- We look at the most important candlestick formations.
- This is not a stand-alone trading strategy but is to be used as confirmation before entering a trade.
My preferred method of undertaking this task is to examine the candlestick patterns on the hourly or 4 hour trading charts of the currency pair in question. Some traders use candlestick charting as a standalone trading strategy, but this is not the point I am making here. I believe candlestick patterns should be used in conjunction with the above mentioned strategies and ideas, as a way to confirm an entry or exit. Ideally, I am looking for a sign that supports my entry and exit ideas and hence give the trade a higher chance of profitability. During this process, you cannot afford to be subjective in your analysis. For instance, you should not enter a trade just because you think it feels right - especially if there are upcoming major technical events or items are indicating the opposite. If you were to continue with such a system then you will only experience significant failure in the time to come.
Instead and especially if you intend to use any of the trading methods described in this book, you should examine trading charts carefully and objectively for possible entry points. After you have achieved this, I would then strongly advise you to undertake an additional confirmation step by studying the candlestick patterns on the trading charts of the applicable currency pair. In other times, when none of my trading strategies are displaying any evidence of new possible trades, I then also study the trading charts for positive candlestick patterns. If I locate one, I then start researching into the possible reasons why they have been formed i.e. fundamental or technical. I also pay further attention to my trading strategies to determine if there are any further backup indications confirming that candlestick patterns are advance warnings for potential new trading opportunities. There are many books on the subject of candlestick patterns – I will give you a quick intro to the subject here.
Candlestick patterns can be used to detect and confirm key forex formations, many of which have been mentioned in this book already e.g. retracements, reversals, breakouts and fakeouts etc. I make great use of candlesticks to help determine and distinguish between reversals and retracements. There are a great number of candle stick patterns and here are the descriptions of a few that I find particularly useful:
This pattern occurs at the end of a bull run appearing with a small body. Traders do not consider the color of the body to be of much importance. They are more interested in the fact that the long lower shadow is at least twice the length of the body and that there is little or no upper shadow. This pattern is considered a bearish sign indicating that there has been a strong attempt to sell off long positions that was only reversed towards the end of the candlestick time period.
This pattern is created when the open, low and close are very close to each other. The other main feature is that there is a long upper shadow that is usually twice the size of the body. This is a significant bearish sign as it indicates that a bull movement was strongly rejected by the market.
This pattern is formed when it opens and closes at its average price in its middle of its structure. There are both upper and lower shadows that can be quite long and are both close to equal in length. On its own, the Doji is neither a bullish nor bearish indicator and as such it is generally analyzed as part of a three candlestick pattern.
This pattern is created by a three period candlestick formation that identifies a strong bullish reversal. The first candle is normally a long bearish candle, the second drops slightly lower while the third is a bull candle that closes above the midpoint of the first candle.
DARK CLOUD COVER
This is a bearish reversal pattern comprising a large bear candle that casts a shadow over a preceding bullish trend. To create this pattern, the final period candle in the sequence must open at a new high and must close below the midpoint of the body of the preceding period.
This pattern is created at the end of a strong downtrend and, as such, signifies a bullish reversal. The hammer has a very small body that is formed towards the end of the current period’s trading. There is no upper shadow to speak about but a significant lower one which is at least twice the size of the body.
Basically, the Hammer shows that the market price has bounced higher after hitting a possible support level.
This pattern is a bullish reversal sign and occurs at the end of a strong downtrend. The candle has an open and close very close to each other, with a non-existent lower shadow but an upper one that is at least twice the size of the body.
Candlestick patterns that have either a long upper or lower shadow with hardly any body are, in my opinion, the most useful e.g. hanging man, hammer, morning star and inverted hammer. I search for these patterns on the more reliable hourly or longer period charts. I use these candlestick patterns in the following way. For instance, if I have been unable to activate any new trades using my strategies, I then search for one of the patterns listed above. Suppose I detect a hammer on a daily chart. I will then investigate into the reasons behind its formation by studying currently important fundamental aspects, upcoming news and technical aspects. From this study, I will then determine if a full-blown reversal is developing or just a relief retracement. Sometimes, if I have other reasons for considering entering a trade, I will still inspect the candlestick patterns on the trading chart of the applicable currency pair for additional confirmation. For instance, suppose that I was planning to enter a bullish trend following trade after studying the 4 hour charts but then notice that a morning star candlestick was forming, I may decide to reconsider and wait for further developments as a result.
Using this candlestick method can help you detect new trades, confirm your already planned trades or prevent you entering trades that will eventually transform into losses.
However, candlestick patterns have limited use about the times of key fundamental news releases. Just as technical analysis they also work better when higher time frames are used; do not look for candlestick patterns on a 5 minute time frame.
Finally, you may consider that you would like to determine the effectiveness of introducing candlestick confirmation into trading strategies. This can be done as follows:
First, calculate the expectancy value of your trading strategy and then repeat the process but include an extra step by introducing candlestick confirmation. Any improvement would demonstrate to you the value of this concept. I am sure that you will find that it does.
Japanese Candlestick Patterns Questions and Answers
Do Candlesticks really work?
Yes, candlesticks really work. The candlestick patterns as they form reflect the changes in demand/supply balance of the market in a particular time moment. Behind every candlestick pattern there is a known process of market sentiment change. Patterns just show these changes visually allowing for fast recognition of the market sentiment changes by the trained traders.
Even before the invention of the candlesticks, traders observed similar price behavior in a similar market circumstances. These repeating price actions in a similar market conditions called patterns got investigated and analyzed to be later used to predict with high certainty the following price behavior. The Japanese Candlesticks just made this process simpler.
Important consideration in dealing with any graphical tools of analysis, including the candlesticks is probability. When we say that classic Head and Shoulders or Gartley's pattern work, we mean that they work in more than 50% of instances. No one should assume that any candlestick pattern would work every time. However, consistent use of the candlestick pattern should produce the positive result (with proper risk management, of course) as it works more often than it fails.
To improve candlestick efficiency it is recommended using them together with other trading tools (as indicators) and building your own trading system for decision making. Remember, everything that is related to visual interpretation, has a high share of personality, skills, and experience of the trader. It is of no surprise, that the same candlestick patterns got interpreted differently by the traders of different background and some may be more successful than the other.
What is a Japanese candlestick?
Japanese candlestick is a way of graphical representation of the price action within a time period. Candlestick provides similar information as bar chart, visualized differently. Top and bottom of candlestick represent highest and lowest price during particular time interval. White (or often green) color of the candle body indicates that the price was rising, while black (or often red) color means that it was falling. The body of the candlestick itself represents the open and close prices.
Every candlestick on the chart represents a single unit of time. For example, in case of the hourly chart, each candlestick represents price action during one hour; 1-minute chart candlestick covers 1 minute, and the weekly chart candlestick visualize one week.
How do you do a candlestick analysis?
There are numerous ways to use candlesticks charts both simple and sophisticated. However two ways of the candlestick analysis are both most common and effective.
- Recognition of the well-known candlesticks patterns, as Bullish and Bearish Engulfing, Hammer, Shooting Star, Morning and Evening Star, Doji and making trading decisions based on these patterns.
- Using the candlestick patterns as a part of your trading system, i.e. the pattern is just component in your decision making process. For example, pattern could be used for confirmation of support or resistance area, as a part of a larger pattern (say Head & Shoulders) or as market reaction on some price target, etc.
- The same candlestick patterns are applicable to any chart of any liquid asset with no exception, currencies, commodities, stocks, bonds, etc.
- Remember the candlestick analysis advantages and limitations. The main advantage is speed as most patterns consist of just 1-3 bars and show signal very fast. The flip side is that generally, the signal is only reliable for the timeframe equal to the timeframe it took to form the pattern.
Which candlestick pattern is most reliable?
Reversal Candlesticks patterns are the most reliable compares to other types - “indecision” or “Continuation” patterns. In turn, the most reliable reversal patterns are the “Bullish/Bearish engulfing”, “Morning/Evening star”, “Shooting star”, “Hammer” and their variations.
Candlestick pattern reliability is inversely correlating to the number of candles that it includes. The “Longer” the pattern, the less reliable it is. This is the reason why most reliable patterns are very short and consist only of 1-3 candles. To use the pattern in trading, the trader has to make a “visual identification” of it, and chance of making a mistake or misinterpret the “Longer” pattern (like Tower Top or Damping Top) are significantly higher compared to one-candle patterns.
The secondary criteria of the patterns quality is the size and the purity of the pattern, how well it matches to the theoretical perfect shape.
Also patterns formed on the higher time frames are more reliable than patterns on lower time frames and the larger pattern is, the more reliable it is.
What is a doji candlestick?
Doji is a special type of candlestick that has no “body” on the chart. This happens when open price of the time period equals to its close price. Visually doji looks like a small cross, or it could take the “T” shape, or reversed “T” shape when open and close prices also equal to either the highest price (T-shape) or the lowest price (Reversed T-shape) for the time period.
Doji has no definitive meaning on the chart by itself and its interpretation depends on context. In most cases common doji is a sign of “indecision”, especially if doji has the length of two times greater than previous few candles on average. Market direction in this case, as a rule, depends on the direction of the doji breakout. This type of doji is called a “High Wave”.
“T”-shape doji is a specific instance of reversal patterns group and has common features with such patterns as “Hammer”, “Shooting star”, “Reversed Hammer”, or “Hanging man”. Specific type of reversal doji is “Gravestone doji”. In all these cases T-shape and reversed-T shape doji should be treated similar to reversal candlestick patterns of the same shape. For example, T-shape doji is interpreted similarly to the “Hammer” at the bottom of the chart or the “Hanging man” at the top, while reversed-T” doji, including “Gravestone” doji is treated similarly to the “Reverse Hammer” at the bottom, or the “Shooting star” at the top of the chart.
Very often doji becomes a component of compound candlestick patterns, such as Harami, Evening/Morning star and some others that consists of three and more candles. In this cases the doji is not interpreted separately, rather the trader must pay attention to the whole pattern.
How does Candlestick work?
Bullish doji always appears at the bottom of the market, after the downside action. It is not necessary for that bottom to be an absolute one, It could be local. However the existence of some downside tendency is necessary condition.
Thus, the doji that appears at the bottom of the market and has T-shape or reversed T-shape is the one that usually is treated as a bullish one. T-shaped doji at the bottom is similar to the Hammer bullish reversal pattern, and reversed T-shape doji is similar to Reverse Hammer. When the same patterns appear at the top of the market, they are treated as bearish.
Doji patterns have the same criteria of reliability as all other reversal candlestick patterns. Doji patterns of greater size, higher time frame, and with stronger and longer preceding downside price action are more reliable.
How does Candlestick work?
Term Candlesticks includes at least two major parts. First is a Candlesticks chart, second – specific patterns that candlesticks form.
Candlesticks charts show absolutely same price information as well-known bar charts. Both candlestick and bar charts consist of a chain or sequence of bars called candles. Every candle shows price information for the specific time frame. On the daily chart every candle shows price information for the day, on the hourly chart – for one hour etc. Candles, as well as bars show high, low, open and close prices for the time period. Both candlestick and bar charts can be used for the recognition of long-forming classic and Gartley's patterns while the Japanese candlestick charts are considered to be easier for the recognition of Head & Shoulders, Double Top or Bottom, Triangle and other patterns.
Candlestick pattern recognition as we know it originated in Japan representing the eastern culture, while bar charts were the most common in the west. In our days however, the candlestick charts became the most common globally used tool.
Candlestick patterns is a specific combinations of 1-5 (or even more) candles that predefines the next price action with high degree of certainty. Candlestick patterns should be treated as a different trading tool, compared to classic or Gartley’s patterns, because of their length. Candlestick patterns are very fast; usually it takes just 1-3 candles to complete the pattern, while classic patterns may require dozens of candles to form. The candlestick patterns and Grartley's or classic patterns are not mutually exclusive. Advanced trades should learn how to combine fast candlesticks patterns with longer-term classic or Gartley’s patterns.
There are few dozens of different commonly used Candlesticks patterns but all of them could be categorized as:
- or Continuation patterns
Some candlestick patterns have poetic names – “Shooting star”, “Three black crows”, “Abandoned babe”, “ Gravestone”, “Evening star”, “Cloud cover” etc.
Overall group of patterns is rather large, but traders most commonly use just 10-15 patterns that form most often on the charts. Many patterns, although they named and look slightly different, represent the same price action meaning. For example, “Bearish engulfing” and “Shooting star”, or “Evening star” – they consist of different number of candles but all of them are bearish reversal patterns as similar market mechanics is at the core of these patterns.
How do you trade every candlestick?
Any trading setup that you want to follow demands estimation of three major parameters below. First is – direction of the trade, second – invalidation point of trading setup, and, finally third – the target of trading setup. Candlesticks are an amazing tool that make evaluation of all these three variables very easy.
The direction. Direction could be determined only for reversal type of candlestick patterns that are traded the most. Other types of patterns, such as “Indecision” or “Continuation” can’t be traded solely and need additional context. Only reversal candlestick patterns could be traded directly. Reversal patterns are divided in two major groups – “Bullish reversal patterns” and “Bearish reversal” ones. Once you have identified the pattern – you definitely know the direction. For example, appearing of the “Bullish engulfing” or “Morning star” pattern at the bottom is a bullish sign and suggests upward reversal and direction.
The invalidation point. This is quite simple for candlestick reversal patterns. The opposite extreme point is the invalidation one for any reversal pattern. Thus, for bullish patterns the low or minimum price of the pattern stands as invalidation point while for bearish patterns – the top of the pattern is. “Invalidation point” means that if price comes out of this level pattern should be treated as failed. Invalidation point also tells you, where you have to place stop-loss order. Stop loss order usually placed slightly above the top of bearish pattern and slightly below the low of bullish pattern. If pattern consists of two, three or more candles only the highest/lowest price of all candles is used as an invalidation point.
The target. Very often reversal candlestick patterns becomes a first sign of big and long-term tendencies. But to use them in this context the more extended trading plan is needed. Speaking on trading candlestick patterns directly, the most reliable and simple target of any pattern is its length, counted in the direction of the pattern.
Say, if we have a bullish engulfing pattern - all you need to do is to estimate its target is just to calculate its range as the «High price» of the pattern less the “Low price” and then add this range to the “high price”. In other words, add the pattern’s length in the same direction. For bullish pattern this addition is up, and for bearish pattern – down.