Are you struggling to use candlestick patterns in an effective way? Although candlestick are very popular at the moment, not everyone is able to use them to the max.
This article explains how candlestick patterns can become an useful and powerful trading tool. They can be used as a stand alone indicator or in combination with other trading tools and indicators.
It also emphasizes practical applications of candlesticks, assuming that reader is familiar with basic patterns. For the basics, check out our basic guide.
Reading the Story
Candlesticks tell us a story about price in general whereas the candlestick patterns inform us of something specific, a warning perhaps. Each candlestick reveals information about the development of the story but it’s the patterns that make us traders alert for potential trading opportunities.
The story unfolds on multiple time frames, too. In trading it’s always good to make multiple time frame analysis to gain an understanding of the entire story, not only one chapter. For example, if a candlestick pattern appears on higher time frames, then it can a benefit to enter the market in lower time frames. That way we can improve our risk-reward ratio and we can get further confirmation or cancellation of trade.
Lets provide an example. Below is example how candlesticks tell us a story of what happened and what may happen.
Here is one way to read this chart with candlesticks. Let’s start with the left side of the chart:
- The uptrend begins with a Hammer, which is then followed by a Dragonfly doji indicating a signal of indecision. This indecision indeed caused a period of price consolidation (sideways movement). So supply and demand are at the moment roughly in balance.
- Also notice how doji high and low became resistance and support. Price went above and below resistance line (blue) and support line (red) but it did not manage to close beyond support and resistance lines (zone 1) in two occasions. Candles which did close just beyond support have large wick which indicated rejection. Side trading continued.
- Just before price start to fall there is candle which wick is above other wicks. It could be variation of shooting star, but there is sideway trading instead up trend before the candle appears. Technically Shooting stars should appear after an uptrend so one can argue that this isn’t a real shooting star. That said, the candle certainly looks like a shooting star (so it have our attention), and it clearly show rejection from higher levels where weren’t any trading for a while, at least 12 candles.
- Next candle is bearish. That is further clue that trend may change. Than second strong bearish candle breaks the Doji support level (Doji low, red line zone 1) and price starts to fall.
Let’s continue with the middle left side of the chart:
- The downtrend pulled away from the 21 ema… but eventually price made a retracement back to the 21 ema zone, which is now a resistance are. This is where shooting star 1 appears. The combination of a bullish candle (white), shooting star and bearish candle (black) form the Evening star pattern. Technically there should be gap between white candle and shooting star. But because of high liquidity in Forex market that kind of gap is very rare.
- The downtrend continues until a Hammer pattern appears that breaks the previous 2 bottoms. The Hammer low can act as support, which indeed held in this case.
- The strong long bullish candle 1 engulfs several candles before it. For engulfing patterns, only the candle body matters. The body must engulf the body of the candle before it. If wicks are not engulfed, engulfing pattern is still valid. Now it could be a good moment, for instance, to look on lower time frame to see what is happening there. There were actually early SWAT signals (see image below) followed by another signal which is not marked.
- Price moved up quickly from there until Shooting star 2 printed. It’s low was broken by a strong bearish candle (that is Marubozu, no lower wick, strong close). But immediately after that there is an Inverted hammer and it looks like bears are starting to losing control. The bull candle after the morning star completes a Morning star pattern. The small downtrend before the Morning star is finished and price is back into an uptrend. (On lower time frame there is no real SWAT signal, so we should not take short trade on red candle which printed on 4 hour time frame and created Shooting star on Daily time frame. That SWAT signal wasn’t valid taking in to account all rules.)
Let’s continue with the middle of the chart (see below):
- Another evening star printed right at Shooting star 2 resistance level. Caution is needed here, because an uptrend is visible at that moment and an Evening star pattern signals possible trend change or pull back. The Evening star was invalidated by a long white candle 2. After that you can see variation of shooting star (not marked) which had a high that was immediately broken… But the low held due to short term support after the pull back.
(At Shooting star 2 there is no real SWAT signal for short trade but it is correct long signal on blue candle (picture 2, signal 3 and 4). So we could enter long early, before daily candle is closed based in 4 hour SWAT signal as we can assume Evening star is just pullback in uptrend).
- In Zone 2, two Doji’s were printed. Two hammers were printed and price went in to side way. A strong black candle pushed through their lows (short term support) and suggested that the uptrend may be over. The bearish candle at the end of the sideway trading broke the low of both hammers. Then short term support were created by inverted hammer which were broken by strong bear candle. The bearish trend made it down to zone 3.
Candlesticks and wave analysis
Is possible to use candlesticks together with wave analysis or any other analysis?
ECS is proud to focus on useful chart analysis. Here is example of GBP/AUD longer term analysis. Below is daily graph of same area (highlighted with rectangle).
In the above image an evening star appears at the end of potential wave 2. This could be first confirmation of wave analysis. Then there are two engulfing twin candlestick patterns.
We can wait for SWAT signals to open trades on lower time frames, which offers more confirmation of our analysis and good reasons to take the trade. Once price breaks below the support line (red), we can see that price went south as expected in the analysis.
Candlesticks are one of the most popular tools with traders. It’s simple information tells us a story about price… A story which is a never ending fight between bears and bulls.
If we read what candles are telling us on higher time frames, we can trade confidently following signals on lower time frames. Combination of candlesticks can give us clues about the path of least resistance. In combination with other tools we increase the probability of successful trading.
Trading is a game of probability so it’s wise to use all information available. Try ecs.LIVE, SWAT or CAMMACD to improve your odds of success.
Read part 1 “learn how Japanese candlestick patterns reveals valuable insight“.
Read part 3 “master guide on candlestick patterns”.
Wish you good trading.
Dusan Vrbovsek and ECS team