Regardless of your trading style, knowing how to read candlestick charts is essential for understanding the psychology of the market and for deciding when to enter or exit a trade.

Patterns generated by the candlesticks are universal - meaning that you can apply them to any market, regardless of whether you prefer forex, stocks or futures trading. Candlestick charting is highly visual and once your eyes have been trained to recognize the patters, you'll be able to tell at a glance the likely direction of the stock.

Candlestick charting gives you a wealth of data, and a simple way to use it is to look for trend reversal patterns and for trend continuation patterns.

Japanese Candlestick Charting

Candlestick charting takes its origin from Japan. In the 1500's there were no currencies and rice became the way of exchanging goods and services and measuring their value.

As a way of regulating the trading, the Rice Exchange was formed, and soon the rice coupons were issued, as one of the first forms of futures trading.

After carefully studying the movements of the market, Munehisa Homma, a wealthy businessmen, started using candlestick patterns in 1724 to represent the history and the likely direction of these movements. For centuries the charting was laboriously done by hand. Today, any stock trading platform allows you to plot the candlestick patterns on the screen in a twinkle of an eye.

Bar Charting Versus Candlestick Charting

Bar charts and candlestick charts show essentially the same information. Many traders are of the opinion that candlesticks offer a graphical representation that is richer and easier to understand, and few Japanese traders would ever use bar charts.

Here is a period of trading of Rio Tinto represented both as a bar chart and a candlestick chart:

Bar chart

Candlestick chart

Bar charts are also called OHLC charts because a single bar gives you Open, High, Low and Close for a given stock:

Likewise, a candlestick chart conveys the same information:

If a bar chart gives you essentially the same information, why bother with candlesticks? Well, better graphical representation is the only reason. While all bars look the same, candlesticks use color to denote whether the stock opened lower and closed higher, or vice versa:

Each candle has:

• Real body
  Real body is the thick part of the candle. It encompasses everything from the opening price to the closing price. If the close price is higher than the opening price, the candle is white or empty; otherwise it is black or filled-in.
   
  
• Wicks
  Wicks can appear either on top (indicating the high) or the bottom (indication the low). Wicks are also called tails or shadows.

By looking at the patterns formed by white/empty and black/filled-in candles, you can tell, with varying degrees of certainly depending on the pattern, what is likely to happen to the stock price in the time to come.

The candlestick patterns are broadly divided into:

• Reversal patterns, indicating that the current trend is likely to change direction, and
   
  
• Continuation patterns, indicating that the current trend is likely to continue.

Take a quick quiz to check / reinforce your knowledge: How to read candlestick charts - quiz.
How did you go? If all's well, proceed to candlestick chart patterns.