Candlestick Patterns

Candlestick Patterns are a visual tool used in technical analysis to chart and interpret the price movement of a security, like a stock or bond. Originating from 18th-century Japanese rice traders, most notably Munehisa Homma, these charts offer a more intuitive and information-rich alternative to simple line graphs. Each “candlestick” represents the price action over a specific period—be it a day, an hour, or even a minute. By displaying the open, high, low, and close prices, candlesticks provide a quick snapshot of the battle between buyers (bulls) and sellers (bears). When these individual candles form recognizable sequences, or patterns, some traders believe they can predict future price direction. For a value investor, while not a primary tool, understanding these patterns can offer valuable insights into market sentiment and the psychology driving short-term price fluctuations.

To decipher the patterns, you first need to understand the language of a single candle. Each one tells a story with two main parts.

The thick, rectangular part of the candlestick is called the “real body.” It represents the range between the opening and closing price for the period.

• A green (or white) body means the closing price was higher than the opening price. Bulls were in control!
• A red (or black) body means the closing price was lower than the opening price. Bears won the day.

The size of the body also matters. A long body indicates strong buying or selling pressure, while a short body suggests little price movement and consolidation.

The thin lines extending above and below the body are the wicks (also called shadows or tails).

• The upper wick shows the highest price the security traded at during the period.
• The lower wick shows the lowest price it traded at.

Long wicks suggest that prices fluctuated significantly during the period before closing near the open, indicating a battle between buyers and sellers that ended in a stalemate.

Patterns are formed by one or more candlesticks and are typically classified as bullish (indicating a potential price rise), bearish (indicating a potential price fall), or neutral. Here are a few famous examples.

These patterns suggest that an uptrend may be starting or continuing.

• Hammer: A single candle with a short body, little to no upper wick, and a long lower wick. It looks like a hammer and often appears after a price decline, suggesting that buyers stepped in to push prices back up from their lows.
• Bullish Engulfing: A two-candle pattern where a small red candle is followed by a large green candle whose body completely “engulfs” the previous red candle's body. It signals a powerful shift from selling to buying pressure.

These patterns warn that a downtrend might be on the horizon.

• Shooting Star: The opposite of a hammer. It has a short body, a long upper wick, and little to no lower wick. It typically appears after an uptrend and suggests that sellers overpowered buyers, pushing the price down from its highs.
• Bearish Engulfing: The evil twin of the bullish version. A small green candle is followed by a large red candle that completely engulfs it, signaling a potential reversal to the downside.

• Doji: This is a special candle where the open and close prices are virtually identical, resulting in a very thin (or nonexistent) body. It resembles a cross or plus sign and signals indecision. Neither buyers nor sellers could gain control. It often precedes a trend reversal.

Let's be clear: As a value investor, your decisions should be rooted in fundamental analysis—understanding a business's health, its competitive advantages, and its intrinsic value. You buy great companies at fair prices, not by reading the tea leaves of a price chart. However, dismissing candlestick patterns entirely is like ignoring the emotional state of the person you're negotiating with. In the market, that person is the famously manic-depressive Mr. Market, and his mood swings create opportunities. Candlesticks are a fantastic gauge of his current mood. Think of it this way: Your deep research identifies a wonderful company that is significantly undervalued. You've decided to buy. Now, looking at the chart, you see a “Hammer” or a “Bullish Engulfing” pattern forming after a long price decline. This could be a signal that Mr. Market's pessimism is finally exhausting itself. Using this pattern as a trigger for your already-justified purchase can help improve your entry point, potentially preventing you from buying just before one last stomach-churning drop. Bottom Line: For the value investor, candlestick patterns are not a crystal ball. They are a supplementary tool for gauging market sentiment and refining the timing of your entry and exit points. Always let fundamental value lead the way; let the candles simply light the path.