Traders need to understand and use technical analysis and reading candlestick charts in order to be a better, more prepared trader.
How To Read Candlestick Charts Beginner’s Guide to Technical Analysis
This guide is meant to set the tone for understanding the basics of technical analysis so that you can better prepare yourself for your first Combine with TopstepTrader.
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In this post learn:
- Candlestick charts
- Support and resistance
- Trend trading
- How to use my favorite indicator
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What is Technical Analysis?
Technical Analysis is by my most simplest definition, reading candlestick charts.
A trader must be able to use charts to their advantage, and a few indicators, in order to better prepare for a day trade.
Investopedia defines Technical Analysis:
Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
Technical Analysis vs. Fundamental Analysis
For the purposes of a day trader and not an investor, fundamental analysis is dead.
Fundamentals of a company or market only matter so much as if you wish to make a much longer term investment in an equity, commodity, future or currency. You would be looking at past performance, P&L statements, SEC filings, future outlook, budgets and the like to determine if your investment will pay off in the future.
We are day traders. We want to make our money now.
Technical Analysis focuses more on the patterns that form when price movement happens in a market. We use charts, indicators, support and resistance lines and try to predict a move based on these factors within one single day.
We place our entry points based on these patterns. We plan our exits based off of the same material.
Today we want to know what the market is going to do. We don’t place a trade today for a market we believe will grow (or crash) next quarter or next year.
Once more,
We are day traders, not investors.
Reading Candlestick Charts
Candlestick charts are extremely popular. It is a specific kind of chart we can use to measure multiple time frames of movement in a certain market.
Below is a photo of such a chart.
Candlestick Anatomy
The anatomy of a candlestick is the first place to start.
If you were looking at a “daily chart” then the candlestick you are looking at would show the movement of this particular market within a period of one day. Similarly, if we were looking at a “5 minute chart” the candlestick bar you are looking at would represent the movement of the market within a 5 minute period. After 5 minutes, a new bar would begin to print.
Assume from this point that we are looking at a 5 minute chart:
Open: As soon as a new 5 minute increment begins it will form a new candlestick. The point at which that new bar opens is on the left hand side of the candlestick. This would also become the beginnings of the “body” of the candlestick.
Low: The low will be indicated by the bottom of the candlestick. If there was a low formed within the 5 minute period and the the market retraced slightly before the close of the period then a “wick” would form. That is the shadow, that thin line, of where the market has been in the past of that particular 5 min period.
High: The high, similar to the low is the highest point in the 5 minute increment that the price has reached. If it retraces during that period then a wick would form just like it would with the low.
Close: The close is indicated on the right hand side of the “body” or the thicker part of the candlestick. This is the most current price of the market, and after the 5 minute time frame is over, this candlestick will print and no longer move.
A green candlestick would mean that the Close of that bar was higher than the Open.
A red candlestick would mean that the Close of that bar was lower than the Open.
Doji: Just a funny word to know. This is when the Open and the Close price of that candlestick are exactly the same.
Support and Resistance
There are millions and millions of people all over the world that read charts. Certain patterns form that the majority of people look for and react in a similar way when these price points are reached.
Identifying support and resistance is the first step in coming up with your trading plan for any particular day.
Mark them on your charts and save them. Below is an example of my daily chart for the 30 year bond.
Support
Support is where, in the past, buyers would come in and keep the price up. When these prices are met at a later date, you can probably expect that a similar reaction might occur.
Resistance
Resistance acts opposite of support. When price action raises to a resistance point, sellers will begin to reject the price, keeping it below that point.
If price action breaks through major support or resistance a lot of traders will begin to take on positions and continue to push the price further, hoping for a big move. Be careful, sometimes the opposite will happen and the price will reverse.
Once a resistance line is broken, it now becomes support. A retracement back to that former resistance may become a better entry point. Same applies for when support is broken.
Where To Look For Support and Resistance
There are many different ways to identify these levels. Here are a few I use.
- Use historic patterns of the market to mark these levels. Just look onto the past days or weeks trading and mark each level on your chart.
- Trading today? Use yesterday’s lows and highs as support and resistance.
- Use today’s open price, today’s lows and today’s highs.
- Identify trendline support and resistance (more on that next).
- Highs and lows of channels.
- Big round numbers, ending in zero.
Identifying Trends
A market will tend to pick an upward or downward direction as the price changes over time.
It is typically very easy to identify a trend.
Price action meets resistance at the top part of this trending channel and will make it’s way back down to trendline resistance. Just draw a diagonal line on your chart to identify a trendline.
Why does this happen?
Again, millions of traders are looking at the same signals. Trends will stay trends because of the mass psychology of all of the traders looking at the same charts, looking for the same patterns and trending the same way at each support and resistance line.
But, like in real life, trends don’t last.
A trend is your friend until the end.
It is useful to use an indicator in order to determine how strong a trend is before you place a trade.
This is my favorite indicator to use!…
Average Directional Index
The ADX is one of my favorite indicators to use.
I keep it open on the bottom of all of my charts.
Stockcharts describes the ADX:
The Average Directional Index (ADX) is used to measure the strength or weakness of a trend, not the actual direction.
At a closer look, there are three lines.
My green line tells me the strength of the buyers in the market. The red tells me the sellers.
Whoever is on top is in control.
The thick, white line in the middle of the two is the ADX line. If the ADX line is positioned above 20 (or 25) then the indicator is telling us that the market is trending.
The direction of the trend is pointed out by either the red or green line being on top.
Be sure to check multiple time frames to confirm the strength of the trend.
Whew!
Thank you all for reading this lengthy post. I wanted to be sure you got these basics down in one go. Because for me it took a few months to figure this out when first starting out.
Good luck team,
Hope it helps.