Learn Forex Trading Lesson 12 – Candlestick Patterns

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In lesson 11 we introduced the various types of candlestick that are formed on a trading chart through specific movements in currency prices. We will now look at the patterns that single and multiple candlesticks indicate in the course of trading. Initially, though, there are a few general principles to convey.

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Candlestick Formations

The 6 Games

The analogy of a football match between two team, the Bulls (buyers) and the Bears (sellers), is a good way to visualise a candlestick.  The candlestick represents the battle between the two teams over a given period of time. A goal for the Bears is represented by the bottom (intra-session low) of the candlestick, whereas a goal for the Bulls is represented by the top (intra-session high) of the candlestick. The closer the close is to the high, the closer the Bulls are to scoring a goal. The closer the close is to the low, the closer the Bears are to scoring a goal. Although there are many variations, we focus in on six types of game (candlestick):

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1   Long white candlesticks imply that the ball (trading) was controlled by the Bulls for most of the game.
2   Long black candlesticks imply that the ball (trading) was controlled by the Bears for most of the game.
3   Small candlesticks indicate that neither team could move the ball and prices finished about
where they started.
4   A long lower shadow indicates that the Bears controlled the ball for part of the game, but lost
control by the end and the Bulls made an impressive comeback.
5   A long upper shadow indicates that the Bulls controlled the ball for part of the game, but lost
control by the end and the Bears made an impressive comeback.
6   A long upper and lower shadow indicates that the both the Bears and the Bulls had their
moments during the game, but neither could put the other away, resulting in a standoff.

 

But… candlesticks do not show what happened between the open and close of trading, only the relationship between the open and the close. Somewhere during trading the high and low was measured, but what the candlestick (and bar chart) cannot divulge is which happened first.

Forex Candlesticks

Which came first?

The first assumption with a long white candlestick is that prices advanced most of the session. However, based on the high/low sequence, the session could have been more volatile. The example above depicts two possible high/low sequences that would form the same candlestick. The first sequence shows two small moves and one large move: a small decline off the open to form the low, a sharp advance to form the high, and a small decline to form the close. The second sequence shows three rather sharp moves: a sharp advance off the open to form the high, a sharp decline to form the low, and a sharp advance to form the close. The first sequence portrays strong, sustained buying pressure, and would be considered more bullish. The second sequence reflects more volatility and some selling pressure. These are just two examples, and there are hundreds of potential combinations that could result in the same candlestick. Candlesticks still offer valuable information on the relative positions of the open, high, low and close. However, the trading activity that forms a particular candlestick can vary.

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Forex Star Position Candlestick

Star Position Candlestick

Now let’s look at some candlestick patterns starting with candlestick positioning.

A candlestick in star position is one that gaps away from the previous candlestick. In general, the first candlestick has a large real body, and the second candlestick in star position has a small real body. The star position candlestick looks isolated from the previous price action and gaps up or down depending on the nature of the previous candlestick. The two candlesticks can be any combination of white and black. You will typically see candlesticks with small real bodies form in the star position, including Doji, Hammers, Shooting Stars and Spinning Tops.

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Forex Harami Candlestick Formation

Harami Candlestick Formation

A candlestick in Harami position is one that forms within the real body of the previous candlestick. Harami, derives from the Japanese word meaning ‘pregnant’. Therefore just as a baby nestles inside its mother, the second candlestick is nestled inside the first. The first candlestick usually has a large real body and the second a smaller real body than the first. The shadows (high/low) of the second candlestick do not have to be contained within the first, though it’s preferable if they are. Doji and spinning tops have small real bodies, and can form in the Harami position as well. Later we will examine candlestick patterns that utilize the Harami position.

Let’s move on to long shadow reversals, specifically the two pairs of single candlestick reversal pattern (1) Hammer and Hanging Man; (2) Inverted Hammer and Shooting Star.

Initially what is a long shadow reversal? A long shadow reversal is a pair of candlesticks consisting of a small real body, one long and one short (or almost invisible) shadow. As a rule of thumb, expect the long shadow to be at least double the length of the real body.

Forex Reversal Candlesticks

Hammer Hanging Man

The Hammer and Hanging Man look exactly alike, but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower shadows and short or non-existent upper shadows. As with most single and double candlestick formations, the Hammer and Hanging Man require confirmation before action.

The Hammer is a bullish reversal pattern that forms after a decline. In addition to a potential trend reversal, hammers can mark bottoms or support levels. After a decline, hammers signal a bullish revival. The low of the long lower shadow implies that sellers drove prices lower during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. While this may seem enough to act on, hammers require further bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume , is needed before acting. Such confirmation could come from a gap up or long white candlestick. Hammers are similar to selling climaxes, and heavy volume can serve to reinforce the validity of the reversal.

The Hanging Man is a bearish reversal pattern that can also mark a top or resistance level. Forming after an advance, a Hanging Man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of selling pressure raises the yellow flag. As with the Hammer, a Hanging Man requires bearish confirmation before action. Such confirmation can come as a gap down or long black candlestick on heavy volume.

Forex Reversal Candlesticks

Inverted Hammer & Shooting star

The Inverted Hammer and Shooting Star look exactly alike, but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or nonexistent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action.

The Shooting Star is a bearish reversal pattern that forms after an advance and in the star position, hence its name. A Shooting Star can mark a potential trend reversal or resistance level. The candlestick forms when prices gap higher on the open, advance during the session and close well off their highs. The resulting candlestick has a long upper shadow and small black or white body. After a large advance (the upper shadow), the ability of the bears to force prices down raises the yellow flag. To indicate a substantial reversal, the upper shadow should relatively long and at least 2 times the length of the body. Bearish confirmation is required after the Shooting Star and can take the form of a gap down or long black candlestick on heavy volume.

The Inverted Hammer looks exactly like a Shooting Star, but forms after a decline or downtrend. Inverted Hammers represent a potential trend reversal or support levels. After a decline, the long upper shadow indicates buying pressure during the session. However, the bulls were not able to sustain this buying pressure and prices closed well off of their highs to create the long upper shadow. Because of this failure, bullish confirmation is required before action. An Inverted Hammer followed by a gap up or long white candlestick with heavy volume could act as bullish confirmation.

There are more patterns that can be considered, but we have introduced some of the main ones that you will encounter in your trading exploits.

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