Forex traders can utilise Japanese candlesticks to gauge the market sentiment surrounding a particular currency pair or security. In a nutshell, these candlestick patterns provide detail on how the emotions of market participants are affecting the price movements of financial instruments. Further, forex candlestick patterns are exceedingly useful in identifying market entry/exit points and in open position management.
Many traders prefer candlestick charts because they are visually appealing and provide substantial information in a small amount of space. If investors can successfully use them to interpret market sentiment, they will have one more tool they can use to determine whether to enter or exit a trade. In this guide we will teach you how to read candlestick patterns for trading the forex market.
What Are Japanese Candlesticks?
Japanese candlestick charts date back to 18th century Japan, when a rice trader named Munehisa Homma discovered the key role that emotions played in rice prices. He was able to uncover this relationship by keeping track of the daily price movements of this commodity.
Every day, he recorded the opening, closing, high and low price of rice contracts, and began identifying specific "candlesticks patterns" with this information. Because he was able to keep track of price movements, Homma had insight into whether the broader markets believed rice was on the upswing or alternatively, moving lower.
He reasoned that if most were bullish about the commodity, it was a great time to take the exact opposite position. Likewise, if the majority believed that rice would soon fall in price, it was instead a time to take a bullish stance.
Forex traders use these exact same techniques today. If investors want to develop candlestick charts for a security, they can start by keeping track of its opening price, whatever high and low it reaches, and also where it closes. Upon building the chart, candlestick patterns may be identified. A few of the most common are the reversal pattern, the continuation pattern and various bullish patterns.
Bullish Candlestick Patterns In Forex
When using Japanese candlesticks to trade on the forex market, there are several different types of candlestick patterns to be aware of. One of the featured varieties are bullish patterns. Bullish candlestick patterns indicate rising price action and a potential northbound directional move. They are invaluable tools for deciphering buying opportunities and managing active long-side positions.
Hammer Candlestick Pattern
The hammer candlestick pattern is a distinct formation that indicates strengthening asset prices. Essentially, the hammer develops when price falls dramatically from a periodic open before rallying to a closing value at or near the open. Thus, the hammer candlestick pattern consists of a small body with an elongated lower wick.
Conversely, the inverted hammer is made up of a small body with an elongated upper wick. It also signifies potentially bullish price action and can be considered a candle reversal pattern.
In the live market, the hammer or inverted hammer occurs during a pronounced downward trend. Due to this location, hammers are each classified as a bullish forex candlestick formation and may be considered a reversal pattern. Upon forming, subsequent candles must be bullish in nature for a hammer's validity to be confirmed.
Morningstar Candlestick Pattern
The morning star candlestick pattern is a reversal indicator that occurs during a downward trend in pricing. Morning stars are multiple candlestick patterns that include three unique candles. The sequence of this candlestick pattern is as follows: one large bearish candle, a small-bodied bullish or bearish candle with elongated wicks, and a large bullish candle.
At its core, the morning star candlestick pattern signals bullish reversal. The initial bearish candle represents a strong move to the downside, while the center candle represents market indecision. Finally, the third bullish candle indicates market reversal and possibly the beginning of a new uptrend. Of all forex candlestick patterns, the morning star is among the most commonly used in bullish reversal trading strategies.
Three White Soldiers Candlestick Pattern
The three white soldiers candlestick pattern is a multi-candle bullish formation. As in name, the candlestick pattern consists of three consecutive large positive candles. Technically, each candle should have an open within the previous candle's body and a close above the previous candle's body. Given this structure, the three white soldiers are viewed as being a viable candle reversal pattern.
The presence of three white soldiers is interpreted as being a bullish indicator. As a forex candlestick pattern, the formation is strongest when each candle's body is large and has very small wicks. In this way, one can reasonably assume that consistent bids are hitting the market and that the bullish price action is likely to continue.
Bullish Engulfing Candlestick Pattern
The bullish engulfing pattern is a forex candlestick indicator that signals periodic trend reversal. It is a multiple candlestick pattern that consists of two candles. The first candle of the series is a small-bodied negative candle with moderate wicks. Second is a large-bodied positive candle that completely surrounds or "engulfs" the first candle. When it comes to pullbacks in upward trending markets, the bullish engulfing forex candlestick formation is a popular indicator.
When trading a bullish engulfing candlestick pattern, it's important to observe the preceding candles. If a series of negative candlesticks exists before the large-bodied positive candle, a bullish reversal is more likely. Because of this fact, many active forex market participants aim to trade the bullish engulfing candlestick pattern on retracements that occur during a pronounced uptrend.
Bearish Candlestick Patterns in Forex
The following are instances of bearish candlestick patterns that occur in the forex market.
Bearish Engulfing Candlestick Pattern
The bearish engulfing pattern is a forex candlestick formation that suggests price action is due to fall. It is a multiple candlestick pattern that consists of two candles. The first candle of the series is a small-bodied positive candle with moderate wicks. Following the small candle is a large negative candlestick that completely surrounds or "engulfs" the first candle.
Among all candlestick patterns, the bearish engulfing pattern is a popular device in technical trading circles. It indicates that a bullish trend is soon to end and sellers are entering the market en masse. Although the bearish engulfing pattern can be interpreted as a reversal indicator, many market participants choose to trade it in concert with larger, prevailing bearish trends.
Evening Star Candlestick Pattern
Of all of the bearish candlestick patterns, the evening star is one of the most popular. The evening star is a multi-candle formation that consists of three unique candlesticks. The first candle of the series is a large positive candle; second is a smaller positive candle that opens gap up from the first; third is a large negative candle that opens gap down from candle two before closing near the midpoint of candle one. When compared to other candlestick patterns, the evening star brings added complexity to the table.
As far as bearish forex candlestick patterns go, the evening star is perhaps the most visually distinct. To capitalise on the signal, technical forex traders strongly consider shorting the market beneath the body of the third candlestick.
Three Black Crows Candlestick Pattern
The three black crows candlestick pattern is a bearish indicator of signal market reversal. The three black crows formation is a multiple candlestick pattern that consists of three consecutive large negative candles. Ideally, each candle in the sequence would feature a close below the previous candle's low and minimal wick sizes. Of all bearish candlestick patterns, the three black crows is viewed as one of the strongest reversal indicators.
To trade the three black crows, technical traders typically place sell orders beneath the body of the third negative candle. This is done in contrast to three white soldiers patterns, which are opposite candlestick patterns to the three black crows.
Continuation Candlestick Patterns
Once forex traders have learned the basics of Japanese candlesticks, they should start learning some of the more basic candlestick patterns. Spinning tops are candlestick patterns that involve small real bodies and long shadows. Because these patterns contain small real bodies, they point to a tight trading range and therefore little volatility.
Spinning tops generally mean that both bulls and bears were active during a trading session, but that they failed to move the security very far in any one particular direction
Doji candlestick patterns appear when the opening and closing price of a security are virtually the same. When this happens, the real body is very short. Any time a Doji candlestick appears, forex traders can interpret them as meaning that market sentiment is largely neutral, at least for the time being.
In other words, investors cannot look at these formations alone and take that information to mean that the broader markets are either bullish or bearish. To obtain a better sense of the market, forex traders can look to the most recent candlesticks that appeared before the Doji.
For example, if Doji candlestick patterns show up immediately after a long white candlestick, this indicates that the bullish sentiment surrounding a financial instrument is beginning to fade somewhat. Alternatively, if a Doji appears right after a long black candlestick, this points to selling pressure that is starting to decline.
Other Important Terms
As you get more familiar with candlestick patterns, it's important to also become acquainted with these important terms.
The open and close form what is known as the real body, and this area is white if the financial instrument closed higher and black if it finished the session lower. Because this area contains the prices a security had when it started and ended a trading day, its length shows how much volatility the asset experienced during that session.
Should a real body be long and white, it points to robust buyer demand. In other words, market sentiment is bullish. However, if a real body is long and black, it generally means that sellers were aggressive, or bearish, about a particular security.
If a real body is short, this points to a modest change in price between the beginning and end of the session, which would not indicate a strong investor desire to either buy or sell.
The high and low points are used to determine the wicks or "shadows" of a candlestick chart. While upper shadows show the session high, lower shadows provide information on the low.
These shadows also provide important information, which vary based on their length and also whether the real body is white or black.
For example, if the upper shadow on a white real body is short, that means the closing value was near the high point for the session. Alternatively, when the upper shadow on a black real body is short, it means the opening price was close to the day's high.
This article was last updated on 8th June 2021.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…