Big Story | How to use candlestick charts to predict stock price

With the stock markets on a bull run fuelled by ample liquidity, interest in guessing the next move of the indices and individual stocks is running high. Technical analysis could come in handy here.

Charts and other tools such as indicators/oscillators are used to identify patterns that can suggest future activity. A chart is a reflection of the mood of the crowd and not of the fundamental factors driving the markets.

Types of charts

There are four types of charts — line, bar, candlestick, and point & figure. Bar and candlestick charts are the most widely used charts in technical analysis to predict future price action. Charts should be read keeping the time horizon of your investment in mind.

For example, for a day trader, the near- or short-term trends are analysed on the minutes chart or the hourly chart. The short-term trends are analysed on daily charts, medium-term trends on weekly charts and long-term trends are best grasped on monthly charts.

Trend

A trend is the general direction in which a stock/security or market is headed. The Sensex was on a downtrend in February and March.

However, since March, the index has been on an uptrend, as a series of higher highs and higher lows have been forming.

In a downtrend, the price forms lower lows and lower highs. When there is little movement up or down in the peaks and troughs, it is a sideways or horizontal trend. The best investment results are attained when the trends in all the three charts — daily, weekly and monthly — point in the same direction.

Understanding candlestick charts

Candlestick patterns are one of the oldest forms of technical analysis originating from Japan. They are now very popular because of their simplicity and the unique insight they give into the sentiment of the market.

A candlestick chart has a body and shadows/wicks (see illustration). The body is the distance between the open and the close of the price, and the highs and lows of a candle is represented by the upper and lower shadows, respectively. A candlestick captures the price behaviour during each time unit — in a daily chart time-frame, one day is represented in one candlestick that shows the open, high, low and close, and in the case of a weekly chart, one week is denoted by one candle.

If the close of a stock price is higher than the open in a particular time period, the candle is represented in green; conversely, the candle will be red in colour.

Bullish and bearish candlesticks represent buyers’ and sellers’ dominance, respectively.

There are many candlestick patterns, starting from a single candle pattern to two- and three-candle patterns, etc. Some of the patterns are known as doji, dragonfly doji, gravestone doji, bullish/bearish engulfing patterns, hammer, shooting star, evening star, morning star, piercing line, dark cloud cover, three white soldiers and three black crows.

Here aresome commonly used bullish and bearish patterns.

Three bullish reversal candlestick patterns

Hammer: A hammer pattern is a single candlestick bullish reversal pattern. This occurs following a prolonged downtrend.

There should be a gap-down open and the price has to decline initially to the low. Then, bulls should suppress bears and take the price higher and close the session almost near to the open price.

A small body, a big lower shadow/wick (at least twice the length of the body) and a not-so-noticeable small upper shadow will complete the pattern. The colour of the body can be either green or red; if the body colour is green, the hammer is considered a little more bullish, as the bulls are optimistic of closing the price higher than the open price.

Confirmation or validation of the pattern is key, so in the next session, the price should ideally move above the high of the pattern. In that case, a buy trade (trade plan) can be initiated with a stop-loss below the low of the candle. For instance, the stock of ONGC (refer the chart below sourced from TradingView) had displayed a hammer in April at around ₹64. Subsequently, it changed direction and continued to trend upwards till ₹80.

Bullish engulfing candlestick: Bullish engulfing pattern, a two-candlestick bullish reversal pattern, is popular among traders.

This pattern can be easily observed on the charts. Generally, this pattern occurs at the bottom of a downtrend.

First, there should be formation of a red/black candle or a bearish candlestick. The second candle should engulf and close above the previous bear candle.

In this scenario, an increase in activity from both bears and bulls are seen, and there is a shift in market sentiment towards bulls.

Confirmation is needed in the form of continuation of the upmove within the next two candles. A buy trade can be set up on confirmation, with a stop-loss below the low of the two candlestick patterns. For example, in the daily chart of Amara Raja Batteries (refer chart below sourced from TradingView), a bullish engulfing pattern occurred in late March this year at around ₹400 and acted as a trend-reversal. Since then, the stock has been trending upwards.

A buy trade after the pattern would have resulted in good gains for traders.

Morning star: The morning star candlestick pattern is a three-bar pattern in which the ‘star’ is a small-bodied candle. It is a bullish reversal pattern that occurs after a downtrend.

First, a long bearish candle is formed. Then, a small-bodied bullish or bearish candle, or a doji (a single candle that has zero or almost zero range between its open and close, but with an upper shadow and lower shadow of various proportions) opens at or below the close of the previous candle.

During the formation of this candle, the trend transitions from bearish to bullish.

Thereafter, a long bullish candle is formed that opens at or above the high point of the previous candle and closes at or above the centre of the first candle. This pattern establishes a potential bottom to the preceding downmove and acts as a buy signal.

A buy trade can be set up with a stop-loss below the low of the small-bodied candle. In the ONGC chart below, the morning star pattern can be noticed in late September; the stock has been trending upwards since then.

A strong rally above ₹72 can take the stock higher to ₹76 in the short term.

Three bearish reversal candlestick patterns

Hanging man: The hanging man is identical in shape to the hammer but the difference is in occurrence. The hammers occur in downtrends, whereas the hanging man pattern occurs in uptrends. In this event, the shadow/wick extends down, contrary to the uptrend, and suggests the emergence of bearish demand capable of pushing the price down.

It is often an initial indication that the uptrend is exhausting and bears are emerging to create a reversal. The trend-reversal can be confirmed if the subsequent bearish candles are seen. A sell trade can be set up on confirmation, with a stop-loss above the high of the hanging man candle.

For example, in the candlestick chart of Vedanta seen below (sourced from TradingView), the formation of a hanging man pattern is apparent at around ₹140 in late September following an uptrend. Subsequently, it began to decline. Traders who had initiated sell trade could have benefited from the pattern.

Bearish engulfing candlestick: This pattern is the opposite of a bullish engulfing pattern, wherein the body of a bullish candle is encompassed by the body of a subsequent bearish candle. Bearish engulfing candlestick is a short-term bearish trend-reversal pattern.

A sell trade can be set up on confirmation, ie, a bear candle should be visible thereafter.

The stop-loss can be placed above the high of the two candlestick patterns.

For instance, the formation of the pattern is evident in the stock of ONGC (refer chart below) in late August at around ₹84, and the stock continues to trend downwards thereafter.

Evening star: An evening star pattern is the opposite of a morning star pattern and occurs after an uptrend, and signals bearish reversal. A change in the balance of power between bulls and bears is seen here. A long bullish candle is formed initially and then a small-bodied bullish or bearish candle.

A bearish third candle completes the pattern. For confirmation, the price needs to continue downwards. A sell trade can be set up on confirmation, with the stop-loss above the high of the small-bodied candle.

An evening star candlestick pattern is apparent in the stock of BSE (refer chart below sourced from TradingView) in mid-September at around ₹600. After confirmation, the stock began to decline and continued to trend downwards.

Notably, there are also other ways to see bullish and bearish signs using chart patterns such as head and shoulders, double bottom and wedge.

The main purpose of technical analysis is to help analyst/investors identify turning points which they may not see because of individual or group psychological factors.

Tenets

Technical analysis is based on three tenets — the market discounts everything, price moves in trends, and history tends to repeat itself.

One, all relevant market information such as company fundamentals or broader economic issues is discounted or reflected in the price. Thus, only the price movement is primarily taken for analysis.

As demand increases, the price is likely to move higher, while as supply increases, the price of a stock is expected to decline.

Two, as demand increases, the price could move higher and establish a trend that is broadly known as an uptrend. Likewise, if there is an increase in supply and the price action charts downwards, it is called a downtrend. When there are not much indication or clue on the demand and supply, the price could consolidate in a band — a sideways trend.

Three, history tends to repeat itself predominantly in terms of price movement.

For instance, market participants tend to provide a consistent reaction to similar market stimuli over time. That is, the overall pattern is made up of smaller versions of the same pattern, whether in stocks, commodities, currencies or bonds.

For example, during the subprime mortgage crisis in 2007-08, during which the Dow Jones Industrial Average slumped sharply, historical price data was beneficial to determine the market base.

Another classic example is visible in the Nikkei 225 chart — to envisage a move beyond 25,000 levels, technical analysts need to do a backtrack of the price action that occurred in 1991.