Before you can get started with candlestick trading, it’s important first to have a basic understanding of what it is and why it’s useful.
Try reading: Choosing a Forex Trading Strategy
In our beginner’s guide, you’ll pick up the key points of the importance of these patterns, reading the different patterns, and how to get trading using candlesticks.
Understanding Forex Charts
To find trades that are profitable, the effective and informed use of charts are critical to your technical analysis. Charts let traders know at which point a currency pair could be profitable to buy and sell at.
Candlestick chart patterns are notorious for doing just that.
However, as with any other trading strategy, reading charts is far more complicated than just looking at numbers and bars from one line to another. Traders from any financial or investment market should ideally scrutinize a myriad of chart varieties to provide them with the edge they need. Relying on a single typical line graph could prove costly if there are other market factors where that chart failed to indicate to you.
When it comes to the popular candlestick pattern however, many traders do tend to rely solely on this credible pattern as it is considered as an extremely reliable trading indicator. While this type of chart looks far more complicated than a traditional line graph, they are relatively simple to learn with patience, diligence, and practice.
Candlestick Trading Benefits
The candlestick is one of the visually associated elements of forex trading, but it isn’t just because it is pretty.
Correctly using candlestick patterns in your forex trading can prove to be highly beneficial for your performance as an FX trader.
On most other forex charts; there is just one point of data presented at a particular moment in time. When you are looking for an informed trading decision, that is not ideal.
When using a candlestick, you’re able take into consideration five factors:
- closing point or price
- direction of market movement
- high point or price
- low point or price
- opening point or price
Due to these five factors, a candlestick trading pattern can provide you with a significant advantage when looking to execute a trade order. The expansiveness of this type of indicator is why many experienced traders recommend using candlesticks as part of your technical analysis. It can provide an incredibly reliable layer of indication when calculating your decisions for trading.
Candlestick trading also has a credible history dating way back to the 17th century, where the Japanese invented this technique for the trading of rice!
How to read a Candlestick Pattern
Reading a candlestick trading chart is just as simple to read as a line graph. Don’t be overwhelmed by the sheer shape.
The basic components:
- The body: this is the hollow or filled area.
- The shadows: these are the lines above and below, also known as “shadows”.
Reading the body of a candlestick pattern:
- Filled body: indicates bearish movement where the price moves down. The close price is at the bottom of the body and the open price at the top of the body.
- Hollow body: this means there has been bullish movement where the price moves up. The bottom of the body being the open price and the top of the body being the close price.
Hollow candlesticks are simply telling you that there is pressure to buy this trade, hence the movement up in price. Whereas filled candlesticks are showing us pressure to sell and a decline in price because of this.
The length of the body also instructs us of the intensity of the buying/selling pressure. The bigger the length, the more volatile and aggressive the pressure is.
Analyzing the shadows:
- Upper shadow: represents the trading session high
- Lower shadow: represents the trading session low
- Short shadows: most the trading activity occurred close to the open and close
- Long shadows: prices stretched beyond the open and close
A long upper shadow combined with a short lower shadow indicates of an aggressive buying session, but with a weak close where selling dominated.
A long lower shadow combined with a short upper shadow indicates that sellers were most aggressive in the session, but buyers forced the price higher towards the end.
Main Types of Candlestick Patterns
This is considered to be one of the most significant of all the candlestick patterns. When prices open and close at the same price, a Doji occurs. A Doji has a thin body and is one of the easiest candles to identify. This type of pattern indicates indecision and the possibility of a change of market trend, but the candle movement that occurred before a Doji must be considered when making such judgement.
When a prolonged downtrend occurs, this bullish pattern is said to be the most significant. The reason for this is because the trade is experiencing a sharp sell-off. Engulfing can be identified when a small body with short shadows is followed by a large body, engulfing the smaller previous candle. There are two types of engulfing: Bullish and Bearish. Bullish Engulfing indicates the buyers have taken over the price movement, whereas Bearish Engulfing indicates the sellers have gained control.
This type of pattern is commonly found in downtrends. The Hammer candlestick is considered a potential reversal signal. It consists of a small body positioned at the top of a long shadow – whereby the shadow must be at least twice the size of the shadow. The long lower shadow indicates strong bullish activity towards the end of that range.
This appears exactly like the Hammer, but instead, it is a bearish indicator of potential reversal found in an uptrend. Following a prolonged uptrend, the formation typically takes place following price movements in the lower ranges after opening.
The Harami indicates trend reversal. It is identifiable when you see two candles, the first candle always engulfing the second, whether it be a Bullish or Bearish Harami pattern. It is important to know that this is different to the engulfing pattern as it occurs over 2 days; the larger candle on day 1 and the smaller eclipsed candle on day 2.
Dark Cloud Cover
This is identified where the black filled body follows a long hollow candle over 2 days. The bearish candle must simply close below the mid-point of the previous day’s candle. Dark Cloud Cover can be used to signal a potential and upcoming bearish market trend.
This is a pattern with a long upper and lower shadow and a small body. This type of pattern indicates minimal movement in price, with equal activity on the buying and selling side. A Spinning Top can indicate a change in the general market price direction.
Other popular candle patterns include:
- Piercing – a 2 day reversal at the bottom of a downtrend
- Morning Star – a 3 day signal that predicts an increase in market price
- Evening Star – the opposite of the Morning Star
- Shooting Star – a bullish signal at the end of an uptrend
Trading with Candlestick Charts
The growing popularity and reputation of candlestick trading has persuaded for many traders to study and analyze these charts more intensely.
To trade successfully using a candlestick chart you have be willing to take the time to understand the formation of how it’s patterns are formed, and what each pattern could signal. It is best advised to undertake this learning process on a demo account initially, but you will only see how well your trading skills work once you take it to a real, live trading account.
Once you confident in your ability to read and trade using candlesticks, you can also integrate this knowledge alongside other indicators and forex signals to enhance your overall trading plan. For example: you could be using a combination of Bollinger Bands and Moving Averages in addition to the analysis of candlesticks to give you an even more reliable technical analysis.
The Bottom Line
For those who are just starting out in forex trading, the use of candlestick charts is a recommended tool to learn.
The great thing about the information provided with candlestick trading is that you get an informed price and trend movement all in one chart – no other chart quite compares. Every trader should consider candlesticks to be added to their trading arsenal.
Just remember, it’s critical to check and recheck figures and charts for accuracy, or try to incorporate a combination of signals and patterns to validate your trades.