Some traders treat all candlesticks equally; that each candlestick tells us something about the market. These are the bar-by-bar guys like Al Brooks.
We tend to take a different view. You may have heard of the Pareto Principle: that 80% of effects come from 20% of the causes. 80% of trading profits come from 20% of your trades. 80% of the market share is owned by 20% of businesses, 80% of commerce occurs in 20% of a city, and so on.
This is how we view individual candlestick analysis.
While each candlestick tells a part of the story, individually analyzing each candlestick leads to analysis paralysis and confirmation bias. Instead, we look at the few essential candlesticks within each trade setup that tell 80% of the story.
Here’s few of those critical “Pareto Candlesticks”:
Doji
A doji is a candlestick with identical opening and closing prices. A doji is said to signify indecision on the part of the market. The Japanese say that “the market is tired.”
The meaning of a doji candlestick depends on the context of the trade setup. A doji near a new low in a sustained downtrend can indicate a change in sentiment. It’s not uncommon to see a gap up followed by an uptrend in these types of situations.
Here’s a chart example from WYNN stock in August 2016:
If we shift the circumstances so that a doji occurs amid a long period of sideways consolidation, the doji’s presence becomes less significant. By definition, sideways price action indicates the market’s indecision, so a doji doesn’t give us new information.
Here’s a chart example of Agilysys (AGYS):
In this sideways chart, there’s no definitive trend to the price movements. It’s just bouncing back and forth between $9 and $12, undecided on what to do next. As you can see by the arrows, there are several dojis in this period of several months, many more than a trending stock would have.
Hammer
The Hammer candlestick has a lower shadow that is typically twice the size of the candlestick body. The upper shadow is non-existent or small.
The Hammer candlestick is typically looked at as a reversal candle. In the common bullish scenario, the stock gaps down at the open amid a sustained downtrend. The bulls then take control throughout the day and the stock closes up on the day.
There’s some real market psychology at play here. The stock is already in a sustained downtrend; it’s value decaying each day. At a certain point, when the price gaps down, many bulls will perceive the price as ‘too low.’ They may be value investors, mean reversion traders, or bottom fishers.
When you see the hammer candle in this scenario, those bulls are thinking they’re getting a good deal; the market has gone too low, and now it’s time to reprice the stock. The hammer is a visual representation of this mass psychology.
The ultimate success of the bulls relies on the market’s agreement or disagreement that the stock is, in fact, ‘too cheap.’ If the market disagrees, the weak hands bought into the hammer candle will sell, resuming the downtrend.
Here’s a chart example in crude oil futures:
As you can see, oil prices we’re getting smashed until the hammer candle. While the price didn’t gap down in this example, we noticed that price moved significantly lower intraday, only to close near the top of the candlestick.
This Bullish Hammer didn’t result in an uptrend, but the bulls at least stopped the bleeding of the previous relentless downtrend.
Marubozu Candlestick
The Marubozu candlestick is characterized by little or no shadow, and all body.
The Marubozu candlestick is the most aggressive of all candlesticks. It indicates that one side–bulls or bears–were entirely in control of the price action from the open to the close.
The psychology at play with Marubozu candles is more straightforward than the previous two candlesticks we’ve analyzed. A Bullish Marubozu indicates that buyers are tripping over each other to buy the stock. There are no pullbacks because buyers are willing to pay higher prices to own the stock continuously. This goes vice versa for Bearish Marubozus.
Multiple Marubozus in a row indicates insanely high pressure on that side of the market. Extreme caution should be used when on the wrong side of these markets.
Here’s a chart example in an uptrend in Universal Corp (UVV):
As you can see, the uptrend was strong enough to take the stock from $54 to $77 in two months. Throughout the trend, you’ll find strings of Marubozu candles, indicating explosive demand for the stock.
A key thing to watch out for in any high-momentum trading setup is the pullback. If you look at the second red line in the UVV chart, that was the trend climax. All green candles with little to no lower shadows. The bulls were firmly in control and tripping over each other to buy shares.
The problem comes when that momentum wanes. As soon as buyers slow down, the insanely high prices become unsustainable. This allows steep pullbacks like those on the right end of the chart to occur.
As they say, there’s no free lunch. If you want to trade stocks with explosive momentum, steep pullbacks come with it.