The development of the school of charting called Candlestick analysis is initially credited to a 17th century Japanese rice trader named Homma form the town of Sakata.
Over time, Candlesticks have evolved to become one of the predominant methods of technical analysis used universally across markets and cultures.
Candlesticks can be used not only to determine the market’s direction, but its turning points as well. They also work nicely in conjunction with support and resistance levels as outlined in part 1 of this series.
Candlestick analysis is a broad topic, and can be studied in-depth. Today, we keep it simple by looking at two powerful yet easy to use methods, for trading trends and reversals.
But first let’s cover some basics.
A candlestick consists of four data points over any given time period: the high, low, open and close. The thin part (the wick) represents the high and low. The fat part (the body) represents the open and close.
If the body of the candle is dark (or red in the below example), it means the price closed below the open (a bearish candle). If it is hollow (or green in the below example), it means the price closed above the open (a bullish candle).
You can see here a candlestick chart of the AUDUSD
Strategy #1 Candlestick Reversals Patterns
There are several reversal patterns you can use in your trading, the first of which is Pin Candles.
Pin Candles have a large wick and a short body, and are excellent for identifying turning points. A Pin candle is also known as a "hammer" (bullish) and a "shooting star" (bearish).
The reason pin candles are of significance is due to market psychology. The pin candle represents an attempt by participants to reach a new high or low, but the market quickly rejects the attempts. This indicates the buyers are coming back into the market in force for a bullish pin candle, or the sellers are regaining control for a bearish pin candle.
You want to look for these candles to occur against an existing trend and not within it.
Here is an example of a pin candle reversal on a 4 hour chart of the EURUSD
For a high probability trade, look for the pin candle to occur at a key support and resistance level.
Another reversal pattern is a Doji in combination with a long bodied candle.
A doji is a compressed looking candlestick with a small body and small wicks. It signifies an intense struggle between buyers and sellers, in which neither side gains any real ground.
As you can see below, the open is barely any different to the close. Same goes for the high and low. Over the course of an hour, for instance, the price may have moved only 10 pips.
In an uptrend, this can mean the buyers have run out of momentum. In a downtrend, this can mean the sellers have exhausted themselves. It is a sign of equilibrium, and equilibrium is a sign of a changing power dynamic.
Therefore, look for a doji after a long bullish or bearish candle to signal the trend may be coming to an end.
Once you see a doji, it’s best to wait for an entry signal in the form of a bullish or bearish candle against the trend.
Another very useful reversal pattern is "three white soldiers" (bullish) or "three black crows" (bearish). Look for three candles to form against the trend:
Here is an excellent example of this pattern occurring on this AUDUSD chart.
Strategy #2 Engulfing candles in a trend
An engulfing candle is when a larger candle "engulfs" the previous smaller candle. While they occur often at support and resistance levels, they are commonly found in trends.
A bullish engulfing candle signals an uptrend is about to continue, whereas a bearish engulfing candle indicates a downtrend is likely to resume.
The trick to this approach is waiting for the price to be in a trend first.
Here is an example on the 15 minute chart of the USDJPY.
Engulfing candles work well on both short and long-term charts.
Here is an example on the weekly chart of the USDCAD.
You can also look for Pin candles to signal a resumption of the trend. Look at the pin candle below. The buyers took the price right up to the high, and yet it fell to the close, which is halfway to the low.
In simple terms, the buyers tried unsuccessfully to push the price up to a new high, but were defeated. They found it impossible to break the trend. Given this knowledge, where would your loyalties lie?
In Forex, unlike in stocks, you do not have access to volume in the traditional sense. Forex is not traded on an exchange like stocks are, and therefore there is no central place for recording volume.
Instead, Forex traders use "tick volume", which represents the number of price changes per trading period rather than the total volume of trades. These volumes can be very telling.
If the price has changed few times, and even this is enough to move a candlestick significantly in one direction, then there was little confidence in the trend, and little resistance to change. More traders may be about to jump on board and move the price even further. (Be wary of volatile price action, especially in illiquid pairs.)
If 2000 price changes have produced nothing but a doji, opinions are clearly divided and price may trend sideways for some time to come.
Alternatively, dojis can precede an imminent breakout: the rationale here being that fierce competition will lead to an avalanche if one side pulls out of the war completely. When this happens, look for an engulfing candle to confirm, and then place a trade in the direction of the new trend.
As you can see, it can be immensely useful to add a tick volume indicator to your chart. When you see a candlestick pattern with above average tick volume, then it can lead to a higher probability trade if you are able to interpret its meaning.
Keep it simple
It can be easy to overcomplicate your technical analysis methods. It’s not rocket science, and there’s no need to treat it as such. We’re simply trying to become attuned to the market. Every candle tells a story, and once you can contextualise these stories, your trading will be a lot more intuitive.
Candlesticks provide some simple ways to get in on a trend, or to trade a reversal. Not a whole lot more, but certainly nothing less. Get out your trading plan now and have a think about how candlestick techniques can work for you.