Candlestick charts are the most popular format for technical analysis. Japanese candlesticks visually display the OHLC prices and the net price movement for the candle. But there’s a problem, a big one too! The last painted candlestick does NOT reflect the current direction of the price.
There is a great misconception that a candle paints the complete picture of price within the specified period. To a certain extent, it’s true. The major price move within the candlestick can be in the opposite direction to what is visible from the net movement.
Simply put, the main move within a bull candle can be bearish and vice versa. So in this post, we shall explore the anatomy of the candlestick.
So let’s dive right into it. Candlesticks are defined by either the time or the number of ticks. Standard timeframes for time-based candlestick charts are 1min, 5 min, 15 min, 1 Hour, 4 Hours, 1 Day, 1 Week, or 1 Month.
Take two identical candles. I mean identical in every aspect – total candle height, candle-body height, and wick heights. Now does it mean that the direction of the main price movement within the candle is identical between both candles? Is the main price movement always in the same direction as the candle body?
Absolutely NOT. This is a grave misinterpretation of the candlesticks.
I know, the whole point of a candlestick chart is to filter the noise of the smaller periods. So why bother to dissect a candlestick to analyze the price of the candle? After all, it’s all noise. The reason is simple. We need to find the direction of the impulsive moves within the candlestick.
The above diagram shows 2 scenarios that can produce the same bullish candle. At a glance, both candles would seem identical. But nothing can be any further from the truth.
In the first instance, the main large move within the candle is “Bearish”. The 2nd instance is the typical price movement for a bullish candle.
The illustration of price movement in the first instance is typical for a bearish candle. But on the other hand, the second diagram shows how the major impulse move within a bearish candlestick can be bullish (green upward arrow).
Isn’t this important information?
Now then, how significant are these “reverse candles” as I call them? Contradictions between the candle direction (open to close) and the major impulse wave within the candle, is usually an indication of price exhaustion. This happens at significant price levels, more often.
Since we are aware of this phenomenon, we can analyze the lower timeframe to establish whether the last candle is confirming or contradicting the impulse within.
However, there is also another application of this knowledge. Do you see that the last swing is in opposite direction to the main impulse within the candle?
What is the most probable thing to happen at the opening of the next candle? Of course the continuation of the last swing. Although it’s not to be used as a trading strategy, it sure can improve trade entries and establish direction bias.
Candlestick anatomy is not just reading the OHLC, but also dissecting the price dynamics within the candle.