When you first looked at a trading chart did you stare in disbelief that anyone could make sense of the mass of bars, squiggly lines, and zigzags? I know I did.
Making sense of trading charts has to be the most basic of requirements when you want to begin trading. The understanding of how to decipher the meaning of patterns and bars and the common configurations that appear at certain points in the market is something that takes a little time to master. Gradually, with practice, reading these ridiculously complicated charts and graphs becomes easier and you can identify trends, spot market reversals and almost predict what the market will do next.
We’ll start with the most commonly used and essential methods used for charting forex trades, and show you how to make sense of those little red and green bars that populate your chart.
Japanese Candlesticks
The Japanese part is a bit of a history lesson, research has shown that it originates from 17th Century Japan and was used for charting the prices of rice, the first futures market. Candlesticks because they have a body (candle) at the top, there is an upper shadow (wick) and at the bottom, there is a lower shadow (tail). The top and bottom of the body signify the opening and close prices, the wick and the tail signify the highest and lowest prices achieved in a certain time frame. If a currency trade has lost value then the candle will be red and if the trade has gained value it will be colored green.
There are other charting option that traders sometimes use, but the Japanese candlesticks are commonly believed to be the best method for visualization of trend directions and volatility
Time Frame or Periodicity
What is the point of seeing the open/close, high/low information if you don’t know what kind of time frame is covered by a single candlestick? This is why setting the periodicity setting for your chart at an appropriate level.
The two examples show just how important this is. These examples both show trading data for EURUSD but have periodicity settings of 1 day and 5 minutes. You can see just how much the trading chart information differs and consequently means different things to different traders.
It is important for each type of trader that their periodicity settings are correct. A day trader (never holding overnight) will find very little information in figure 1, he would opt for the figure 2 option as it will show him how the market is trending over the course of a day. In figure 1 there are only two bars of information, that’s not enough to analyze the market for his trading style. Conversely, a long-term trader will find two days of fluctuating information useless. What use is the fluctuation of a day if he’s going to keep his trades going for weeks or even months?
Hammers, Shooting Stars & The Hanging Man – Common formations
They sound like impressive and exciting names, but they are simple, graphical formations that can indicate a change in market behavior.
Hammers & Hanging Men
They look very similar and essentially they are the same shape formation, the difference between them is when they appear in particular trends. The key identifying features of these two patterns are a small (or non-existent) upper shadow (wick) and a lower shadow (tail) that is at least twice the length of the body.
The hanging man appears toward the end of an upward trend. A large sell-off soon after the new period opens, but buyers are still buying in high enough volumes to push the price back up close to, or even higher than the opening price. It is an indication that a bullish trend is slowing and demand is disappearing.
The Hammer appears as part of a downward trend. This price pattern forms when the traded security drops in price shortly after the new period opens but then rallies back up to close to its opening price. This indicates that a security is declining and attempting to determine a new bottom threshold. This tends to happen if a downward trend is slowing.
Shooting Stars & Inverted Hammers
Again these two price pattern formations are very similar and the name of the pattern is determined by the market conditions when they appear on a trade chart. The identifying features of these patterns are the exact opposite of the two above a small (or non-existent) lower shadow (tail) and an upper shadow (wick) that is at least twice the length of the body.
The Shooting Star tends to appear near or at the end of an upward trend, signaling the imminent downward move in the market. The formation appears as a result of prices advancing well beyond the opening price, but returning to close just above or below that opening price.
The Inverted Hammer is the direct opposite and appears at the trough of a downward trend. The market conditions being that buyers started driving the price up shortly after the period opened but sellers were continuing to push the price down again.
All four of these formations are indicators of a market shift or reversal. However, the confirmation that the indication was correct comes with the next candlestick.
Did you find this information useful? This is just a first step in understanding trading charts, but I hope it has made reading a Japanese candlestick chart that little bit easier.