In previous articles, we already discussed candlesticks, how they form and how you can use them for your trading. For this article, we will take a closer look at the conclusion you can draw from candlesticks about market psychology and market phases. This will help you to not only guess what will happen, but understand what the price is doing and why it is doing it. From that knowledge, you can get to a more sophisticated prediction about future price movements, and become a better trader.
Each candlestick indicates the momentum the price has to move in the direction of the candlestick. There are three main criteria to determine the momentum of a candlestick: The length of the candlestick, the length of the body, and the length of the wick.
A long candlestick with a long body and a short wick is a typical sign for a lot of momentum in a certain direction. The smaller the candlestick, the smaller the body, and the longer the wick in relation to the body, the less momentum a candlestick has.
Knowing this can convert the seemingly random sequence of candlesticks in a price chart to a series of valuable information that you can use for your trading.
For example, when the price has risen with long candlesticks with short wicks in the past, and now enters a period with shorter candlesticks with longer wicks in the opposite direction, you know there is more potential for an upwards movement than a downwards movement. This is invaluable information if you are thinking about trading a High/Low option, for example. You know the falling prices are likely only a short break to create new demand, and that sooner or later the bigger upwards momentum will probably make prices turn around again.
In situations like this, many traders ask why there is a downwards movement at all, if there is more momentum for rising prices. To understand this, it is important to remember that the price of an asset is solely determined by supply and demand. When demand exceeds supply, prices rise. When supply exceeds demand, prices fall. When there is a strong bullish momentum, as indicated by long candlesticks with a short wick, there are more traders willing to buy then to sell.
Still, there will eventually come a time when all traders willing to buy right now have bought. Other traders are simply not interested in buying this asset at this time – maybe they have not yet recognized the opportunity, maybe they do not have any money to invest, maybe they need to sell other assets first before they can invest in this asset.
Whatever the reason may be, some time needs to pass before these traders can buy, and the market can rise again. This time is usually characterized by smaller candlesticks that can vary in direction, and is considered a consolidation period. After this period is over, prices will likely resume moving in the direction they did before.
As a trader, you can make the safest investments in the direction of a strong momentum. The market direction is more predictable, and you will win a higher percentage of your trades.
When prices have lost momentum, they tend to change direction often and get less predictable. Making successful predictions becomes harder during these periods, which influences your trading negatively. To avoid this problem, you can try to find candlesticks with more momentum in different time frames or different assets.