To understand a book, you need to be able to read the words. To understand sheet music, you need to be able to read the notes. To understand price behavior, you need to be able to read and interpret the charts. So, let’s get to one of the cornerstones of Technical Analysis, which is understanding candle charts and patterns.
Charts come in different styles, but we will focus on Japanese candlestick or candle charts, which have become by far the most popular because they provide the quickest visual grasp of price action and the market sentiment behind it. Much has been written about the advantages of candle charts and why they’ve become the dominant charting style since they were ﬁrst introduced to the West by analyst Steve Nison in 1989, and popularized in his seminal book, Japanese Candlestick Charting Techniques, nearly a decade later. However, we’ll stick to an overview of what you need to know to make money in forex trading.
First, study the parts of each candlestick, shown in Figure below.
The length of the bodies and the wicks, in absolute terms and relative to each other, can tell us a great deal about market sentiment over the duration of a given candle. That can be signiﬁcant for candles covering longer periods like an entire day, week, or month. As with any technical indicator, candles and their patterns over shorter durations are less meaningful because price movements within a given day or less often can be caused by random money ﬂows unrelated to any real market sentiment.
Here’s the key to understanding the relationship between wick (or shadow) and body length and the meaning of an individual candle:
A relatively long lower wick suggests initial strong pessimism and selling which reversed as buying increased at the lower bargain price, and short-sellers took proﬁts. In other words, a lower price level was tested and held ﬁrm, turning back attempts to drive the price lower.
A short lower shadow suggests less indecision, less testing of lower prices, and lighter selling pressure that required few buyers to reverse it. If the currency pair closes at its low for the period covered, the candle won’t have a lower wick.
A relatively long upper wick suggests initial optimism or buying pressure that reversed as sellers stepped in and buyers took proﬁts. In other words, a higher price level was tested and held ﬁrm, turning back attempts to drive price higher.
A short upper wick shows less indecision, less testing of higher prices, less struggle between buyers and sellers. If the closing price is the high for the period covered, the candle won’t have an upper wick.
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Source: Forex Trading MasterClass
Japanese candle charts mostly indicate reversal or indecision (i.e., possible reversal), whereas Western charting patterns tend to indicate continuation (trend pausing before resuming) or reversal. Candle patterns are a vast topic. Our goal here is to introduce you to the most important among them.
Note that the table classifies candles and patterns as bullish, bearish, or neutral. The adjective “bullish” refers to candles that show price rising or patterns that suggest the price will rise because a bull gores its adversary in an upward motion. “Bearish” is used to refer to candles that show price falling or patterns that suggest the price will drop because a bear swipes at its adversary in a downward motion.
Depends on whether higher or lower close. Significance increases if occurs after an extended move in the opposite direction of the close.
In this example, the most recent candle showed a black, lower close. If these spinning tops occurred at the top of an extended uptrend, it would suggest a coming reversal. If they occurred at the bottom of a downtrend, they’d merely suggest continued downtrend, already the default assumption in an ongoing downtrend.
Neutral: The more wick relative to the body, the more indecision because buyers and sellers are more evenly matched. The lack of a body means that the doji pattern suggest indecision and possible end or reversal of a trend. Thus they’re more meaningful when finding after a long move up or down because they suggest the move may end and perhaps reverse.
Conversely, the more body relative to wick, the more decisive the move and the clearer the dominance of buyers or sellers. White suggests buyers dominant, so usually suggests more upside. The black version suggests the opposite.
Hammer and Hanging Man have the same shape: Long lower wick, little or no upper wick two to three times the length of the body.
Opposite meaning depending on the following:
a. Occurs after extended move lower = Hammer, bullish, suggests market probing and hitting a bottom.
b. Occurs after extended move higher = Hanging Man, bearish, suggests market hitting a top.
In either case, higher or lower close unimportant.
Inverted Hammer and Shooting Star share the same shape and are the inverted forms of the Hammer and Hanging Man shown above. It has a long upper wick, little or no lower wick two to three times the length of the body. As usual, needs to occur after a move higher or lower, needs the start of reversal to confirm the pattern.
Opposite meaning depending on the following:
a. Occurs after extended move lower = Inverted Hammer, bullish, suggests markets hitting bottom, confirmed by a bounce higher
b. Occurs after extended move higher = Shooting Star, bearish, suggests markets hitting a top, confirmed by bounce lower.
In either case, higher or lower close unimportant though if it’s in the opposite direction of the prior candles, it’s a bit more suggestive of a halt or reversal of prior candles’ trend.
Bullish Engulfing occurs when a bearish candle (lower close) is followed by a noticeably longer bullish candle (higher close), which “engulfs” the range of the prior bearish candle. The longer the bullish candle, the more it “engulfs” or exceeds the range of the prior bearish candle, the more bullish the pattern. Obviously, as always, context and timing matter. The pattern is more bullish if this pair appears after an extended downtrend, at strong support, or both, because these other signs confirm that the odds are higher that the downtrend is exhausted.
Bearish Engulfing occurs when a bullish candle (higher close) is followed by a noticeably longer bearish candle (lower close), which “engulfs” the range of the prior bullish candle The longer the bearish candle, the more it “engulfs” or exceeds the range of the prior bullish candle, the more bearish the pattern. Obviously, as always, context and timing matter. The pattern is more bearish if this pair appears after an extended uptrend, at strong resistance, or both, because the odds are higher that the uptrend has become exhausted.
Looks like a pair of tweezers at the top of an uptrend. Ideally:
Think of these wicks as knocking against a ceiling of resistance, or the market rejecting a certain higher price as it probes for a top.
The opposite of the above. Looks like a pair of tweezers at the bottom of a downtrend. Ideally:
Think of these wicks as knocking against a floor or support, or the market rejecting a certain lower price, as it gropes for a bottom.
Evening Star and Morning Star are the bearish and bullish variations on the same theme:
This pattern is comprised of three long-bodied bullish (higher close) candles after a downtrend and signals a longer-term reversal higher.
To be a valid pattern:
The opposite of the above Three White Soldiers. This pattern is comprised of three long-bodied bearish (lower close) candles after an uptrend and signals a longer-term reversal lower.
To be a valid pattern:
Found during a downtrend and signals its possible end. Characterized by:
The opposite of Three Inside Up. Found during an uptrend and signals its possible end. Characterized by:
In sum, it’s a very basic bearish swing pattern. The longer the second and third candle, the more convincing the reversal signal.
Though the patterns are classified as a reversal (indicate a reversal of the trend’s direction), continuation (indicate trend continuation), or indecision, depending on which is their more common role, these are generalizations. Like any technical indicator, they don’t always work and should be used in combination with others that confirm or refute them.
The evidence from Technical Analysis is useful for timing entries and exits but is rarely unequivocal. It’s up to you to weigh contradictory or inconclusive forex signals from the total of your Technical Analysis and fundamental analysis and discern where the balance of evidence points. Your interpretation of these candlestick patterns and any other indicator depends on the context in which it occurs in the forex market and stock market.
As with everything, context and timing make a difference when interpreting Japanese candle patterns: A bullish reversal pattern (like a hammer or bullish engulfing pattern) is more suggestive of a bullish reversal pattern if it comes after an extended downtrend than it is after a brief one, especially if that brief one comes within a longer-term uptrend.
That same bullish reversal pattern will have more credibility if it happens to occur at a strong support level where we’d expect a downtrend to be more likely to reverse.
If the picture isn’t clear enough, look for another opportunity. Remember, some of the best trades you’ll ever make are the ones you decide not to take. Missed opportunities only hurt your ego; bad trades hurt your capital. Remember this if you want to learn how to trade forex and make money from it.
Combine candlestick patterns with western chart patterns (triangles, head and shoulders, double top and bottoms, cup and handle) and the most powerful forex indicators (Bollinger bands, moving averages, MACD, RSI, Ichimoku, and many others)
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