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Japanese Candlestick

A technical analysis method used to describe the movement of securities, currencies, and derivatives

What is Japanese Candlestick?

Japanese Candlestick is a technical analysis method that traders use to describe the movement of securities, currencies, and derivatives. The concept of candlestick charting originated from Japan before it was introduced to the West. It was developed by Munehisa Homma, a Japanese rice trader. During routine trading, Homma discovered that the rice market was influenced by the emotions of traders, while still acknowledging the effect of demand and supply on the price of rice.

 

Japanese Candlestick

 

Homma developed candlesticks that graphically displayed the nature of price movements by using different colors to denote the differences. The traders would then use the candlesticks to find the most occurring patterns and make decisions based on the short-term direction of the prices.

As a legendary rice trader of financial instruments, Homma dominated the rice markets and became popular for discovering the candlestick charting method. When the Japanese stock market began in the 1870s, local technical analysts incorporated Homma’s candlestick methodology into the trading process. American technical analyst Steve Nison introduced the technique to the West through his book “Japanese Candlestick Charting Technique.” Japanese Candlestick is now a popular technical indicator that traders use to analyze financial assets.

 

How Japanese Candlestick Works

Candlesticks provide more detailed and accurate information about price movements compared to bar charts. They provide a graphical representation of the supply and demand behind each price bar’s action.

 

Japanese Candlestick - Chart
Source: Stockcharts.com

 

Each candlestick includes a central portion that shows the distance between the open and the close of the security being traded, and the area is referred to as the real body. The upper shadow is the price distance between the open and high for the trading period, while the lower shadow is the price distance between the close and the low for the trading period

The closing price of the security being traded determines whether the market is bullish or bearish. The real body is usually white if it closes at a higher price than it opened. In such a case, the closing price is located at the top of the real body while the opening price is located at the bottom.

On the other hand, if the security being traded closed at a lower price than it was opened, the real body is usually filled up or black in color. In such a case, the closing price is located at the bottom while the opening price is located at the top. Unlike traditional candlesticks, modern candlesticks now replace the white and black colors of the real body with more colors such as red, green and blue. Traders can choose among the colors when using electronic trading platforms.

 

Japanese Candlesticks vs. Bar Charts

Both Japanese candlesticks and bar charts provide the same information to traders but in different graphical formats. Candlesticks are more visual, and they use different colors for the price bars and real bodies, which make them better at differentiating between the opening and the closing price of a trade. They also display graphically the forces (such as supply and demand) that contribute to each price bar’s movement.

On a candlestick chart, the area above and below the real body is known as shadows, which show the high and low prices for that day or trading session. For example, when the upper shadow is short, it dictates that the closing price for the day was near the high. In summary, the real body can be long or short and with different colors like black or white, and the features are determined by the trading day’s open, low, close and high.

 

Japanese Candlestick Patterns

Candlesticks are created by price movements, which movements may form patterns that traders use to analyze their trades. Some examples of candlestick patterns include:

 

Doji: It is a candlestick formed when the opening and closing prices are the same, or very close to each other. The shadows may have different lengths.

Doji

Gravestone Doji: This pattern resembles a gravestone, hence the name. It is formed when the open and the close occur at the lowest of the day.

Gravestone Doji

Dragonfly Doji: It is formed when the opening and the closing prices of a security are at the highest of the trading day. It includes a long upper shadow, and it signals a reversal of an uptrend.

Dragonfly Doji

Bearish Engulfing Pattern: The pattern is created in an uptrend, and it shows that there are more bears than bulls. It consists of a large black real body that completely engulfs a small white body. When it appears, it signals a major reversal.

 

Bearish Engulfing Pattern

 

Bullish Engulfing Pattern: The pattern is formed at the end of a downtrend. It comprises a small black body that is engulfed by a large white body.

 

Bullish Engulfing Pattern

 

Hammer: The Hammer pattern includes a long tail on its lower end and a near-negligible upper shadow. When it occurs during an uptrend, it is known as a hanging man.

Hammer

 

Additional Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Forex Trading – How to Trade the Forex Market
  • Guide to Commodity Trading
  • How to Read Stock Charts
  • Technical Analysis – A Beginner’s Guide

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