In this chapter, we will explore the basic structure of candlesticks and examine the key factors to consider when reading candles. We will first discuss three main types of candles and then look at their important characteristics for accurate candle reading. This chapter approaches the topic in a unique way, unlike traditional studies that often list around fifty types of candle patterns. However, let’s understand why we should use this visual price representation. The reasons are simple. First, a picture conveys more than words. Second, making profits in the stock market requires precise timing for trade entries and exits. Any position taken without proper timing won’t yield expected results within the desired timeframe. Candlesticks assist in timing your trade entries and exits. Your market success relies on both the trades you enter and when you enter them. Candles provide the answer to the timing question. The Anatomy of Candles Just as a picture is worth a thousand words, a candle represents numerous words, price quotes, and interpretations. A candle visually represents the prices traded within a specific period. For instance, a 5-minute candle shows the price range during that 5-minute span. The first traded price sets the candle’s opening level, while the last traded price determines its closing level. Additionally, a candle displays the highest and lowest prices reached during that time. If the closing price is higher than the opening level, the candle appears green (or white); if it’s lower, the colour is red (or black). A green candle reflects a bullish sentiment among market participants, indicating that buyers successfully pushed prices up. Conversely, a red candle shows a bearish mood, where sellers managed to drive prices down. Therefore, each candle represents the struggle between buyers and sellers during the given period.
A candle consists of two main parts:
• The main body, which is the green or red section, represents the opening and closing price levels.
• The shadows, which are found both above and below the body. These shadows, or tails, reveal the highest and lowest price levels reached during the period. It takes buying power to move the price from its lowest point to a closing value above it. The greater the buying strength, the larger the rebound from the low, resulting in a longer lower tail or shadow. Similarly, it takes selling pressure to push the price down from the highs to close below that level. A longer upper shadow indicates that sellers pushed prices lower from the highs before the candle closed. If you understand this concept clearly, you will see that a small red candle with a longer lower shadow is more bullish than a small green candle with a longer upper shadow — and vice versa.
Important Factors in Interpreting Candles It’s crucial to study Figure 2.1 and understand that it’s not just the candle’s body colour that indicates bullishness or bearishness. The body size matters, as does the size of the candle’s shadows. For instance, a small green candle with a long upper tail is more bearish than a red candle with a long lower tail. The closing level is also vital and should be examined in relation to the candle’s highs and lows. Keep the following factors in mind when reading candles:
1. Candle colour: Green signifies bullishness, meaning buyers are winning; red indicates bearishness, with sellers in control.
2. Size of candle body: The larger the body, the greater the victory for the winning side.
3. Length of candle shadow: A longer shadow means a larger pullback from the extreme, indicating a stronger rejection of that level.
4. Candle closing level: Never judge a candle before it closes. The closing price is crucial, and interpretations made without considering this could be misleading.
Markets revolve around spotting opportunities. A clearer and deeper understanding of your subject boosts your chances of success significantly. So, let’s delve deeper. The market is filled with books discussing technical indicators; sometimes a whole book is dedicated to just one indicator. Our goal is different. We won’t dive into commonly known candle patterns with names like stars, harami, engulfing, hammer, hanging man, two crows, three mountains, four soldiers, and so on. The list is endless. Fifty or more of these names are widespread. Is it realistic to identify all these patterns in real time in a rapidly moving market? We don’t think so. Sticking to our promise of simplicity, we will capture the entire theory in a practical way and focus only on three main candle formations. Yes, just three types! It’s important that we learn to quickly recognize the psychology behind these candle formations to understand traders’ mindsets and take calculated risks. Afterward, minor variations won’t matter if you grasp the underlying psychology of the candle. Understanding market emotion is essential because it creates momentum. This momentum can lead to significant moves with solid follow-through. That’s where the profits lie.
3 Types of Candles – and What They Reveal about the Market’s Mind We will concentrate on three main types of candles:
1. Under-sized candles, known as XXS-sized or Lilliput candles.
2. Giant-sized candles, or XXL-sized, also known as super-sized candles.
3. Candles with exceptionally long shadows or tails, called rejection or reversal candles.
Typically, most candles have regular body and tail sizes, showing a normal amount of buying or selling sentiment. These three types of candles stand out from the rest.
We will start our study with under-sized candles, which are much smaller than typical candles. Then, we will look at super-sized candles, which are larger than the regular ones. Finally, we will examine long-tail candles, which are important because of their tails rather than their bodies. We will learn how to interpret these three types and how to leverage them.
**Under-sized / Lilliput / XXS-Sized Candles**
When we refer to super-sized or under-sized candles, we always compare them to the average size of the previous candles. There isn’t a formula to specify this, but visual interpretation should be enough for a trader. A Lilliput candle has a small price difference between the opening and closing levels compared to the previous candles. Depending on whether the candle is green or red, you can tell which side is winning. However, no matter which side has an advantage, the price movement is minor, and there is no significant action happening. This isn’t necessarily bad. In fact, it’s a healthy situation. You can’t expect a major move every day or even every hour. There are many ways to interpret and use such candles.
**Doji Candles – A Variation of Lilliput Candles**
Doji candles are a minor variation of Lilliput candles. In a Doji candle, the body is not just small; it’s nearly negligible. The opening and closing prices are almost the same or very close. The range may vary between wide and narrow, but the real body appears almost like a single horizontal line rather than a rectangle. If every candle is a battle between bulls and bears, then doji candles indicate a match that ends in a draw. The candle body shows neither a bull victory nor a bear victory since the price closes close to where it opened. If the tail is particularly long, this changes, and we will discuss this when we look at rejection candles later. Overall, candles with small bodies and small tails show a phase of pause. They suggest indecision among participants unless there is a special message coming from long upper or lower tails. As long as Lilliput candles have regular-sized tails, they reflect a neutral stance among market participants. For better clarity, review Figure 2.2.
**Super-sized / Giant / XXL-Sized Candles**
We have learned that every candle represents a battle between bulls and bears. The closing price of the candle determines the winner. When bulls successfully overpower the bears, they push the closing price much higher than the open compared to an average-sized victory. This results in giant green candles or super-sized green candles. Conversely, when bears dominate the bulls, you get super-sized red candles. A super-sized candle represents a massive victory for the winning side and a strong market emotion driving it. Keep in mind that we are talking about the size of the candle’s body, not the shadows. Average-sized candles do not convey any special message other than quiet continuations or slight reversals of the current direction. When you see super-sized candles, it’s time to pay attention. They could signal a breakout, a reversal, a new start, an end to the current trend, or even consolidation. It likely means that further movement in the direction of the big candle is probable. This may be the moment to act. One should not freeze in inaction upon seeing such candles. It’s time to make your move or suffer losses if the candle is against you. Quick action is necessary when giant candles appear. No second thoughts allowed here. “When you gotta shoot; shoot, don’t talk.” – Tuco in the Good, the Bad, the Ugly Sometimes, a giant candle may cover several earlier candles, either partially or completely. The greater the coverage, the stronger the potential move that follows. This is a candle type we must always watch for and act upon. How and when to act? That’s something we will discover as we continue. The shadows of giant candles, both the upper and lower ones, could be of normal size compared to neighboring candles or exceptionally short, or even absent. If the giant candle is green and its tails are small, it indicates that the candle moved higher from the start, with hardly any downward movement afterward. It also shows that the candle closed near its highest value during that period. If, however, the giant candle is red and its tails are small, it means that prices started falling right from the beginning, with no successful attempt to push the price higher, resulting in a close at the lowest point of the period. These factors contribute to the candle’s bullish or bearish nature, indicating how much control participants have over the move. This control can be partial or total. The larger the body and the smaller the tail, the stronger the control. In essence, giant candles indicate strong momentum, which doesn’t fade easily. A big candle with a small tail suggests we can expect further moves in the same direction. Remember, whenever a candle closes at or near its extreme ends, it shows acceptance of price by the participants. This means they are willing to accept price on that side and may agree to further moves in that direction in the next candle. You can see a visual representation of the significance of giant candles in Figure 2.3, which depicts regular-sized tails or small, negligible tails. But what if these tails are exceptionally long? That signals an important formation called reversal candles or rejection candles.
**Reversal or Rejection Candles**
Candles with long shadows should be called reversal or rejection candles. They can have a long top shadow, a long bottom shadow, or both. The body can be green or red, small or large, but their defining feature is their shadow. Green indicates bullishness, and red indicates bearishness, but the key message comes from what the tail tells us. These candles reflect strong directional bias and should never be seen as neutral, irrespective of the body size or color. The key lies in the tail. A long bottom tail signifies that the candle’s closing price is reached after a significant upward pullback from the lows during the candle’s formation. This means the extreme lower price that was once touched could not be sustained. Buyers rushed in, providing support and stopping the decline. We expect higher prices ahead depending on the broader context and strong follow-through. Sellers who positioned for a further drop are now trapped. A long bottom tail pattern with a green body is extremely bullish. This interpretation remains valid even if the candle is red. The candle body will usually be located in the upper part of the candle’s range. Even a Doji, typically seen as neutral, will be considered bullish if the lower tail is long. In contrast, a long top tail indicates that the market participants rejected the high price reached during the candle’s formation, believing it went too high and needed to pull back. Supply pressure comes in, pushing the price lower. Bulls who tried buying at the top are now stuck. If such candles also have follow-through on the downside, the situation is even worse for the bulls. Thus, a Lilliput candle with a long top shadow and a red body increases the bearish outlook, and the larger the red body, the stronger the bearish implication. The bearish view holds even for a green candle with a long top shadow. Even a Doji with a long top tail is considered very bearish and not neutral. It’s important to understand that long tails signify price rejection. A top tail shows rejection of higher prices while a bottom tail shows rejection of lower prices. These rejections increase the likelihood of the next candle moving in the opposite direction, as illustrated in Figure 2.4. Besides these three types, other candles fit into the category of regular candles, suggesting typical bullishness or bearishness depending on the case and color. We have included a normal candle in Figure 2.3. Please check it out. Together, these insights should help you assess the bullishness or bearishness of any candle or situation. That’s what truly matters. This simplifies over 50 types of candles into just three main types, making this tool both easier to understand and more effective. Review the candlestick chart in Figure 2.5 to see how everything we’ve learned about candles looks in real market conditions. Next, we will learn how to utilize all the information that a candle pattern provides with the help of charts showing actual market movements.
Key Points for Candle Reading
Let the Candle Form Fully Before You Start Interpreting It
Before judging any candle, it is crucial to wait until it fully forms and closes. Your interpretation of the candle could change significantly by the time it closes. A candle that initially appears highly bullish, or even suggests a breakout, can end up indicating a temporary peak. Similarly, a candle that seems to signal a breakdown may prove to be just the opposite if a long bottom tail forms.
The closing of the candle will show us what to expect next. Always keep this in mind and practice patience.
Before Looking for a Trend Reversal Signal, Look for a Trend Reversal
Candles that indicate a reversal need a well-defined trend to reverse from. It is important to have a clear understanding of market conditions before making decisions. Remember, reversal patterns that appear at significant price levels are much more important and should be considered carefully. Patterns that appear elsewhere might not lead to the desired changes or outcomes.
Candles Work Better on Longer Time Frame Charts
For instance, a 5-minute candle chart will be more reliable than a 1- or 2-minute chart. Similarly, a daily or 15-minute candle chart will be more reliable than a 5-minute chart. This doesn’t mean you can’t trade smaller time frames. The longer a candle takes to form, the more participants are likely involved. Therefore, higher emotions are at play. This principle also applies to chart analysis. Higher time frames offer greater reliability. While all time frames can be traded effectively, what works best depends on your mental make-up.
You Don’t Have to Take the Very First Trade That Comes in View
Just because the markets are open doesn’t mean you need to take the first trade you see. You always have the option not to act. Use this option wisely. Implement filters before committing to a trading position or decision. As we progress, you will see how we evaluate each stock or chart before adding them to our daily watch list.
Always Wait for Pattern Confirmation
Most chart patterns require confirmation before they yield positive results. Wait for that confirmation in your chosen time frame. There is no rush. The market teaches us: “Never chase trades. If one opportunity goes away, another will come along.” Always enter a trade after confirmation, not before. If a particular candle pattern needs another candle to form for confirmation, let it happen.
Location Where the Pattern Forms is Very Important
The location significantly impacts the success rate of a pattern or candle. Corrections often find support at moving average lines during an uptrend. In a downtrend, resistance often appears when a counter-trend upmove meets a moving average line above. This can include the 20MA, 50MA, or 200MA, among others. If these lines provide support or resistance, the original trend should resume from there. Therefore, any reversal patterns or candles that form at these levels should be watched closely and given more importance than those appearing elsewhere.
Moving average lines are areas of potential reversals, and a counter-trend reversal occurring there signals that the trend may resume soon. This can create fresh buying interest in an uptrend or strong selling pressure in a downtrend.
Always check where a reversal pattern or candle is forming to gauge its relevance. Other significant locations include floor pivot levels, which we will discuss in the next chapter, the previous day’s closing level, swing turning points, and prior highs and lows on the charts. The probability of success for a chart or candle pattern increases when it forms at these crucial levels. Always remember that location takes priority, followed by the pattern. Ignoring this order may lead to random results.
Timing of the Pattern
If you often sit in front of the trading screen, you can relate to this point. Certain time periods during the day signal when the market and major stocks begin their decisive moves. These time zones are high-probability periods when stocks that were previously stagnant start to make significant moves. Depending on the overall context, the move could follow the trend or signal a reversal. Therefore, any reversal or breakout pattern that appears or confirms during these times should be noted and acted upon immediately.
In the Indian market, we can break down the current operating hours into the following time zones:
9:00 a.m. to 9:15 a.m. – This is the market pre-open time. A serious trader will pay attention to local and global setups, news, and signals before the markets open. In fact, they would likely be at their desk well before this time, preparing for the day.
9:15 a.m. to 10:30 a.m. – The first hour is crucial, often providing decisive moves in many stocks. These moves might continue trends from the previous day or react to overnight news. This period is filled with activity and requires your full focus and concentration. It’s a fast-paced time that demands trading agility.
10:30 a.m. to 1:30 p.m. – This period can be quieter. However, that doesn’t mean there won’t be important moves. The level of activity and attention required will depend on your trading strategy and the number of stocks you are following. You may notice many stocks simply moving sideways during this time.
1:30 p.m. to 3:30 p.m. – This will again be a busy time requiring your undivided attention. Moves starting during this period can determine the day’s closing level and trend.
It is important to be aware of which pattern or candle appears at what time. Patterns appearing during critical times require close attention and prompt action. You can have more confidence in moves starting at these periods. So always pay attention to the timing of a pattern and choose patterns from high-probability time periods for trading. Remember, money should flow in easily. We are not here to fight the market, but to move with it.
A Single Candle Doesn’t Tell the Whole Story
The market doesn’t accomplish anything with just one price swing or single candle. If a stock starts moving in a certain direction and the move is genuine, it will continue for a while—this usually means several swings or candles. The story doesn’t end with one candle, whether it’s up or down. Only when the market moves consistently in one direction for a period that allows for trading does it make sense to commit.
If the stock or index is producing alternating green and red candles, it signals a lack of conviction—this is a warning sign. If this pattern continues, it may be best to avoid that move. Longer moves tend to be more tradable, and every significant beginning in a longer move typically leads to good follow-throughs.
Multiple Favorable Factors Lead to Moves that Sustain
The more factors supporting your trade, the greater the likelihood that the move will last. A meaningful move in a stock or index usually persists until it continues in the same direction for at least 3, 5, or even 8 candles. This applies to chart patterns as well.
For example, when the price moves above a moving average line from below and finds support at that line on the first retracement, it is likely to do so again. Without this follow-through, significant breakthroughs cannot occur.
New Trends Provide Higher Probability Trades
Entering a newly initiated trend offers better odds of success than getting into one that has been ongoing for a while. Those who entered early are likely to take profits at higher points or cut losses at lower levels in a downtrend. Your timing of entry impacts the chances of a successful trade. Always remember that entry signals appearing after a decline, near support, are more likely to work in the short term than those after significant price increases near resistance. In summary, location, prior movement, pattern timing, and strong follow-through are all essential for good trades.
Trading with a Trend Carries a Higher Probability of Success
Any move that aligns with the trend has a greater chance of being successful compared to a counter-trend move. This doesn’t mean we should never trade against the trend, but those counter-trend moves should be limited to specific setups, which we will discuss later. Generally, sticking with the trend is the smarter choice.
You can lose a lot if you try to control the markets or go against the trend. Holding onto your opinion and hoping for a change while the market moves against you shows a lack of understanding of trading tactics. You need to connect not just with the trend in your trading time frame, but also with the trend in higher time frames. When price action matches across all time frames, moves happen smoothly and last longer. Money should flow in easily. Pay close attention to the trends in higher time frames, as well as to the support and resistance levels in those time frames, because those levels are strong.
Understand Candles / 65
Check the Volume
Volume is crucial. If it is above average when you plan to enter a trade in the direction of that move, it works in your favor and boosts your chances of success. Any price breakout that begins with a strong volume breakout has better odds of continued success.
50% Counter Trend Limit for Ongoing Trends
A trend remains reliable as long as retracements or counter-trend moves stay within a certain limit. If they exceed that limit, the trend’s reliability becomes questionable. Different theories suggest various threshold limits. For our trading tactics, we will maintain this limit at 50%.
This means that for a trend to hold, counter-trend moves should not erase more than 50% of the trending move. If the market moves two steps forward and only one back, you can trust it. Any retracement that goes beyond this limit should raise doubts about the trend’s continuation. For example, if you’re observing a move from a swing low to a swing high, the retracement must remain within 50% of that increase.
In a downtrend, any upward retracement should also stay within this 50% limit. If a large green candle appears in the trend’s direction, the following candles may be counter-trend and corrective, but they shouldn’t erase more than 50% of the previous large candle. If they do, the legitimacy of that big green candle becomes questionable. A minor retracement, however, is normal, expected, and healthy. It also provides another chance to enter in the trend’s direction at a better price.
The key point is that the retracement should not be so significant that it leads to a loss of control for the winning side. This is crucial. As they say in life, relationships that remain respectful have a better chance of lasting longer. Similarly, every retracement of a trend should stay within limits for the trend to continue positively.
All these factors matter. The more positive factors you have on your side, the better your chance of succeeding significantly. In Chapter 3, we will discuss how to use our candle study. We will learn how, when, and where to apply each type of candle. Before that, let’s review the 12 important candle characteristics discussed in this chapter.
Summary of Important Points for Reading Candles
1. Never judge a candle before it closes.
2. A clear prior trend is essential for a meaningful reversal.
3. The higher the time frame, the greater the accuracy and reliability.
4. Use enough filters before committing to a trade; select only the best opportunities.
5. Look for confirmation of a candle signal before making a trade commitment.
6. The location of the candle is very important and must be carefully considered.
7. Timing of patterns is crucial; choose high-probability timings for better success.
8. Nothing is achieved with a single candle; it typically takes 3, 5, or 8 candles.
9. Newer trends are often more profitable to trade than older ones.
10. Trades that follow the trend are better than counter-trend moves.
11. Volume support greatly impacts trades, so always check it.
12. Never forget the 50% retracement rule; the retracement must stay within the 50% limit for the trend to continue for longer.
Milestones Covered
1. The two colors the body of a candle can have—green (or white) and red (or black)—and their interpretation.
2. Five important variations of the candle body: Giant, Lilliput (Tiny), Rejection, Regular, and Doji.
3. Four major variations in the lengths of candle tails: long, very short, regular, and absent.