User menu

Sign up Login
3 tháng 12, 2021

Candlestick analysis: time tested profit

Candlestick analysis: time tested profit

When High-Frequency (HFT) trading conquers an increasing segment of stock transactions, it may seem that there is no longer a place for humans and standard strategies in the market. This is not the case - even the most advanced mathematical algorithms cannot do without time-tested techniques such as candlestick analysis of the Forex market.

The method of analyzing price dynamics using "candles" was developed by the Japanese rice merchant Munehisa Homma in 1755 and has not undergone significant changes and additions for 2.6 centuries. He also described the main combinations of Japanese candlesticks, which can be used to determine when the market will reverse or continue the current movement.

In terms of the technical analysis, candlesticks confirm two basic principles:

  • The price (in our case, the candlestick) includes all the factors influencing its formation, so no additional analysis is required (one of the principles of the Dow theory)
  • History repeats itself and with the help of graphical patterns, it is possible to predict the actions of the bulk of stock market players (Elder's Chaos theory, Elliott wave model).

The scope of the article does not allow us to describe in detail all the models of graphical analysis, we will focus only on the simplest and at the same time strong combinations of Japanese candlesticks , which can be immediately used in trading even for newbie’s traders.

Combinations of Japanese candlesticks

Table of contents:

  1. Reversal candlestick patterns
  2. Trend Continuation Candlestick Patterns
  3. Reversal "Doji"
  4. Recommendations about using candlestick analysis

Reversal candlestick patterns

The main task of graphical analysis is to enter the market at a price reversal, which is much more important; to close current positions as close as possible to the end of the current trend, therefore, a reversal candle requires special attention.

The phrase "reversal pattern (candlestick)" is not entirely accurate. It seems that the direction changes instantly, but this behavior is rare. A reversal, primarily a change in the mood of the market crowd, for example, to rise after a fall. It happens gradually, and on the chart, it can be seen as a period of consolidation in a narrow range. 

Therefore, it is better to consider such candles only for the first signal of a trend change and open opposite deals only when the new trend receives final confirmation.

«Hummer» and «Hanged»

Patterns can be either bullish (buy) or bearish (sell), depending on the current market trend - a top for an upward movement or a bottom for a downward movement. There is no contradiction here; there are also similar “mirror” patterns such as “Triple Top/Bottom” in technical analysis.

Example: patterns on the EUR/GBP (Euro/Pound) currency pair. Cross pairs are very volatile and reversal patterns usually work correctly. A small upper shadow is allowed with the condition that its length is no more than 2-3% of the lower. We open a deal at the end of the next candle.

Reversal pattern "Hummer" and "Hanged"

The lower shadow of the candlestick should be twice as large as the body, the upper shadow should be short or without it at all. The white “Hammer” more strongly indicates an uptrend, and the black “Hanged Man”, respectively, indicates a downtrend.

When “Hanged” appears, we always wait for an additional bearish signal, as it means that the price could not go above the local maximum, but the potential of buyers is still high. Therefore, a candlestick cannot be the final signal of a top reversal.

«Engulfing», «Cloud Cover» and «Piecing Pattern»

The above patterns were single price bars, but most of the charting signals are a combination of price candles such as «Engulfing»:

  • There is a strong uptrend or downtrend;
  • Body of the second candle is larger than the first and it’s “engulfing” (without shadows);
  • The second candlestick of the opposite color. An exception can only be for very small first bodies similar to "Doji".

In the process of a comprehensive analysis, one should take into account the factors that increase the likelihood of a trend change after the formation of an «Engulfing»:

  • A big difference between the bodies of the first and second candlesticks, this confirms the end of the trend;
  • The reliability of the reversal candlestick increases on long-term or very fast trends. If the trend lasts for a long time, then large players calmly increase pending opposite trades and reverse the price. In the case of sharp movements, as in fundamental events, quick profit-taking begins and an engulfing candle appears.
  • Several bodies are «Engulfing».

Example: currency pair USD/JPY (Dollar/Yen). Forex is active throughout the trading day, but candle patterns work more during the Asian session when Japanese traders enter the market. Trade all “Engulfing” as a trend reversal first. “Piecing” appears more often after the end of a correction or a rebound from the boundaries of a sideways range, indicating a point of a local price reversal. 

Patterns on the chart

The "Dark Cloud Cover" can be considered an incomplete version of the Bearish engulfing, but the candlestick analysis believes that it does not decrease its reliability. We look at the position of the downward candle - the more it “closes” the upward candle, the more reliable the signal.

If the shape appears on the vertices, then the "Cloud Cover" model of the bases. The opposite condition applies: the higher the white candle with the first black, the sooner the reversal.

If the second candle cannot break through a significant support/resistance level, this means that the market is not yet ready for a reversal and it is necessary to wait for the situation to develop.

«Harami» and  «Harami cross»

This candlestick is the complete opposite of «Engulfing» - the body of the second candlestick must be completely (including shadows) inside the first candlestick. If the "classic" of graphical analysis considers "Engulfing" as a "lever" for price reversals, then, in this case, we are dealing rather with a "brake" temporarily stopping the movement. But, this is still a reversal signal, especially if it appears at a price maximum.

Example: EUR/USD pair (Euro/Dollar) and timeframe 5 minutes (M5). Here you can already start trading using candlestick patterns. "Harami" gives more reliable signals; it shows a rapid change in the balance of power between buyers and sellers. There is a high probability of a local trend reversal; you can open a short-term trade. When "Harami Cross" appears, you need to make sure that it is “cross" and in front of it is a candle with a large body.

"Harami" and "Harami cross" patterns

The pattern is stronger the smaller the candle body. It is very logical - when the opening/closing prices coincide, this means a maximum of market uncertainty or "Harami cross". There are no strict recommendations at what size of the candlestick body the pattern is considered a "cross" - we leave it at the discretion of the trader, depending on the asset and volatility. It is recommended not to go beyond 2-3 points. We look at the shadows – it's better if they are as identical as possible!

“Harami cross” cannot be ignored! According to statistics, patterns at tops often lead to a trend reversal than at bottoms. Therefore, it is recommended to close medium and long-term positions regardless of the current profit/loss.

«Tweezers»

This is one of the rare candle patterns that use shadows, rather than candle bodies, for analyzing and opening trades. On the chart, it looks like several highs/lows of candles that are approximately at the same level. If the candlesticks have formed a pattern at the same time, as shown in the figure, we use "Tweezers" as an additional confirmation.

Example: USD/CAD (Canadian Dollar). If there is a reversal pattern on the pair, we can expect a trend on the next 5-10 candles on any timeframe. There can be several situations like the one in the figure per trading day, more often during the American Forex session. The more candles on the “Piecing” pattern, the stronger the signal. It is recommended to have at least 3-4 candles at the same level (a difference of 2-3 points is acceptable). "Tweezer" both at the top and the bottom. The main requirement is that the third candlestick of the pattern is equal to or greater than the first one.

Reversal signal "Tweezer"

Several shadows at the same level are usually the result of several unsuccessful retests of strong support/resistance levels, the breakout of which is not yet needed by large players planning to start moving “against” the trend.

Stop Loss of their pending positions may be behind such levels, but the potential for a reversal is still insufficient. Market makers who fix profits before the final trend reversal or try to continue the movement can also keep the shadows at one max/min. To understand who is behind the "Tweezers", in addition to graphical analysis, we look at the situation by technical indicators. Let's not forget about the fundamental background.

All reversal patterns should be accompanied by a rapid increase or decrease in market volumes (even tick). Sometimes they give a signal before a reversal candle appears. Volumes can reverse even an explicit pattern!

Trend Continuation Candlestick Patterns

The Japanese concept of the market says "there is time to sell, time to buy, and time to rest". A group of "to continue" patterns indicate precisely a break in the price movement, after which a resumption is more likely than a trend reversal. Visually, it looks like the appearance of a break in the price chart or, in terms of graphical analysis, "Window".

Example: EUR/GBP pair again. If the major pairs “Window” and “Gap” usually appear only at the beginning of a new Forex trading week, then they can appear on the crosses also within the day. For example, after the publication of strong fundamental news for the pairs included in them (in our case, the Euro and the Pound). 

Remember when planning a trade: "Window" can be a speculative impulse from market makers, then a quick close and the trend continues. But the "Tasuka Gap" has a 50/50 chance of continuing. The reasons for its appearance are more global; the trend can reverse instead of continuing.

Important. All the examples and information are given work with all Forex assets. The figures only show how the patterns look in "classic" form on the price chart. In the trading terminal, you can find similar situations on other timeframes and historical periods.

"Window" and "Gap" continuation patterns

Such zones, in which there is no visual activity, are well known to traders. In technical analysis, they are called gaps. They usually appear at the opening of a new Forex trading week. Classic candlestick analysis states that you need to open positions in the direction of the "window".

Before the continuation of the trend, there is always a period of rollback completely or partially "closing" the gap; with a sufficiently wide range, you can try to open short-term deals against the main trend. You can also add technical indicators and trade from the gap boundaries, which work as support/resistance levels.

"Tasuki Gap" is a more dynamic variant of a gap – even the second candle after the start of the first session on Monday can completely close it and continue the main trend. If the next 2-3 candles remain inside "Tasuki", the signal is canceled or we look for additional confirmations.

“Break of adjacent candles" and “Trade Open/Close Day Gap”

Both combinations of candles are quite rare, especially the separation of adjacent ones on the downtrend. If on an uptrend it can be considered as a stronger version of the "Tasuki Gap", then on a downtrend it is not a bullish model in any way, buyers just decided to close some of the short positions.

Continuation patterns “Break of adjacent candles" and “Trade Open/Close Day Gap”

Example: GBP/JPY (Pound/Yen) and one minute timeframe (M1). On this timeframe, there is mainly market “noise”, trends last 3-4 candles. Reversal patterns give a large number of false signals if you trade only "break" and "gap". In the previous example, we already said that gap is a more global phenomenon than "window" and "break". It can be used as a leading signal showing what market makers want - to close a gap or continue a new trend.

In our example, the up gap closes quickly. This is the first signal for downtrend continuation. You can switch to large timeframes by opening a sell trade (SELL). Further, the price of M1 continued to fall, this is confirmed by the signal from the "Trade Day Gap".

Continuation patterns

The price max/min in the candlestick analysis is not considered a local extreme, but a period of brief consolidation (flat) on a strong trend, followed by the next "window". In this case, candlesticks can form "Tweezers" and a gap in the opposite direction, confirming the continuation of the main movement.

"Three Method" and "Three White Soldiers"

Number Three plays an important role not only in Japanese candlestick combinations, but also in Western technical analysis: Triple tops "are three phases of the market (accumulation, distribution, and culmination), and so on. The reliability of triple structures is confirmed by practice – double ones are too unstable, and quarter ones appear when the movement is almost over, it is no longer possible to get a big profit.

In "Three Method", after a large candlestick according to the current trend, there are at least three retrenchment candles that should not go beyond its body with shadows. Of course, options are allowed, and if the next candle again goes in the direction of the main movement, we can say that the market failed to turn around.

Example: as the big currency pair in the Forex market in terms of trading volume and liquidity, EUR/USD quite reliably fulfills most candlestick patterns. In our case, these are short-term patterns on which, after the formation, the price passed 30-40% of the current trend. It is not recommended to set too large Take Profit - the price may reverse or go consolidation before reaching the profit level. The figure clearly shows this, all combinations of patterns are similar in implementation. Three candles identify the pattern from the beginning of the local trend. Then you can enter BUY/SELL and take profit in 2-3 candles or when the opposite signal appears.

On the M5-M15 timeframes, you can visually control the transaction without setting Take Profit (mandatory Stop Loss!) by closing it "on the market" in profit. An option only for experienced traders! Take Profit of 10-15 points is recommended for beginners.

"Three Methods and Three White soldiers" patterns

Three consecutive uptrend candles (soldier) can appear both at the top and the bottom to represent a signal of a stable start or continuation of the uptrend. If the second and third candlesticks at the top are too stretched to the previous 3-5, we look at the overbought technical oscillators. If not, we stay out of the market until a reversal pattern with confirmation appears!

In the opposite situation, when 2-3 candles are less than the first, we can talk about the resistance of sellers (advance block) and may appear "Harami".

Reversal "Doji"

This reversal signal is so strong that it deserves a separate section of candle analysis. The main strategy is that the less often the Doji candlestick appears, the more important it is and the most stable results are observed on timeframes from M30 and higher. At shorter intervals, there are too many "Doji" and they are practically useless for analysis.

The main strategy is that the rarer the Doji” candle appears, the more important it is and the most stable results are observed on timeframes from M30 and higher. In the classic "Doji", the closing price is equal to the closing price +/- several ticks. But if the body of the candlestick is small, but still clearly visible, does classical candlestick analysis work or not?

There are no strict criteria here; it all depends on the average volatility of the asset. Sometimes even 2-3 points can be a normal situation. We also look for additional signs such as overbought/oversold or moving average crossovers.

In any case, the appearance of such a candle (even if false) requires detailed consideration; otherwise, significant losses from a sharp trend change are possible!

The main variants of the "Doji" pattern:

  • After a long white candle (on top)

This means that the potential of buyers is almost exhausted. It is important to understand here that this candlestick does not mean that the balance of power is beginning to shift in favor of buyers. Rather, the market is in a stage of indecision and hesitation. For adequate analysis, at least three next bars are needed to confirm a reversal or the beginning of consolidation.

On a downtrend, the accuracy of "Doji" signals drops sharply, as do virtually all Japanese candlestick variations. Paradoxically, it looks like more effort is needed to move the price down than to increase it. It's a matter of psychology: it's easier for most small and medium-sized players to expect the start of a correction or reversal than to continue to open for sale, mainly market makers push the price down. Even if a candlestick appears, indicating the end of the movement, the asset may well still "fail" to the levels of pending large Take Profit.

Therefore, "Doji" at the lows requires more careful confirmation than at the highs!

Example: the following example is for EUR/USD on the M1 timeframe. It can be seen how Doji retains its strength as a reversal pattern even in the conditions of market "noise". Their advantage is that their appearance is already a signal for a reversal. Even if you open a deal at the close of the next candle, you can "pick up" most of the short trend. First trades "classic" Doji after 2-3 Long Candles, followed by "Long-Leggend" and "Gravestone".

On M1 there may be "doji continue" on which there are many false signals. The continuation of the trend should always be confirmed by technical indicators; here Doji is only the first signal. Technical analysis is difficult to work on M1, but if there was a reversal signal at the top (we have Rickshaw Man) or the base before, you can open a small volume position.

Variants of the "Doji" pattern
  • «Long-Legged», «Rickshaw Man» and «Gravestone»

These candles also indicate that the market is "tired" or, as Japanese analysts say, the trend has "gone astray". But here the situation is different. If a long white candlestick indicates buyer’s weakness, then a long upper shadow on the Long-Legged or Gravestone” Doji indicates that sellers are constantly trying to stop the uptrend.

The price continues to up but constantly runs into strong resistance, which returns it almost to the level of opening. 

The classic candlestick analysis holds that "Man Rickshaw" appears when an attempt to reverse a trend ends with a temporary balance between buyers and sellers, as evidenced by nearly identical shadows and a small body.

Professional traders believe that "Rickshaw Man" will be a reversal signal, only if it is next to at least one classic Doji, stay out of the market!

  • «Three stars»

The strongest reversal model of this group. In the classic form, it almost does not occur usually there are 2-3 candles in different directions between the extreme Doji. They are equally well worked out both at the tops and the bases.

Recommendations about using candlestick analysis…

  • Visual analysis of the price chart is not available to everyone. Unfortunately, this is the case. A trader should be able to recognize graphical patterns at a glance. Now on Forex, their "classic" form is rarely found, the load on visual memory increases, especially at short intervals with limited time for making a decision. Take screenshots; watch how the patterns work in a "non-classical" form on currency pairs.

But, there is a solution to the problem: many methods have been created to improve the memorization of visual information, among which you can always find several that are right for you. Even if you choose a "non-graphical" strategy based on indicators, market volumes, or fundamental news, you cannot remove most of the strong false signals without graphical analysis.

  • Candlesticks, like any other market analysis tool, cannot be the only decision-making factor. Perhaps 200 years ago the situation was simpler, it was possible to trade successfully only by candle combinations, but now in the current market, we have to take into account a lot of external technical and fundamental factors. Therefore, patterns, like everything else in trading, only indicate the likelihood that the market will reverse or continue the current trend.

For novice raiders who study graphical analysis, it is a good idea not to look at the market too stereotypically, forgetting that on any trading asset the situation never repeats with 100% accuracy. Candlesticks that worked well a year ago, when volatility and the macroeconomic situation change, can start to give losses, so constant monitoring of the correctness of the pattern is required.

  • Additional confirmation is required. Candlestick analysis should always be confirmed by technical instruments, especially support/resistance levels. Watch price movement on multiple timeframes, especially the presence of divergences and abrupt volume changes.

Example: the combination of the two types of analysis on the chart gives the trader a more accurate picture of the market. Technical analysis allows you to see the situation in terms of market volumes, trend dynamics, balance of forces (overbought/oversold), market phase change, and other important factors that can only be obtained from historical data. The disadvantage is that the calculation of the history gives a delay in the data to the current market.

The graphical analysis makes it possible to see the market “here and now” by reducing the delay factor. In other words, technical analysis shows "where" the price came from, graphical "how" it moved to the current level.

The figure shows three examples of collaboration:

  1. Confirmation of the signals of the Stochastic oscillator. You can decide two ways: the patterns confirm the oscillator or it confirms the reversal by candlesticks. Both options are equivalent.
  1. Strong Doji price levels. The appearance of a pattern means a strong price level from which there is a reversal. It can be a historical max/min, a zone with a large number of pending orders of market makers, etc. Candlestick analysis allows a trader not to look for a reason, but to immediately build a level of 2-3 Doji for trading on a rebound or breakout.
Candlestick and technical analysis
  1. Leading signals. Technical indicators require adjustment for volatility and other features of the asset and the current situation. If the periods of oscillators or trend instruments are incorrectly selected, you can skip good entry points (remember the delay), open a deal at the very end of the trend with a loss on Stop Loss. Candlestick analysis does not have changeable parameters; it is "se tup" by traders themselves. It can be faster and more accurate.
  2. Constantly learn new patterns and control how the classic ones work. We have shown only the most basic and fairly simple candlestick combinations, but there is a downside to their popularity. Yes, they attract the attention of most traders and it is not uncommon for a market "crowd" to bring the figure to a classic look by all means, although there are no market factors to this. At the same time, they are being watched by large players who can play against small traders. For example, seeing the formation of a «Doji» candle at the top or bottom, enter with a large opposite volume. Instead of a reversal, we have a continuation of the trend with the departure of small Stop Loss.

It is recommended to choose a cautious strategy, gradually increasing the position as the signal is confirmed, or choose an equally reliable option - to trade more rare but also profitable patterns, such as "Three black crows" (reversal) or "Division" (continuation). Since they are unknown or uninteresting to most traders, their stability is higher (especially on older timeframes from H1).

Candlestick patterns on fundamental events
  • Keep track of the price relative to the pattern. The longer the candlestick combination on the chart, the more likely it is to end quickly. Especially if there are no strong fundamental events, then the major players have no option how to "swing" the situation, since during periods of "silence" you can't get a good profit. And candlesticks of an outwardly reliable pattern quickly turn into meaningless combinations. It is necessary to develop clear criteria for the onset of the “deterioration” of the pattern when it is necessary to close deals regardless of the current profit/loss.
  • Always be calm. If you failed to enter at the beginning or from the key point of the figure, you should not look for the entry point where it does not exist. It is better to wait for a pullback and look for an opportunity to open a reversal trade there. But always remember that graphical analysis most often involves only one correction or rollback. There may be 2-3 of them; we look at the technical indicators. But the final choice must be made based on the current situation and data from other instruments.

Let's summarize.  Candlestick analysis will be relevant for at least another 10-20 years, despite the growth in the use of AI and HFT in trading. Most stock transactions are still made by people, which mean that its principles will continue to work and make a profit.

Still. On the Internet, you can find many offers of automatic Expert Advisors based on candle analysis. Before you install or buy such an advisor, think about how it works. Technical analysis works on mathematical algorithms that do not change. Chart patterns rarely appear on the chart in a "classic" form, you need to be ready to trade "incomplete figures", or by looking at the chart, you will miss the signal. The adviser cannot do this. There may be a situation when an advertisement speaks of "trading by patterns" and in fact? a deal is opened by technical indicators.

Use such tools only to search for possible patterns, no automated trading!