78% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.

What are forex candlestick patterns?

Forex candlestick patterns are Japanese candlestick patterns used to analyse currency price action. Traders have been using Japanese candlestick patterns to study the movement of prices for hundreds of years.

Candlestick patterns are a form of technical analysis that relies on past price action to forecast future price movements. Japanese candlestick charts are thought to date back to 18th century Japan and a rice merchant called Munehisa Homma, but they were introduced to the west by Steve Nison in his book, Japanese Candlestick Charting Techniques.

Conceptually, candlesticks measure market sentiment in the form of greed, fear and complacency. Many of the patterns describe market trends as well as reversals, and continuations in a price pattern. Japanese candlestick patterns are a popular form of technical analysis that is used by traders to analyse the foreign exchange market.

How to read forex candlestick patterns

Forex candlestick patterns are technical analysis tools that can be viewed on charts and graphs. The formation of a candlestick requires the open, high, low and close prices of a specific period. For example, a trader would need the daily, open, high, low and close price to generate a daily candlestick. This would be the same for either a weekly or monthly candlestick. For the candlestick to be successfully evaluated, you would need to wait for the closing price of a session.

Candlesticks are generally coloured, as it makes it easier to see whether the candlestick is bullish or bearish. The body of the candlestick is hollow, and the areas above and below the body are called shadows. Candlestick charts provide several different types of trading strategies. These include patterns called the doji, kicker patterns, hammer, inverted hammer, hanging man, shooting star and morning star.

The doji pattern

Doji candles provide data on their own, but can often be used as part of other patterns. Dojis generally represent indecision as they are neutral candles, as the open and close are at the same level. However, a doji with a long upper shadow is different to a doji with a long lower shadow.

The evaluation of a doji depends on the preceding candles or the trend of the market. A doji after an advance indicates that positive momentum is beginning to weaken. When there is a doji after a decline, negative momentum is slowing. While a doji does not signify a reversal, it indicates that supply and demand are becoming more evenly matched.

Types of doji patterns

There are both long-legged and short-legged doji patterns. A long-legged doji shows that there is a lot of market volatility but no clear direction for the market. The short-legged doji indicates that there is still indecision but very little volatility.

Dragonfly and graveyard doji

A dragonfly doji is where the open, high and close are all at the same level. Prices will have tested lower levels for most of the trading session but ended at the highs of the day at the close. This looks like a ’T’ and indicates that bears were active during the session but unsuccessful in pushing prices lower. This type of information is helpful when compared to the trend. A reversal following a dragonfly doji depends on previous price action and would require future confirmation.

Gravestone doji

A gravestone doji is a doji pattern where the open, low and close are at the same level. The shadow extends higher, but bulls were unable to gain traction and prices eventually closed at the low. This looks like an upside down ‘T’. Similar to other doji patterns, the gravestone doji will help determine a reversal based on prior price action. 

Reversal patterns

There are two single candlestick patterns that are specifically used as reversal patterns. These both need some form of confirmation to signify that a reversal is underway. The presence of a reversal pattern is a warning that the trader should prepare for a change in the direction of the market. These candles have small bodies and long shadows. In most instances, the long shadow will be double the length of the body of the candle. The open will be higher or lower than the close.

Star position

A candlestick that gaps away from the previous candlestick on the open is said to be a star. This feature is visible in the shooting star and morning star patterns. Stars generally have small bodies. The star tends to appear isolated from prior stars. Two star positions that are similar are the shooting star and inverted hammer. Both have small bodies, and a long upper shadow, but have different ramifications. This will depend on the prior trend. These candlesticks could be a signal of a trend reversal, but require confirmation. The shooting star occurs at the end of an uptrend and the close is lower than the open. An inverted hammer occurs as a reversal to a downtrend. Here the open is lower than the close.

Hammer and hanging man

These two patterns look similar but have different implications, like the shooting star and inverted hammer. Both have small bodies and long lower shadows and no significant upper shadow. Similar to other patterns, the hammer and hanging man require confirmation of the reversal.

The hammer reflects upward price pressure and forms following a drop in an exchange rate. The hammer marks support as well as the potential reversal of a downtrend. The reversal is capped with a robust close. This indicates that traders are willing to go home for the night with a long position.

The hanging man is considered to be a bearish signal when it comes at the top of a rally after upward price pressure. This usually marks resistance. Although bulls control price action, this indicates that selling pressure has entered the market. The confirmation comes on a gap lower on heavy volume as the next trading session begins.

Harami position

A Harami position consists of two candlesticks, where the high in the second candle is lower than the previous candle’s high and the low is higher than the previous candle’s low. Haramis can be bullish or bearish indicators, depending on the prevailing trend.

Forex candlestick pattern trading strategies

Candle body

When the open is lower than the close, the body is usually clear or green. When the open is higher than the close, the body is generally red or black. This provides more information than other charts, for example, it’s instantly visible whether the price rose or fell over the interval represented by the candle. 

A clear or green candlestick represents upward buying pressure, which caused the close to be higher than the open. A red candlestick reflects selling pressure, as the close is lower than the open. Long body candles reflect either greater buying or selling pressure. Short body candles on the other hand reflect range-bound trading and consolidation.

Long versus short shadows

Before a trader can develop a candlestick trading strategy, they would need to understand some other nuances when it comes to interpreting candlesticks. In addition to the body of the candle providing information, the upper and lower shadows on candlesticks also say something about the market. The higher shadow shows the high of the interval while the lower shadow reflects the lows of the period. Generally candlesticks with short shadows show that price action during the period being evaluated was near the open and close. Candlesticks with long shadows show that prices extended further away from the open and close during the period.

If you see a candlestick with a short lower shadow and long upper shadow, it shows that upward pressure dominated the trading session. If, on the other hand, there is a long lower shadow and short upper shadow, downward price pressures dominated the session. You can use candlesticks for both short- and long-term trading. You can generate take profit levels, as well as stop-loss orders, based on candlestick patterns. The short-term reversals that candlesticks can help to predict can provide potential opportunities for day trading using leverage. Additionally, many option traders use candlestick reversal patterns to trade the forex markets.

What risks are involved when using candlestick patterns?

There are several risks involved in using candlestick patterns. When trading the financial markets, you are constantly exposed to market risk. While trading following patterns and studies, traders should always be aware of the potential risk of algorithmic trading. This uses information at the speed of light and can alter the landscape at any time using data that might not be available to the trader.

A candlestick reflects the constant push and pull between supply and demand at any given time. Each data point on a candle tells traders what occurred during that period. If you’re trading intraday, a candlestick pattern can offer the edge by providing reversal levels.

Candlestick patterns focus on the relationship between the open and close prices. Many candlestick patterns require confirmation and therefore should be used in conjunction with other candlestick patterns or forms of technical analysis. The patterns generally describe the relationship between other periods as well as the open and close of the period represented by one candle. 

It’s important that you consider risk management prior to entering any trades. Similar to other systems of trading, you will need to have an idea of where to stop out and where to take profits before you enter a trade.

Disclaimer

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.

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Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 78% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.