3. Candlestick Charts

How to Read Candlestick Charts – Price Trends

Everybody knows what a trend is. It’s when something is consistently going in one direction for a period of time. The same stands true for the stock market: when a stock is consistently going in one direction (up or down) over a period of time, that’s a trend. Market trends can last seconds, minutes, hours, even decades.

Think about the most recent bull market in the US stock market. The market had gone up consistently for about 10 years before finally making a substantial pullback:

On the other hand, consider this intraday (intraday means inside one day) trend in Zillow stock (Z), which lasted just a few hours: 

So how do identify trends in candlestick charts? It’s quite simple actually, and it’s similar to the method for identifying charts on other graphed data. 

There’s three steps to identifying a trend on a candlestick chart and they’re quite simple:

  1. First, just glance at the chart quickly. Is the stock going up, down, or sideways?
  2. Second, we zoom-in a bit and analyze the intermediate-term peaks and troughs in the trend
  3. Lastly, we use steps one and two to make an educated guess about where we are in the trend currently: are we closer to a low or a high?

Highs and Lows, Peaks and Valleys

So now we have our gut feeling as to where the trend direction. Now we just need to perform some simple trend analysis so we can get a more detailed understanding of how the trend is playing out.

You probably understand the concept of peaks and valleys as it relates to mountains. Mountains have their very high peaks, which are usually followed by much lower points called valleys. Few, if any mountains follow a straight path upwards. The same is true for stocks. Even if the strongest trends will have momentary pullbacks. 

The peaks and valleys in stocks trends are the most important aspect of trend analysis in my opinion. It’s high level information that tells the entire story. We can sum up our trend analysis with the following maxim: 

An uptrend consists of higher highs and higher lows.

A downtrend consists of lower highs and lower lows. 

In other words, a strong stock trend is characterized by not just high peaks, but each peak and valley being higher than the previous peak and valley.

 The below chart is a great example of a strong uptrend. Sure, the stock still comes down sometimes and forms a valley (or a trough, same thing), but each successive peak and valley are higher than the last.

When a trend fails to make a higher high or higher low, it should be considered a weakened trend at the least, and a trend reversal at worst. These are not the ideal trend setups to trade. 

Here’s an example, from Stocks & Commodities Magazine, which displays a weakened trend perfectly: 

The Educated Guess

Now we need to form a hypothesis.

So, how do we form our hypothesis? You can make this as simple or complicated as you please, but I’m going to outline a simple example here, with some more complex ideas to follow. 

We want to first measure whether the gap between peaks and valleys has been widening or tightening over time. We can achieve this by finding the peaks and valleys and drawing lines connecting them. Are the lines getting steeper or flatter?

Of course, what constitutes a peak or valley will vary from trader to trader. But this will give a rough idea of how long it takes for a peak-to-valley to occur, and how significant the resulting changes in price will be.

As you can see in our chart example of Adobe (ADBE) above, the stock momentarily broke it’s trend of higher lows. However, when this occurred, buyers got so aggressive in buying the stock at those levels, pushing it back up very quickly. This is indicative of outsized demand at these levels.

If we extrapolate a similar trajectory to the forming of the most recent peak, we can see that price is currently at about the midpoint. This is because we expect the coming peak to surpass that of the late 2019 peak in price, or else our hypothesis would be proven incorrect.

This represents the power of a candlestick chart, that long wick was able to tell us so much about the mindset of the market in just a second. 

This is relatively superficial analysis, but hopefully you get the idea behind it. As you advance as a trader and study more, you’ll create your own ways to analyze trends

Bottom Line

Candlestick charts have become the standard choice for technical traders today for a good reason. They give you plenty of information without making it difficult to absorb.

Steve Nison, considered the “grandfather” of candlestick analysis, says that candlesticks key you into what traders and investors are thinking at any given time.

Candlestick analysis is a deep subject with plenty of thick books to absorb for those wanting to study more. This article was meant to give you a big-picture understanding of how to read a candlestick chart and how to apply some basic analysis on a candlestick chart.

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