The great insight of Behavioral Economics is that markets are made up of people who do not necessarily act in the way that traditional economic models suggest they should. In other words, at least in the short term, markets are driven by human psychology. This being the case, it is not unreasonable to suggest that the movement of prices yesterday and today will influence the way prices move tomorrow, which is the underlying logic behind candlestick analysis.

It is important to note that this reasoning applies strictly in the short term. In the long term, economic fundamentals swamp trader psychology. However, as a short term trading strategy, candlestick analysis and other technical analysis methods do have some academic backing.

Interestingly, the more traders buy into candlestick analysis, the more powerful a technique it becomes. For example, if a significant portion of traders involved the gold market observe a ‘Gravestone Doji’ in gold prices (indicating a market top) and act accordingly, it becomes very likely that gold prices will decline the next day. In effect, the ‘Gravestone Doji’ will be something of a self fulfilling prophecy. For this reason, the mere fact that Japanese Candlestick Analysis is a widely used technique is evidence that it is a potentially lucrative trading system.

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