What are Forex candlestick patterns and how to use them in trading?

Professional traders base their predictions on technical or fundamental analysis or both. Both methods have their benefits and drawbacks. You can find a lot of fundamental traders that are completely ignoring technical analysis and vice versa. In order to have a healthy approach to trading, it’s best to learn about both methods and make up your own mind about the subject.

Some traders are using both methods to open their trading positions. For instance, a trader might use fundamental analysis to predict the future direction and technical analysis to locate the best entry point.

Japanese candlestick patterns play an important role in conducting technical analysis. Their unique structure enables traders to digest the price action data faster and better. Reading candlestick patterns can greatly improve trading results.

What are Japanese candlesticks?

Japanese candlesticks were developed by Japanese rice traders. Later the candlesticks became popular in financial markets. The Japanese candlesticks are highly informative and no wonder they have replaced traditional price action sketches.

Japanese candlesticks give us a glance into a trader’s psychology. They are showing us an open price, close price and highs and lows. Depending on a candle’s shape, we can predict the market exhaustion, hesitation, determination and more. The candles can be bearish or bullish. What’s more, using forex candlestick patterns is not difficult.

Bearish candles have higher open price and lower close price. Bullish candles open lower and close higher. Usually Bearish candles have red or black colors on the chart depending on the layout. And Bullish candles are in green or in white.

The difference between a candle’s body and highs and lows are called shadows. Shadows are important as they help traders better position their stop loss orders and take profit targets. If a price has reached a certain point recently, there’s a chance that it will reach the point again. By placing the order higher than a shadow (or below depending on the trade direction), gives traders the tightest risks. Why does that happen? To answer this question let’s see how prices are created in Forex. Market and limit orders create prices on any given currency pair. Market order says I don’t care what the price is, I wanna buy an asset at the current price at the current moment. Limit order says that I will only purchase or sell a security if a price reaches a predetermined level. This way, prices are moving between limit orders and market orders are moving them. When a candlestick leaves a shadow, it might be a sign that there are strong limit orders in that area. Which makes it logical to place stops under(or above) the shadows.

It may take beginner traders for a while to fully transition from regular line charts to candlestick charts, but once they do, they’ll notice the difference instantly. Trading forex with candlestick patterns greatly improves the market analysis.

Examples of Japanese chart patterns

A lot of trading patterns have been found by financial traders that are based on the candlesticks. Below we will discuss some of the best and the most commonly used ones. Chart patterns are usually formed at the top or a bottom of a trend and they help to reverse the trend or continue. Patterns that help a trend continue are called continuation patterns. Patterns that reverse a trend are called reversal patterns. Most patterns give traders entry signals, and stop loss targets, but fail to provide predictable take profit targets. The reason is that when a trend reverses and starts going to a new direction, it is hard to tell when that new direction will reverse again. In such cases, traders can use additional indicators and reasons to stay in the trend or take profits. Trailing stops are also a good idea. In order to make money trading, it’s important to cut your losses short and let your winning positions run and make money. Most novice traders do the opposite because they do not want to take the losses.

Hammer Patterns

Hammer patterns have short bodies and larger shadows. Hammer patterns can be bullish or bearish. The pattern usually appears at the bottom of a downtrend and it informs us that the buyers have resisted the pressure from the sellers and might be an indication of reversal.

Bullish and Bearish Engulfing

Bullish Engulfing chart pattern occurs at the bottom of a downtrend and reverses it. The pattern consists of 2 candles. The first candle is bearish and the second is bullish. The second candle is larger in size and completely engulfs the first candle. Which indicates that the buyers are taking the initiative. Please keep in mind that in order to trade the pattern, patience is important. Traders should always wait for a pattern compilation. If the second candle closes lower than the previous one and leaves a giant shadow, the pattern will not be in place and the open order will not be justified.

Bearish Engulfing chart pattern forms at the top of an uptrend and predicts reversion. The pattern mirrors the bullish Engulfing one just in the opposite direction.

Morning Star and Evening star

The Morning Star candlestick pattern is one more reversal pattern. It appears at the downtrend and predicts the price to start trending in the opposite direction. Morning star pattern is a bit more complex than the others as it takes 3 candlesticks for the pattern to form. The first candle is bearish and has a large size. The second one is still bearish but has a much larger body. The last candle is a large bullish one. The pattern to be considered complete and ready to be entered, the third candle needs to be fully closed. Stop loss can be placed beneath the 3 candles’ shadows. The profit target is not specified and it depends on the strength of a new trend.

Three White Soldiers and Three Black Crows

The three white soldiers chart pattern appears at the end of a strong downtrend. The pattern consists of 3 bullish candles. Usually the candles have little to no shadows. They represent the determined bulls and the pattern is considered to be giving a buy signal.

The three black crows pattern is very much the same as the three white soldiers. The only difference is that it is reversed.

Doji

Doji represents indecision in the markets. From this point, the price direction is unknown. Trading Dojis can be beneficial for a simple reason, even though the direction is unknown, the risk reward ratio can justify entering the market in any direction. However, the following candles can have bigger shadows and traders should not enter the trade too soon. It’s best to trade the pattern in a context.

Shortcomings of candlestick analysis

Many fundamental traders have valid points in their criticism of technical analysis. And of course the same criticism can be applied for the Japanese candlestick chart patterns. The candlesticks are just technical tools and they fail to take into consideration market news and political turmoils. However, traders can simply avoid trading during important news events. On the other hand, market conditions are often changing and the older patterns might lose the ability to provide a trading edge to traders. In addition, candlestick patterns do not tend to work as good trading lower time frames as they do with the higher ones. The reason is that there’s a lot of market noise on the lower time frames.

Benefits of candlestick analysis

Candlesticks patterns help traders see the traders’ sentiment. They help us see the market’s psychology. Candlesticks help traders to get valuable information from a single glance at the charts. Which is nearly impossible using other charting methods. They provide data about candle’s open price, close price, maximum and minimum points. The candles help better place stop loss orders.

Do patterns work?

There are many chart patterns available on the market. But do they work? The patterns are created based on older information and studying the historical data. Technical analysis assumes that what has happened before will most likely happen again, or at least will happen at the pace that will provide traders an edge. On the contrary, markets are changing all the time. Fast digitalization, global internet and breaking barriers to join traders’ communities has enabled large amounts of new, inexperienced traders to participate. Which inevitably has an effect on price movements. Inexperienced traders know less chart patterns and are more likely to trade against them, which can break the patterns. In addition, trading algorithms are also getting smarter at predicting future prices. All those changes ultimately affect the way markets are moving.

In order to be able to trade the patterns without hesitation, it’s a good idea to backtest them first. Backtesting will show you whether some of the well known patterns are producing satisfactory results for your preferred markets or not.

The main takeaways

To sum everything up, Japanese candlesticks are an essential part of technical analysis. Understanding forex candlestick patterns can improve the trading results. The main advantage of using the candlesticks is that they carry a lot more information than regular lines. Candlestick is displaying the information regarding its open price, close price and the highs and the lows. In addition, candlesticks make it easier to place stop loss and take profit orders thanks to shadows. Candlestick chart patterns offer an unique view on the battle of bulls and bears. For instance, a bullish engulfing chart pattern appears at the end of a downtrend, it consists of two candles. Red candle is followed by a larger green candle that engulfs the previous one. The pattern indicates that the reversal is expected to take place. It shows us that after a downtrend, bears were overtaken by bulls and have taken the initiative. There are candlestick chart patterns that signal indecision such as doji, which means that price can go in any direction after it’s fully formed. There are reversal and continuation candlestick patterns. Keep in mind that patterns only work when they are fully formed. Traders should wait for the candle to close and only trade after the new candle opens.

FAQs on Forex candlestick patterns

What is the most reliable candlestick pattern?

Candlestick reliability depends on the asset type that you are trading, trading setup and many other factors. The best way to know what is the most reliable candlestick pattern is to backtest them on your preferred instrument. In this guide we have provided you with the most widely used candlestick patterns.

What is the best way to learn candlestick patterns?

The best way to learn how to read and spot candlestick patterns is to try to find the patterns on your chart one by one. The more experience you gain with the charts, the better you will get at finding the patterns. Furthermore, most chart patterns appear at the top or bottom of a trend. They help prices continue in the same direction or reverse, which makes them even easier to spot.

What makes Japanese candlesticks so popular?

Japanese candlesticks offer a unique view of traders’ psychology. Candlesticks give us information about a certain instrument’s open price, close price, highs and lows. And the candlesticks do that in a short scape on the chart. Candlestick patterns help traders spot hesitation, they can help us place optimal stop loss and take profit targets, spot reversals and continuations and more.

Why are candlesticks called Japanese?

The reason is simple, they were first developed in Japan. Japan has a long history of rice cultivation and the first candlesticks were developed by rice traders. Later they gained popularity in the financial markets due to their informative nature and has become a dominant charting method throughout different financial markets.