History of candles
Japanese traders were analysing the price of rice to predict trends and get profit in the 18th century. They noticed that a traditional representation of the rate chart with a single line does not show the full range of information coming from daily forex trading.
As a result, analysts invented a candlestick - a visual view that shows four key parameters of a daily price:
How does a candlestick looks like and what does it tell a trader
The image below shows an example of a bullish candlestick when a close rate is higher than an open rate. A bar, connecting open and close prices, is called body, while lines between open and high price and between close and low price are called shadows. Forex candlestick analysis is applicable for any given period such as a day, week, or 1 hour.
Candlesticks chart are graphical representations of price movements for a given period of time. They are commonly formed by the opening, high, low, and closing prices of a financial instrument.
A bearish candlestick looks like this:
The main advantage of a candlestick view, compared to other ways of representing the chart, is that it indicates not only open and close rates but also shows the price action throughout the period. Traders may easily understand what happened during a day by the first sight on the forex candle. For instance, if the upper shadow is much longer than the body, then the price was soaring throughout the day but reversed and went back down at the end of the trading period. Such a candlestick tells that sellers (bears) fought with buyers (bulls) at a certain price level during the day, taking the market under control for some time.
What are Candlestick Patterns
Most of the candlesticks chart have certain features, allowing traders to predict the market trend. Traders noticed several forex candle formations, which are common for reversal pattern or continuation market conditions. Those formations may provide clues on what happened recently and what to expect in the near future. Best Forex trading candlestick patterns include:
Single Candlestick Patterns
- A Doji morning Star is formed when the open and close prices are equal, or the body is extremely low, while both shadows are much longer. This formation happens in a period of uncertainty when buyers and sellers cannot determine the general trend direction, and prices are hovering around the same level without going anywhere. Doji Stars might signal a trend reversal pattern if they occur after long-term one-way action.
- Hammer candlestick pattern occurs when the body is small and the lower shadow is at least two times longer than the body, while the upper shadow is completely absent. The body can be whether green or red, while the main application for hammers is used after a long-term downtrend as the formation signals that the bearish momentum is exhausted, and buyers are coming back to dominate.
- Hanging man candle is another version of the hammer pattern but it happens after an uptrend. The body has to be at least two times smaller than the lower shadow, while there's little to no lower shadow.
- There are also different modifications of single candlesticks chart mentioned above. For example, an inverted hammer, dragonfly doji, shooting star, etc. The common idea is that those formations might signal possible reversal forex trading patterns and speculators should get ready to close current positions or even consider an opposite position.
Multiple Candlestick Patterns
- Bullish or Bearish Engulfing. If the next candle’s open price is lower than the previous candles close price and the close covers the latest high, then a bullish engulfing is formed. That traditionally points to an end of the downtrend and possible start of an uptrend. Bearish engulfing is the mirrored formation, signalling a possible end of the uptrend and the start of a new downtrend.
- Harami cross is a reversal sign and it consists of a candlestick with a large body and a small doji placed between open and close prices.
- Three bullish or bearish crows. After a strong bearish action, three large bullish candles appear, charting higher highs. This is a bullish reversal signal based on multiple-bars candlestick strategy. Three bearish crows signal a contrary action.
How to read candlestick patterns forex
Most of the beginners start learning how to read charts with forex trading candle patterns as the market always shows its intentions by representing common formations on the chart. However, most of the candlestick patterns have to be used in accordance with other types of technical instruments. For example, a doji morning star appearing in the middle of a sideways consolidation range does not reverse anything. It just underlines the current market uncertainty. In contrast, if a doji morning star was charted after a strong upside action, then the likelihood of a bearish reversal pattern is getting higher. Technical gurus have also developed a special candlestick pattern indicator, helping traders to recognize reversal and continuation formations.
If you like this strategy, you might also be interested in this Renko Strategy
How to trade forex with candlestick patterns
Below are several examples of profitable forex trading:
- Entry on Bearish Engulfing
- Doji Star reversal pattern
- Three Bullish Crows
Limitations of using candlestick patterns in forex trading
Traders should remember that like any other strategy based on the graphical analysis, forex candlestick patterns have to have confirmations and additional filterings. One of the best ways to implement the Japanese strategy is to add a couple of technical indicators to the chart.
Sometimes, candlestick patterns do not show a perfect stop-loss or take-profit orders’ value, while other technical tools might be useful in determining those pivot points. However, money and risk management principles have to be executed and the profit/loss ratio must be kept at an acceptable level. Testing strategies on demo accounts is a useful option for beginners.
Forex candlestick patterns proved their efficiency in speculations for centuries as they bring much more information to a trader than traditional western types of price chart views. Reading market charts is getting easier, especially for beginners, when they use candlestick formations to analyse the market conditions. However, additional technical tools have to confirm the trading signal.