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How to trade candlestick patterns

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Lesson 6

Candlestick price action makes use of the hollow (or filled) candlestick pattern and the wicks (or shadows), which determine the open and close and the high and low, respectively. Based on distinct patterns, candlestick price action can help traders to determine what is happening in the forex and crypto markets.

The idea behind learning patterns is that these candlestick patterns tend to repeat overtime, and traders can use them as signals for trend continuation or price reversal.

Understanding the meaning behind the candlestick patterns and applying this understanding to the market can help traders when making decisions. You can use different time frames, and you will note the same patterns repeating overtime. By knowing the outcome of a pattern, you can put the odds in your favour.

Your goal as a trader is not only to focus on the small formations but also to always have an eye on the big picture. For example, if you see a doji candlestick on the chart, you have to consider whether it is in the middle of a range or at a support/resistance level. But focusing on the dogi candle alone won't be enough.

There are different types of candlestick patterns, but they can be broadly classified into single, double and triple. In this article, we will discuss some of the most popular formations.

Doji candlestick

The doji candlestick is unique because it is usually identified when the open and the closing prices are the same. The doji is visually distinguishable for its flat body and often the long upper and lower wicks.

A doji candlestick can be powerful when it forms at the top end of the rally or at the end of a decline. This candlestick pattern signals a temporary pause to the trend. Based on how the next candle emerges, traders can then ascertain whether there will be a change in trend or a continuation in the trend.

A bullish candlestick after a doji at the bottom end of a downtrend can signal a reversal or a correction to the trend. Likewise, a bearish candlestick after the doji forming at the top end of the rally can signal a correction or a reversal to the uptrend.

Doji candlestick

Most commonly, traders look at the doji candlestick in isolation. However, examining price action prior to the doji and price behaviour after the doji reveals much more information.

It is important to know the market sentiment behind the candlestick. For most traders, the doji is often associated with indecision in the markets. While this is true, looking at it in isolation does not really give true meaning to the price action in question.

There are different types of doji candlesticks, such as the dragon fly and the rickshaw man. However, regardless of their names, all doji candlesticks exhibit the same property.

Shooting Star candlestick

The shooting star candlestick pattern is, in fact, a three-candlestick pattern. However, the shooting star alone is visually seen by the long upper wick and a relatively small body. This pattern is the most powerful when it forms at the top end of a rally and with some strong bullish candlesticks preceding the shooting star candle.

Following the shooting star candlestick, a bearish close confirms that price action could be heading lower. The formation of the shooting star candlestick pattern is most evident as it often coincides with a resistance level.

The shooting star candlestick pattern is somewhat similar to the doji. The main difference is the body of the shooting star pattern is more obvious than the doji that has the same open and close prices.

Shooting Star candlestick

The above GBPJPY example shows different variations of the shooting star candlestick pattern. You can see how prices tend to rise to the top and then are rejected, leaving long upper wicks. In almost all the above cases, price starts to reverse, pushing lower after the shooting star is formed.

Hammer Candlestick

The hammer candlestick pattern is the exact opposite of a shooting star. In other words, the hammer pattern is identified by a long lower wick and a small body. The hammer pattern visually stands out as a hammer, hence the name.

The appearance of a hammer pattern at the bottom end of the rally can indicate a reversal to the upside. This pattern gains more prominence when the hammer candle is formed after a strong decline with some bearish candlesticks.

Hammer Candlestick

The above GBPJPY chart shows the hammer pattern, which as you can see results in a reversal in price. It is always best to wait for the next candlestick to form, after which traders can take long positions. A bullish close after a hammer pattern can mean the markets could be going higher.

The hammer pattern usually coincides with a support level off which prices tend to bounce. Using this information along with the market context can help traders to trade the hammer pattern with more confidence.

Inside Bar/Harami Pattern

The inside bar pattern is a two candlesticks pattern: the first candle is often longer and is followed by a second candlestick, with a range contained within the previous candlestick.

While in bar chart terminology it is known as the inside bar, in candlestick terminology, it is referred to as the Harami pattern.

Inside Bar/Harami Pattern

The inside bar pattern can form at any point in a trend. When the inside bar is formed within a trend, the breakout from the inside bar often signals a continuation of the trend. A breakout in the opposite direction of the trend results in a short-term reversal.

Inside bar patterns can become reversal patterns when they form at the top or the bottom end of the trend.

Outside Bar/Engulfing Pattern

The outside bar or engulfing pattern is the exact opposite of the inside bar/harami pattern. Here, the second candlestick or bar completely engulfs the previous candlestick or bar.

A bullish engulfing pattern is a bullish candlestick that engulfs the previous candle, while a bearish engulfing pattern is a bearish candlestick that engulfs the previous candle and signals a decline.

However, the appearance of an engulfing pattern doesn’t always signal a reversal, so traders should be careful.

Outside Bar/Engulfing Pattern

The engulfing candlestick patterns are most useful when you notice them forming at the top or the bottom end of the rally. These patterns can signal strong changes to the trend. It is also advisable to look at the engulfing patterns that coincide with support or resistance levels as they can be more validated.

The above main types of candlestick patterns are some of the most popular patterns that traders use in price action. While there are many other types of candlestick patterns, these five patterns are the most commonly occurring on the forex and crypto markets.

When combining the candlestick pattern with the support and resistance levels or trend lines, for example, traders can make good judgments on what the market is doing and what the market is preparing to do.