What Are Candlesticks in Finance and How Do They Work?

Candlestick charts are a widely used tool in financial markets, helping traders analyze price movements and identify potential trends. Originally developed in Japan centuries ago, they provide more visual detail than traditional line or bar charts, making it easier to spot patterns that may indicate future price direction.

Understanding how to read candlesticks can give investors an edge by revealing market sentiment and momentum shifts.

Candlestick Composition

Each candlestick represents a specific time period and consists of four key price points: the opening price, closing price, highest price, and lowest price. The rectangular body shows the difference between the opening and closing prices, while the thin lines extending from it, known as wicks or shadows, indicate the highest and lowest prices reached during that period.

The color of the body helps traders quickly assess price movement. A green or white candle means the closing price was higher than the opening price, signaling buying pressure. A red or black candle indicates the opposite, showing that sellers were in control. The length of the body reflects the strength of the price movement—long bodies suggest strong momentum, while short bodies indicate indecision or minimal movement.

Wicks provide additional context by revealing price extremes. A long upper wick suggests buyers pushed prices higher before sellers regained control, while a long lower wick indicates selling pressure that was later overcome by buyers. When wicks are short or nonexistent, most trading activity occurred near the open and close, showing a more decisive market sentiment.

Single-Candle Patterns

Some candlesticks can provide useful insights on their own, helping traders assess potential reversals or continuations in price movement. While they should not be used in isolation, recognizing these formations can improve decision-making when combined with other technical indicators.

Hammer

A hammer appears after a downtrend and suggests a potential reversal to the upside. It has a small body near the top and a long lower wick at least twice the size of the body. This signals that sellers initially drove the price lower, but buyers regained control and pushed it back up before the close.

For a hammer to be significant, it should form at a support level or after a prolonged decline. A green hammer, where the closing price is higher than the opening price, is generally a stronger bullish signal than a red one. However, confirmation is needed—traders often wait for the next candle to close higher before considering a trade.

For example, if a stock has been declining for several days and forms a hammer at $50, followed by a green candle closing above $52, this could indicate a shift in momentum. Traders might buy at this point, setting a stop-loss below the hammer’s low to manage risk.

Doji

A doji forms when the opening and closing prices are nearly identical, resulting in a very small or nonexistent body. This pattern signals indecision, as neither buyers nor sellers established dominance. The wicks can vary, leading to different types such as the long-legged doji, dragonfly doji, and gravestone doji.

A dragonfly doji has a long lower wick and no upper wick, suggesting sellers initially pushed prices down, but buyers regained control by the close. This can indicate a potential bullish reversal if it appears after a downtrend. Conversely, a gravestone doji has a long upper wick and no lower wick, meaning buyers drove prices higher before sellers took over, which may signal a bearish reversal when found at the top of an uptrend.

Traders often look for confirmation before acting on a doji. If a doji appears after a strong rally and is followed by a red candle, it may suggest a trend reversal. On the other hand, if a doji forms at a support level and is followed by a green candle, it could indicate a buying opportunity.

Shooting Star

A shooting star is the opposite of a hammer and appears after an uptrend, signaling a potential reversal to the downside. It has a small body near the bottom and a long upper wick at least twice the size of the body. This suggests buyers initially pushed prices higher, but sellers regained control and forced the price back down before the close.

For a shooting star to be meaningful, it should form at a resistance level or after a strong upward move. A red shooting star, where the closing price is lower than the opening price, is generally a stronger bearish signal than a green one. However, traders typically wait for confirmation, such as a lower close on the next candle, before making a decision.

For instance, if a stock has been rising and reaches $100, then forms a shooting star with a high of $105 but closes at $98, this could indicate weakening buying pressure. If the next candle closes below $96, traders might consider selling or shorting the stock, placing a stop-loss above the shooting star’s high to limit potential losses.

Multiple-Candle Patterns

While single-candle formations can be useful, patterns involving two or more candles often offer stronger signals about price movements. These formations help traders identify trend reversals or continuations by analyzing how consecutive candlesticks interact.

Engulfing

An engulfing pattern consists of two candles and signals a potential reversal. A bullish engulfing pattern appears after a downtrend and consists of a small red candle followed by a larger green candle that completely engulfs the previous one. This suggests buying pressure has overwhelmed selling momentum, potentially leading to an upward move.

A bearish engulfing pattern forms after an uptrend. It features a small green candle followed by a larger red candle that fully engulfs the prior session’s body. This indicates sellers have taken control, which may lead to a price decline.

For example, if a stock has been declining and forms a bullish engulfing pattern at a support level, traders might see this as a buying opportunity. Conversely, if a bearish engulfing pattern appears near a resistance level, it could signal a selling opportunity. Increased trading volume strengthens the reliability of this pattern.

Harami

A harami pattern also consists of two candles but differs from the engulfing pattern in that the second candle is smaller and contained within the body of the first. A bullish harami appears after a downtrend, with a large red candle followed by a smaller green candle. This suggests selling pressure is weakening, and a potential reversal may be forming.

A bearish harami occurs after an uptrend, where a large green candle is followed by a smaller red candle. This indicates buying momentum is fading, which could lead to a downward move. The significance of a harami pattern increases when it forms at key support or resistance levels.

For instance, if a stock has been rising and forms a bearish harami near a previous high, traders might interpret this as a sign of hesitation among buyers. If the next candle confirms the pattern with a lower close, it could indicate a shift in trend. Traders often use additional indicators, such as the Relative Strength Index (RSI), to confirm weakening momentum before making a decision.

Morning Star

A morning star is a three-candle pattern that signals a potential bullish reversal. It typically forms after a downtrend and consists of a large red candle, a small-bodied candle (which can be red or green), and a large green candle. The middle candle represents indecision, while the third candle confirms the reversal by closing well above the midpoint of the first candle.

This pattern suggests selling pressure is diminishing and buyers are gaining control. The strength of the morning star increases if the third candle has high trading volume or forms near a key support level.

For example, if a stock has been declining and forms a morning star at $40, with the third candle closing above $42, traders might see this as a sign of a potential uptrend. To manage risk, they may place a stop-loss below the low of the second candle.

Interpreting Candlestick Signals

Understanding candlestick signals goes beyond recognizing individual patterns. The broader context, including market conditions, volume, and confirmation signals, plays a significant role in determining the reliability of a potential trading opportunity.

Market structure and prevailing trends should always be considered. A reversal pattern forming within a long-term uptrend might indicate only a short-term pullback rather than a complete trend shift. Similarly, a continuation pattern appearing in a strongly trending market carries more weight than the same pattern emerging in a choppy, range-bound environment.

Volume is another factor in assessing the strength of a candlestick signal. A reversal pattern accompanied by a noticeable spike in volume suggests stronger conviction from market participants, increasing the likelihood of follow-through price action. Conversely, if a pattern forms on low volume, it may indicate a lack of commitment from traders, making the signal less reliable.