Understanding Candlestick Charts: Technical Analysis 101

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.

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.

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.

Despite its advances over the line chart, the candlestick chart is hardly a new invention. This charting method was developed in the 18th century Japan by rice traders.

Reading the Candle Stick Chart

Taking a look at a candlestick chart like the one above, the stock's overall price movement is fairly easy to spot, much like in a line chart. Unfortunately, that's the extent of most investors' understanding of candlestick charts.

So how do you glean all of that other information from a candlestick? Take a look at the diagram below:

Source: Wikipedia

Essentially, the color of the candle's body determines the stock's direction for a given period. (Individual candles can represent any length of time -- we'll assume it's a day for simplicity's sake.) A filled candle body represents a down day, whereas an empty candle is a higher move. Most charts today are also coded by color.

On days where the stock moved higher, the bottom of the body is the open price, the top of the body is the close price. The opposite is true for down days. The shadows (also known as tails or wicks) represent the intraday price swings that fell outside of those two levels.

Naturally, for days when price action stayed between the open and close, no shadows will be present. (These candles are known as "marubozu" in Japanese charting lingo.)

Trading Tactics Using Candlestick Charts

Different traders use candlestick charts for very different trading techniques. While breakout or momentum trading is popular with the added information candlesticks provide, the practice of analyzing patterns formed by specific groupings of candlesticks is popular as well.

Clearly, understanding how to read candlestick charts is only one of the early steps toward undertaking technical trading outright. 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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