By Nathan Boardman
In the realm of trading, it is commonly observed that despite the vast literature available on the topic, traders tend to gravitate toward a limited selection of candlesticks or Forex candlestick patterns that prove truly advantageous in their endeavors. The extensive assortment of potential candlestick patterns frequently engenders a state of cognitive stagnation commonly called “paralysis by analysis.”
By restricting the utilization of candlestick patterns as signals to a select few of the most optimal designs, one can enhance their trading approach by instilling a greater sense of confidence and mitigating the tendency to engage in excessive trading activities. Below, we will elucidate the process of identifying candlestick patterns.
What Are Japanese Candlesticks?
Japanese candlesticks are a visual representation method for depicting price fluctuations over a given period. In Western nations, traders historically employed bar charts for analytical purposes. However, during the 1990s, the Japanese candlestick format gained global prominence as traders widely recognized its enhanced informational value compared to the conventional bar chart.
Similar to a graphical representation found in financial analysis, each Japanese candlestick symbolizes the price variation observed during a specific historical period, contingent upon the temporal scope of the price chart on which it is depicted. In the context of a daily price chart, it is worth noting that each candlestick corresponds to a single day. The candlestick chart is constructed based on each unique candlestick’s open, high, low, and closing prices.
A uniform hue occupies the region horizontally from the opening to the closing price, called the “real body.” When the closing price exceeds the opening price, the candlestick assumes a bullish hue, typically represented by green or blue colors. When the closing price is lower than the opening price, the candlestick takes a bearish hue, commonly depicted as red. When the price surpassed the higher value between the close and open prices during the formation of the candlestick, a vertical line is observed to ascend from the actual body of the candlestick, ultimately reaching the highest point at which the price was traded.
In instances where the price exhibited a decline below the lower of the close or the open within the timeframe during which the candlestick was being constructed, a vertical line is extended in a downward direction from the base of the natural body, ultimately reaching the nadir at which the price was transacted.
It is widely observed that contemporary technical analysts generally perceive Japanese candlestick charts as more understandable than bar charts and more capable of conveying the narrative about the underlying price fluctuations.
Through diligent practice, one shall acquire the ability to discern the narrative conveyed by the sequential motion of the preceding ten or twenty candlesticks. This heightened perception shall enhance one’s analytical prowess when examining the immediate one, two, or three candlesticks. By considering the broader historical trajectory, one gains valuable contextual insights into the present circumstances, facilitating informed judgments regarding the opportune moment to engage in long or short trading positions.
How to Understand Forex Candlestick Patterns
Upon acquiring a comprehensive understanding of various significant candlestick patterns, one may develop a sense of enthusiasm to apply said patterns within the realm of Forex trading. It is imperative to exercise caution in this matter, as excessive diligence in identifying such occurrences may inadvertently result in their perceived prevalence, potentially precipitating a propensity for extreme trading activities.
It is recommended to thoroughly analyze historical Forex price charts, explicitly focusing on candlestick patterns that exhibit prominent visual prominence. Is it possible that they have executed a prosperous transaction on your behalf? Is there a commonality among the successful candlestick setups when they are analyzed? It is commonly observed that the most optimal candlestick patterns exhibit a significant size and possess a high degree of clarity, facilitating ease of interpretation.
It is imperative to comprehend that candlestick patterns at significant support and resistance levels or extreme highs and lows exhibit a higher propensity to generate favorable trading outcomes than patterns manifesting in inconspicuous locations.
The subsequent elucidation pertains to a collection of Forex candlestick patterns that exclusively encompass Forex reversal candlestick patterns. These patterns serve as potential indicators of significant price inflection points. Identifying possible reversals can serve as valuable entry points for initiating trades, offering a high likelihood of yielding a favorable reward-to-risk ratio.
The candlestick patterns can also serve as continuation signals when they do not result in a reversal, prompting the price to extend its movement beyond the observed price action in alignment with the prevailing longer-term trend.
Now, let us examine the most significant Japanese candlestick patterns within Forex trading. By acquiring knowledge of these concepts, you will significantly progress in comprehending the intricacies of price action.
Hammer/Shooting Star
This pattern exhibits bullish and bearish variations, similar to other candlestick formations. The bullish candlestick pattern resembling a hammer is commonly referred to as such. The bearish one is referred to as the shooting star. The hammer exhibits a downward wick and relatively equal opening and closing levels.
The initial selling during the opening phase is followed by a subsequent return of buyers, resulting in a significant upward push of prices, ultimately leading to a nearly unchanged level. Sellers have not effectively maintained price stability, potentially leading to a sense of weariness among them. After a downtrend, these factors hold significant importance as they frequently indicate a potential shift in the prevailing trend.
Inverted Hammer
The shooting star, also known as the inverted hammer, is the hammer’s precise antithesis. The inverted hammer is the opposite of the hammer candlestick. In essence, it can be described as an inverted hammer. The formation occurs during a pullback or at the bottom of a downtrend, indicating buyers entered the market but could not sustain the gains. When the market surpasses the upper end of the wick, it means a significant shift. The buyers demonstrated persistence by attempting to reach the resistance level within one candlestick and returning with increased force to overcome it.
The inverted hammer appeared following a strongly bearish candlestick on the price chart. After a few candle intervals, additional pseudo-inverted hammer formations emerged in the market. Eventually, when the market surpassed the highest point of the candlestick week indicated by the arrow, it experienced a significant upward movement. This shows the remarkable resilience of the buyers during that period.
Bullish/Bearish Engulfing Candlestick
The engulfing candlestick fully encompasses the preceding candlestick. Some analysts distinguish between engulfing candlesticks, where the actual body contains the natural body of the prior candlestick and outside candlesticks. Forming an engulfing or outside candlestick on a higher time frame typically necessitates a tumultuous and unpredictable trading session.
The candle symbolizes a significant battle between bulls and bears with a definitive outcome. A candle closing within the final 20% range indicates considerable conviction. In a bearish engulfing candlestick, it is ideal for the closing price to be within the lower 20% of its content. Candlestick patterns can indicate an impending directional movement as momentum gathers.
Doji
The doji is a frequently observed candlestick pattern discussed in this article. A doji represents a state of indecision in the form of a candlestick. The shooting star and hammer can be seen as variations of the basic doji, indicating exhaustion. A doji is a candlestick characterized by a range that does not break in either direction.
Various dojos exist, yet they ultimately signify a common state: indecisiveness. Indecision often precedes a significant price movement; thus, it carries meaningful implications when the price breaks beyond the doji range. The graphic displays the formation of a doji candlestick, followed by a subsequent breakout in the following session, indicating an upward movement.
Marubozu
“Marubozu” is the Japanese term used to describe a candlestick pattern representing a significant price movement in financial markets. A marubozu candlestick lacks a wick at its closing point. The candle must close at either the extreme high or low, although it may exhibit some volatility in the opposite direction. The concept of a “bald man” candlestick revolves around its lack of “hair” (wick).
The significance of this candlestick lies in its indication of traders’ unwavering commitment to a particular market direction, as evidenced by their refusal to secure profits. The marubozu candle is indicated by the arrow in the price chart below. The market’s closing position at the bottom of the candlestick indicates a notable downward momentum shift. Placing a stop loss beyond the candlestick requires a significant change in market sentiment for the position to be exited.
Three Candle Reversal
The “three bar reversal” or “three candle reversal” is a simple yet remarkably impactful candlestick pattern. Essentially, it is a three-candlestick pattern reversing the prevailing price trend. The example in the price chart below represents a bearish reversal, which can be either bullish or bearish.
The market had been experiencing a sustained uptrend characterized by consecutive bullish days. The three circled candlesticks depict an initial upward movement on the first day, followed by another attempt on the second day, and ultimately a downward trend on the third day.
Upon observing the downward break of the initial candlestick, traders engage in selling activities, perceiving a shift in momentum from bullish to bearish. The stop loss is commonly placed beyond the middle candlestick to account for a potential pattern reversal indicated by a substantial change in rate upon breaking above that level.
The candlestick pattern discussed here is highly responsive to support and resistance levels. Therefore, identifying a way that aligns with a significant support or resistance level on a long-term chart enhances its effectiveness.
Conclusion
Traders can utilize various strategies to incorporate Forex candlestick patterns into their trade entries or exit on a live price chart. It is advisable to exercise patience and observe the closing position of the subsequent candlestick before making any decisions. Aggressive traders execute trades immediately when the candlestick is broken in either direction.
However, as the doji candlestick example demonstrates, this approach can lead to a whipsaw situation. By waiting for the close, the trader could have gained greater confidence in the significant increase in bullish momentum. It is essential to consider that the reliability of candlesticks or candlestick patterns in technical analysis increases with higher timeframes.
The mentioned candlestick patterns are widely recognized and can influence market behavior due to their popularity and visibility. Price movements in financial markets can never be guaranteed with absolute certainty. Therefore, it is important to maintain realistic expectations and not perceive any candlestick pattern as an infallible indicator.
Candlestick patterns provide insights into market direction and potential areas of resistance or support. One should avoid fixating on the perfection of candlesticks but instead, focus on interpreting their overall message regarding the price’s inclination towards its next movement. Reading charts involves following basic patterns and developing a sense of artistry that can only be honed through practice and experience.
