Anatomy of A Japanese Candlestick

Its the most popular method of visualizing a chart in trading. Japanese candlestick in a chart not only displays the OHLC but also the overall price direction within that particular candle period in a more convincing visual mode.

 

I used to believe that a candle explains the price behavior as a whole for a given candle period. For a certain extend its true. But there may be instances where the price momentum and the price trend direction within the candle would entirely oppose the candle type – Bull or Bear.

Candlesticks are based on periods measured by time or number of ticks. e.g. If one candle represents 300 ticks that chart is referred to as a 300 tick chart. Similarly price action based on time would have candles representing a set period of time – 5 min, 15 min, 1 H or Daily.

However tick charts completely disregard time and it may take 5 minutes to form one candle and 5 hours to form the next, depending on the market activity. Hence tick charts provide a compact price action based vantage point to the market.

What the tick charts do best is that it eliminates time periods where the market has no activity.

In this post, I only want to focus on the time based candlestick charts; they are the most widely used ones.

So lets dig deep into the meat. Take two exactly similar candles. I mean exactly similar in total height, body height and wick heights. So does it mean that the direction of the main impulse leg or main price movement within the candle is the same in both the candles? or the main price direction is same as the direction of the candle body?

Absolutely NO. This is the biggest misconception with regards to candlesticks.

I know, the whole point of a candlestick chart is to filter the noise of the smaller periods. So why do you need to bother dissecting a candlestick to analyze price behavior of within the candle? The reason is the main price swing within the candle could be entirely opposing to that of the actual body. Still confused?

Here you are…

 

bullish candle anatomy
Price movement within a bullish candle
bearish candle anatomy
Price movement within a bear candle

Isn’t this important information?

Now then, how significant are these reverse candles as I call them? Well, as per my observation when these swing and candle type contradictions occur, its usually an indication of price exhaustion. This usually seems to happen at significant price levels, more often than not.

So to explore this idea even further. To start with, a bullish candle might not represent bullish movement in its entirety and vice versa. Since we are aware of this phenomena, we can go one timeframe lower and asses the price action with regard to last candle on the timeframe we use for trading.

However, there is also another application of this knowledge. At the close of each candle in the above diagrams, do you see that the last swing has opposing directions per each of the price movement pattern within the candle? This makes it another clue to look for when entering a trade.

What is the most probable thing to happen at the open of the next candle? Continuation of the last swing at the close of the previous right. So the last price swing will continue at least for few pips. Although its naive to use this as a trading strategy on its own, this sure can improve our trade entries and grow confidence on our direction bias when entering trades.

I am actually in the process of developing an MT4 indicator to better analyze these reverse candles. Its actually half cooked, so far the trial results (price points and levels where these candle occur) are quite interesting to say the least. Keep your fingers crossed, you might get your hands on the cookies as soon as they come out of the oven.

Until my next experiment!

Happy trading…

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