That kid you know who's now driving a Lambo because he traded something called dogecoin? He has more in common with Japanese rice traders from the 1700s than you might think.
Besides the ability to brag about their newfound riches, both traders likely analyzed price action and investor emotions by using the candlestick charting style.
Although modernized in the late 1800s by journalist Charles Dow, the core principles of candlestick charting remain intact today. Both the modern and historical technical analysts who swear by the style regard price action as more important than earnings, news or any other fundamental principles.
In other words, all known information is reflected in the price, which is precisely displayed in the candlestick.
Anatomy of a candlestick
A candlestick represents the price activity of an asset during a specified timeframe through the use of four main components: the open, close, high and low.
The "open" of a candlestick represents the price of an asset when the trading period begins whereas the "close" represents the price when the period has concluded. The "high" and the "low" represent the highest and lowest prices achieved during the same trading session.
Every candlestick uses two physical features to display the four main components.
- The first feature, known as the body, is the wide midsection of the candlestick and it depicts the open and close during the observation period (most charts will allow you to set the range for the candlesticks)
- The close is represented at the top of the body in the green candlestick and at the bottom of the body in the red candle.
- On the opposite is true of the open, which forms the bottom of the green candlestick and the top of the red candlestick.
- The final two components, the high and low, are represented in the second feature of the candlestick known as the 'wick.' Wicks are simply displayed as the thin lines extended above and below the body.
Cryptocurrency traders tend to take advantage of the inherent market volatility by using charts on the intra-day time frames. Each candlestick typically represents one, two, four or 12 hours. (A longer-term trader will likely choose to observe candlesticks that represent a single day, week or month.)
A candlestick becomes "bullish," typically green, when the current or closing price rises above its opening price. The candlestick becomes "bearish," typically red, when its current or closing price falls below the opening price.
The money makers
A candlestick rarely keeps its figure for too long in the volatile cryptocurrency market.
For instance, if the 2-hour candlestick opens at a price of $10 and jumps to $13 an hour later, the shape of the candlestick will have drastically changed since opening.
But traders have also come to realize the same candlestick shapes occur at the same stage of a price trend, no matter what is being traded. It can be very lucrative to identify such formations because they can expose clues as to when a trend might reverse, continue or when market indecision is at its peak.
Three of the most useful candlesticks for identifying a potential trend change or for gauging market sentiment are the "doji," "hammer" and "shooting star."
The doji is a prime example of what traders mean when they say a candlestick represents human emotion or market sentiment. When the asset price swings in both directions before closing near its opening price, it is clear the market is indecisive about the asset's true value.
The classic doji candle representing an indecisive market comprises equal-length wicks and a very thin, centrally located body. Further, there are several variations of doji, which signal trend exhaustion/trend reversal.
A hammer is the precursor to a potential downtrend reversal and can be a big money maker for the bulls.
Hammers are formed when price sinks below the open only to later return and then close above the open. Such price action signifies that at one point during the trading period sellers temporarily gained control but quickly gave it back and then some, for a bullish close to the candlestick.
The physical features of a hammer consist of only one wick roughly two times the length of the body which is located at the top of the candle.
Last but not least, the shooting star is the exact opposite of the hammer.
The shooting star occurs at the peak of an uptrend when the bulls rally to start the trading period, but eventually lose control to the bears who drag prices to a close below the open.
It's important to keep in mind that the longer the duration of the candlestick, the more powerful its effect is on the overarching trend.
For instance, a hammer spotted in a one-hour candlestick will have almost no impact on a 6-month long downtrend, whereas if the hammer formed on a 1-week long candlestick, its reversal impact would be much more significant.
Candlesticks via Shutterstock