book made the principles of candlestick charts accessible to a wider audience.
The clear representation of patterns and the straightforward application contributed to the rapid rise in the popularity of candlestick charts. Visualizing price information with candlestick charts allows for an effective depiction of market sentiment, trends, and reversal points.
Traders appreciate the clarity of these charts and the ability to quickly draw conclusions from patterns. With the increasing digitization of financial markets, candlestick charts have become a standard tool in technical analysis.
What is a Candlestick?
The simple answer to this question is:
A candlestick is a graphical representation of price movements in a financial market. It displays the opening, high, low, and closing prices for a specific time period.
The detailed answer starts with an exploration of how prices are generated in the first place.
With each trade executed in an underlying market, a price is established at which the trade took place. A seller and a buyer agree on a price for the underlying financial instrument (such as a stock, commodity, currency, etc.) and trade a defined quantity.
The price of this trade is referred to as a tick, representing the last recorded price at that moment. By stringing together each individual trade to visualize them, a tick chart or line chart is created.
The individual prices have no time reference. For example, there may be 5 ticks per second, or in less liquid markets, only one tick every 10 seconds.
If we want to group the individual ticks into time intervals, candlesticks or bars come into play. Suppose the tick prices are grouped as candlesticks over time intervals; this results in the following chart.
This is a simplified representation to explain the concept more clearly.
Individual prices are grouped into time intervals, and these price fluctuations within the respective time period form the candlesticks.
Structure of a Candlestick
A single candlestick consists of two main components: the body and the wicks or shadows (upper shadow and lower shadow).
To visualize a candlestick, four pieces of price information are required:
- The first price recorded in the specified time period.
- The highest price recorded in the specified time period.
- The lowest price recorded in the specified time period.
- The last price recorded in the specified time period.
The following illustration shows the structure of a candlestick that indicates a rising price movement (left) and a candlestick that indicates a falling price movement (right).
Candlestick Body
The area between the opening and closing prices is called the body of the candlestick, or simply the body. Depending on the charting program or user settings, candlesticks with a closing price higher than the opening price are displayed in white or green. Candlesticks with an opening price higher than the closing price are typically shown in black or red. This color coding allows traders to quickly identify whether the price movement is rising or falling.
The body of a candlestick can vary in length. A long white or green body represents strong buying pressure, while a long black or red body indicates strong selling pressure within the specific time period.
Short candlestick bodies, on the other hand, represent a more balanced market, where neither buyers nor sellers exert strong pressure.
Upper and Lower Shadows
For a rising candlestick, the upper shadow marks the price range between the highest price reached and the closing price within the time period displayed. The lower shadow marks the price range between the opening price and the lowest price reached within that same period.
For a falling candlestick, the upper shadow marks the price range between the highest price reached and the opening price in the time period displayed. The lower shadow marks the price range between the closing price and the lowest price reached in that period.
Significance of Upper and Lower Shadows
An upper shadow represents a higher price level above the body that was traded but could not be maintained by the close of the period.
A lower shadow represents a lower price level below the body that was traded but was not sustained by the close of the period.
Just as a candlestick body can vary in length, so can the upper and lower shadows.
Short shadows indicate that the traded price range within the period mostly stayed near the opening and closing prices of that period.
A long upper shadow suggests that buying pressure was present but was eventually countered by selling pressure.
A long lower shadow indicates that there was strong selling pressure, which was then balanced out by buying pressure.