Candlestick I: Introduction to Candlestick and its patterns
What is a candlestick chart?
Candlestick charts
shows information about the price action and the movement of the currency price over a specified period of time. It contains the market's open, closing, low and high of that specific time frame.
shows information about the price action and the movement of the currency price over a specified period of time. It contains the market's open, closing, low and high of that specific time frame.
Below is an analysis of a candlestick chart and its components.
On a daily chart, each candle represents a 24 hours period. It contains information of the daily open and daily closing price, the highest and lowest price during that day. On an hourly chart, each candle represents an hour and so on. Since the forex market is a 24 hours market, there is no real daily open or closing price. The chart provider will decide a time, 5pm EST for instance, as the daily open and closing time. Different chart providers may have different choices for the open and closing time. Traders may find the charts from different providers are slightly different to each other.
What are candlestick patterns?
Technical analysts found that, by observing the candlesticks, there are recurring patterns on the candlestick charts. Such patterns are like recurring pictures on the candlestick charts and they tend to occur when a trend is about to end or reverse its direction. The patterns are very good visual representation of the price movements and give traders a good grasp of what is going on in the market.
Why are candlestick patterns so important?
Why are candlesticks so important? It is because they are the best gauge of what is going on in the market at the present time. If a candlestick is very short, it implies that the range for the trading day was very tight. If this candle appears after a strong up-trend, it may suggest that sellers have now begun to enter the market more aggressively, and thus the price may be on its way back down.
Eventually, candlesticks patterns can easily be used to identify potential reversals of trends in the market - especially when used in conjunction with other indicators. By observing the candlestick patterns, traders can speculate potential reversals of trends and entering the market with strong reference to the patterns.
The following are key patterns to watch out for:
Piercing Line
Bullish reversal patterns which shows sellers are losing their dominance.
Dark Cloud Cover
Bearish pattern showing slower buying momentum.
Shooting Star
Reversal patterns that occurs after gaps. Buyers make new high but are fail to sustain then.
Harami
Harami shows a trend that is losing its momentum and may reverse. Bullish or bearish depends on the existing trend.
Evening Star
Reversal pattern shows trend has changed direction after making new highs.
Morning Star
Similar to evening star, reversal pattern shows trend has changed direction after making new lows.
Hammer/Hanging Man
Good reversal pattern after a severe trend. Signifies weakening market sentiment. Pattern is considered a hammer after a down trend and a hanging man after an up trend.
Bullish Engulfing
Usually occurs after dramatic down trends. Good indication that downside momentum is lost as a large candle is completely reversed at next time frame.
Bearish Engulfing
Common pattern after strong up trends. Signifies that buyers are losing control.
Doji/ Double Doji
Pattern implies indecision in the marketplace as the price has a big range but does not going anywhere.
Candlestick II: Spikes Days
Apart from the popular patterns described in the previous articles, there are other patterns that are indicative of the market's psychology that are worth to take a look.
A spike high is a period whose high is sharply above both the high of the previous period as well as the high of the following period. Conversely, a spike low is a day whose low price is sharply below both the low of the following period as well as the low of the previous period. Spikes can often signal reversals of the most recent trends and they can often look similar to hammers and hanging man.
The greater the spike is - meaning the larger the difference between the high/low on the spike and the high/low on the periods before and after the spike - the greater its significance. Also, a spike high's significance also increases when the market is trending upwards, while a spike low's significance increases when the market is trending downwards.
The charts below illustrate how spike highs and lows can be identified, and what they can signal for traders who choose to incorporate them into their trading arsenal.
Candlestick III: Reversal Days
A reversal high day is a day in which the high price reaches a level higher than the previous high, and then reverses to close below the previous close. Like spike days, a reversal high day's mirror image is a reversal low day, in which the market sets a new low before reversing to close above the previous close. Also like spike days, the significance of reversal days increases when there is a preceding up trend (for reversal high days) or a preceding downtrend (for reversal low days).
While reversal days are widely watched and hence warrant attention from all traders, they are still prone to yielding many false trade signals. As a result, many traders who rely heavily on candlestick patterns prefer to see a reversal high day reverse to close below not just the preceding day's close, but also the preceding day's low. This signifies a strong reversal in the market, suggesting that sellers have taken control and that now may be a time to enter a short position.
The chart below illustrates how reversal day can be identified and what they can signal for traders who choose to incorporate them into their trading arsenal.
Candlestick IV: Thrust Day and Run Day
A thrust day
An up-thrust day is when the close for the current period surpasses the previous period's close. A down-thrust day is when the close for the current period is below the previous period's close.
Similar to spike and reversal days, thrust days signify both the strength in the market as well as the possibility of directional reversals. A series of up-thrust days would suggest a pronounced up trend, while a series of down-thrust days would indicate a downtrend dictated by seller dominance in the market.
A run day
An up run day occurs when the true high of the run day surpasses the true high for the past N days, and when the true low is less than the minimum true low on the following N days. A down run day is simply the mirror image of an up run day
Run days can be thought of as a trend-following indicator in the sense that they can only be identified N days after the trend has past. As a result, they may not be ideal for forecasting direction, but can be used as confirmation that a clear trend has in fact manifested itself.
Candlestick V: Using Candlestick Patterns in a Range bound Market
In a range bound market - meaning a market that does not possess a clear directional trend, but rather moves back and forth between support and resistance - traders are essentially looking to short at the top of the range, and buy at the bottom of the range. It is worth noting that this strategy often results in limited profits, as it does not seem to rely on identifying a trend. Nevertheless it can be useful in capturing many small moves for the trader who can maintain discipline and self-control while trading this strategy.
Traders should start by identifying a range bound market.
Once the market is identified to be range bound, traders should look for oscillators suggesting overbought/oversold levels at support and/or resistance.
Traders should then look for a candlestick pattern that also suggests a reversal at the top/bottom of the market's range. When this has been identified, traders can enter once the reversal is confirmed.
Candlestick VI: Using Candlestick Patterns in Trending Markets
Using candlestick patterns to trade trending markets can be an extremely useful tool to profit from exchange rate movement. The process is simple:
Identify the overall trend
Look for a retracement
Look for a candlestick pattern to confirm a reversal at the retracement level
The candlestick pattern serves to confirm the fact that the market is acknowledging the importance of the retracement level. Traders should look to enter the position just outside of the reversal candle's range. At that point, there is sufficient reason to believe that the retracement is over and that the primary trend is ready to resume.
Candlestick VII: Candlestick Patterns Confirming Reversals
Candlestick patterns are used to confirm reversals. Often when a price moves towards a support or resistance level, it is unclear for several periods on the chart whether it is going to break through or reverse. Intraday penetrations of important technical levels are often misleading signals, but quick bounces off support can be false signals as well. Candlestick patterns offer a means of confirming that a price has reversed itself at a key technical level. They also provide a precise entry point and ensure that the market's momentum is in the direction of the trader's position at the time of entry.
In the chart below, the Euro has made its famous double top against the US dollar. The first relative high has been established, and although there are later several intraday breaks above this level, no daily candle has closed at a new high. Shortly after, a rapid fall from the 1.29 level creates a bearish engulfing pattern that allows the trader to sell the next day with the market's momentum to the downside. The stop is placed just above the black resistance level, because a further test of the recent highs could easily lead to a breakout higher.
