Japanese Candlesticks in Forex Trading

Japanese Candlesticks in Forex Trading

6.1. What are Japanese Candlesticks?

Japanese candlesticks is the charting technique which makes it easy to see the relationship between the opening and the closing prices for specific periods of time (e.g. for a day, an hour or 5 minutes). The thick part of the candlestick is called the real body. It shows the distance between the opening and the closing prices for the period of time the candle represents. If the closing price is higher than the opening price, the body is white. If the closing price is lower than the opening price, the body is black. The thin lines above and below the candlestick body are called shadows.

White or Bullish Candlestick

Bullish Japanese Candlestick

Black or Bearish Candlestick

Bearish Japanese Candlestick

Examples of the bullish and bearish candlesticks seen on the monthly USD/JPY chart.

Bullish and Bearish

Click to Enlarge.

Note: Colours for each candle type can vary depending on the forex charting software that you use.

Candlestick patterns provide immediate feedback (once they are completed) on the state of the balance between the buying and selling forces that operate in the marketplace. This benefit makes Japanese candlesticks an ideal tool for staying alert to the frequent sentiment shifts characteristic of the Forex market and is behind their popularity among professional forex traders.

6.2. Examples of Candlestick Patterns

6.2.1. Hammer: A hammer is a bottom reversal signal. It has long lower shadow and a small real body (black or white) at its top. There should be a downtrend preceding this formation in order for the hammer to reverse the trend. The stronger the downtrend before it and the longer the lower shadow (ideally twice the size of the real body) - the more bullish this formation is.

Ideal Hammer

Hammer

An example of the hammer which appeared on the daily EUR/USD chart.

Hammer

Click to Enlarge.

6.2.2. Shooting Star: a shooting star is a top reversal signal. It has long upper shadow with a small real body (black or white) at the lower end of its range. Since the shooting star is a top reversal signal, it should appear after an uptrend. Longer upward shadow coupled with a gap from the previous candle's high increase reversal potential.

Ideal Shooting star

shooting star

An example of the shooting star which appeared on the daily CAD/JPY chart.

shooting star

Click to Enlarge.

6.2.3. Doji: a doji can be a top or a bottom reversal signal. It is one of the most important candlestick patterns signalling indecision amongst the market participants. This formation has horizontal line instead of a real body or very small real body (because open and close are the same or almost the same). A doji is more powerful if it appears after a long white candle in an uptrend or a long black candle in the downtrend. It is best to wait for confirmation of this pattern in the form of a long black candle for tops or a long white candle for bottoms. The longer the shadows of a doji the more likely the reversal.

doji

Two Dojis stop the uptrend on the daily USD/JPY chart

doji

Click to Enlarge.

One Doji ends the sharp downtrend visible on the daily GBP/JPY chart

doji

Click to Enlarge.

6.2.4. Dark Cloud Cover: this is a bearish reversal pattern which appears after an uptrend. Dark Cloud Cover is formed by a black candle closing below the midpoint of the previous white candle’s real body. The lower the second candle closes into the first candle, the stronger the signal. The larger both candles are, the more forceful the reversal is likely to be.

Ideal Dark Cloud Cover

dark cloud cover

The Dark Cloud Cover stops the uptrend in the EUR/GBP

dark cloud cover

Click to Enlarge.

6.2.5. Piercing Line: this is a bullish reversal pattern which occurs after a downtrend. The "piercing line" is the opposite of the "dark cloud cover". The higher the white candle "pierces" into the black candle, the stronger the bullish signal.

Ideal Piercing Line

piercing line

Piercing Line ends the downtrend in the CHF/JPY pair

piercing line

Click to Enlarge.

6.2.6. Engulfing Pattern: this pattern is a major reversal signal composed of two real bodies of different colour. The real body of the second candle should completely engulf the real body of the previous candle. The larger the real body of the second candle than the real body of the first candle and the stronger the preceding trend the more significant the reversal signal.

Bullish Engulfing Pattern

bullish engulfing pattern

Bearish Engulfing Pattern

bearish engulfing pattern japanese candlestick

Two Bullish Engulfing patterns mark the start of corrections in the long-term AUS/USD downtrend

bullish engulfing

Click to Enlarge.

Bearish Engulfing pattern reverses the uptrend visible on the daily AUD/JPY chart

bearish engulfing

Click to Enlarge.

 

6.3. Combining Candlesticks with other Technical Analysis Tools:

Candlesticks are very effective stand-alone analysis method; however, their predictive power can be further increased if you combine them with the other technical analysis tools. Applied in conjunction with tools like trendlines or Bollinger bands candlesticks allow to catch the precise moment when the currency price is "ready" to move in the opposite direction.

6.3.1. Candlesticks with Trendlines: whenever the prices test a trendline, a reversal candle(s) occuring at the test level increases the odds of the test being successful.

Examples of candlestick patterns occuring close to the up trendlines visible on the EUR/JPY hourly chart (from 06.09.07 to 14.09.07).

candlestick patterns in uptrend

Click to Enlarge.

Examples of candlestick patterns appearing close to the down trendlines visible on the EUR/NZD daily chart (from 01.07.05 to 05.12.05).

candlestick patterns in downtrend

Click to Enlarge.

6.3.2. Candlesticks with the Bollinger Bands: candlesticks work very well with the Bollinger Bands. Watch for reversal patterns when currency prices touch or push outside of the top or the bottom band. The further the shadow of the reversal candle (e.g. of a doji or a hammer) shoots through the band and the closer the top and the bottom bands are to each other the higher the probability of reversal.

Two Hammers at the bottom Bollinger band on the 15-minute EUR/USD chart (12-13.09.07) predicted strong upward reversals

hammer bollinger bands

Click to Enlarge.

Shooting star pierced the top Bollinger band on the 1-day EUR/CAD chart (17.08.07-25.09.07) predicting the subsequent fall.

shooting star bollinger bands

Click to Enlarge.

Quote: "I have employed candlestick charts for many years and prefer them to bar charts; they create a clearer picture for me", John Bollinger, creator of the Bollinger Bands, in his book "Bollinger on Bollinger Bands".

6.3.3. Candlesticks with Retracement Levels: candlesticks are often the first to tell which one of the fibonacci retracement levels (38%, 50% or 62%) will act as support (when the prices retrace after a rally) or resistance (when the currency prices correct after a fall).

The Piercing Line confirmed the 50% retracement of the uptrend in EUR/JPY (from 13.06.06 to 27.02.07) as the support level.

fibinacci retracement japanese candlestick

Click to Enlarge.

The Doji, Bearish Engulfing and Dark Cloud Cover appeared close to the 38,2% retracement of the downtrend visible on the daily EUR/USD chart (from 14.03.05 to 04.07.05), resulting in the resumption of the downtrend.

candlesticks fibonacci retracement

Click to Enlarge.

Note: Various candlestick patterns are often mentioned in combination with the other technical tools in forex bank reports and by the major forex newswires.

6.4. Mastering Japanese Candlesticks:

Candlestick analysis is an essential tool for making market timing decisions. Therefore, if you plan to trade on forex - you should consider investing your time in mastering this technical analysis technique. You can study this technique from one of the industry-standard books on the candlestick analysis. Once you have learned all the major patterns and their corresponding trading signals you should train yourself to watch for these patterns and take them into account (by including them in your checklist)- when making decisions at which level to enter or exit your trades.

Quote: "After spending some time with candlesticks, I am sure that you, like me, will not trade without the insights they offer", Steve Nison, the author of "Japanese candlestick charting techniques : a contemporary guide to the ancient investment technique of the Far East".