In reality, the interpretation of a candlestick chart does not differ much from the interpretation of any other graph. In the investment world, the time frame is indicated on the x-axis and the price on the y-axis. The big difference is the notation in the graph. In the investment world, the standard line graph is generally not used, instead, they use a concept that was used for the first time in 1700 by a Japanese rice maker: The Candlestick. This article will briefly explain the following issue: how does a candlestick chart work?
A candlestick consists of a body and a shadow. The body indicates the opening and close within the viewed timeframe. If the price closes higher than where it opened, then the body generally has a green colour. If it closes lower than where it opened, the body’s colour is generally red.
The shadow, the line above and below the body, indicates the highest and lowest points. It may occur that the price reaches a higher or lower level than the opening or closing level. The shadow is always a line above and / or below the body.
What makes a candlestick chart?
In case the time frame is set to 1 minute, the body will display the opening and closing price in that minute as well as the highest and lowest points within this minute, by means of the shadow.
At the end of this minute, a new candlestick will appear that will do the same for the next minute. In this way, there is a chart consisting of candlesticks.
To show exactly how a candlestick is created, it’s easy to view the price of 5 of these 1 minute candles mentioned above.
We now see where the price opened in the 5 minute timeframe, as well as the highest and lowest points, and where the price closed.
- The point at which the first 1 minute candle started was the start of the 5 minute candle body.
- The highest point from 1 minute graph corresponds to the top shadow of the 5 minute candle.
- The point at which the last 1 minute candle closed indicates where the body of the 5 minute candle closes.
- The lowest point in the 1 minute graph corresponds to the lower shadow of the 5 minute candle.
All candlesticks are constructed in this way. It does not matter if we look at a timeframe of minutes or hours, or even days or weeks. The interpretation remains the same.
To find out how candlesticks are applied in trading, read our trading tutorial.
A gap between candlesticks
It also does not always have to be that a new candle opens on exactly the same level as the closing price of the previous candle. In that case, we are talking about a gap.
For example, a gap occurs when there is bad news about a company after the closing of the stock markets. On the next trading day, investors will be less willing to pay for the share, while no direct trading has taken place between these two levels. This is a way of creating a gap, but certainly not the only one. For example, in the case of low liquidity, gaps may occur more often.
Hopefully, you have understood the basics of how a candlestick chart works.