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Understanding Candlestick Charts: Technical Primer

BALTIMORE ( Stockpickr) -- As any real-world practitioner of technical analysis will tell you, charts are paramount to finding profitable trades. But like most tools of the trade, there's much more to reading a stock chart than just looking at a line from one price point to the next.

Technical traders look at a bevy of different chart types that give them a significant advantage over the standard line charts most retail investors are familiar with. Today, we're going to take a look at the basics of reading the most popular: the candlestick chart.

In technical analysis, charts are crucial because they provide a graphical depiction of price action, the single most important indicator of a stock's behavior. While the legalese on your 401(k)'s mutual fund prospectuses may warn you that "Past performance does not guarantee future results," successful quantitative and technical traders have shown that, in some cases, past performance is actually highly correlated with future results.

Related: Must-See Charts: Abbott, Toyota, Schlumberger

That's why price action is so important. Because a stock's price fluctuates in response to fundamental and economic factors (such as earnings numbers or jobs data), price is the only metric that encompasses all other relevant metrics. As a result, market technicians can get cues about trends and psychological price levels by paying attention to price.

Of course, the importance of price means that it's extremely important to pick the right kind of chart.

While the simple line chart (which graphs a stock's price over time as a single, horizontal line) may be the most well-understood chart type, it's far from the best. Over time, a slew of different charting techniques have been developed -- including bar charts and point-and-figure charts -- to give traders more information in the same space. The candlestick chart is arguably the most popular; you've probably seen them before.

Above: A daily candlestick chart of the S&P 500 index, including a number of technical indicators.

The benefits of candlesticks are major. While a line chart gives you only one data point (normally the close price) for a stock at any point in time, candlesticks actually give you five: open, close, low, high and direction of movement. That's a significant advantage when your trading decisions are based entirely on price action.

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