Candlesticks In Forex Trading - What You Need To Know

Candlesticks were first used in Japan by rice traders, the use of candlesticks charts then became popular in other markets, including Forex trading. Today, Japanese candlesticks are one of the mainstays of technical analysis in markets, why is their use so popular? Here we will take a look at what candlesticks are and how you can use them effectively in Forex trading.

What are candlesticks in trading?

Candlesticks are a type of price chart that show the high, low, open and closing prices for a specified period. The timeframe of candlestick charts is determined by the trader, for example, H1, H4 and Daily. If a trader uses the H1 timeframe then a new candlestick would be formed every hour the market is open, H4 would be every four hours and the daily would be after every trading day.

 

Here is an example of a candlestick chart showing the high, low, open and closing prices.

Candlesticks are easy to understand, as shown above, if the close is above the open then the candle is considered to be bullish, should the close be below the open then the candle is considered a bearish candle. Bullish candlesticks are usually coloured green or white and bearish candlesticks are usually coloured red or black, however, a trader can decide on whatever colour they prefer on their platform.

The coloured part of the candlestick, the difference between the opening and closing prices, is known as the body of the candlestick, the lines representing the high and low prices are known as the wicks.

Following is an example of the same period on USDJPY, however, the first is a line chart and the second is a candlestick chart. It is clear to see that far more information can be extracted when compared to line charts.

 

USDJPY Daily- Line Chart

USDJPY Daily- Candlestick Chart

This is great and all, but what information can we extract and how can it be used?

How are candlesticks used in forex trading?

Because candlesticks show all the important prices during the specified timeframe, these price charts are a great way to gauge the supply and demand in a market as well as the emotions of market participants.

The distance between open and closing prices, as well as the size of wicks, leaves a trace of the buying and selling that takes place, and the strength that bulls and bears show in the market.

But how can you use these charts to gauge the emotions of traders and why would you want to? Well, emotion is one of the driving forces in the market, so having a way to determine the factors that are influencing others decision making is a huge advantage. Again, this is done by analysing the prices that are provided and understanding the reactions that market participants have to certain events, levels and market movements.

Ok, I am done beating around the bush, how can you use it in your trade execution? To be effective, candlesticks should be used alongside other technical analysis tools such as horizontal support and resistance, trendlines, Fibonacci, and indicators (for example MACD and Stochastics).

1. Act as signals to buy or sell

What I am about to say can significantly improve your trading, listen carefully, candlesticks should be implemented to time your entries, however, other forms of technical analysis (such as the ones mentioned) should be the basis for the placement of the trade.

For clarification, candlesticks alone do not constitute a trade, essentially, they are the best way for a technical analyst to time their entries and get the maximum profit. Another way to phrase this is they act as a signal to place a trade.

 

Candlestick signal to buy- GBPJPY H4

The bullish candlestick at support signalled that it was time to place a buy trade.

 

Candlestick signal to sell- NZDUSD H1

The bearish candlestick at the declining trendline indicated that it was time to place a sell.

2. Can be used for stop loss and take profit placement

Since these charts show supply and demand through the prices, candlesticks can also be used to determine where to place stop losses and take profits, again though, it is more effective to use alongside other tools.

 

Use in SL and TP placement- GBPJPY H4

Looking at the previous GBPJPY example, the low of the wick on the entry candle can be used as a reference to place the SL and the TP can be set at the level of resistance, the lowest closing price of the range.

By using the candlestick patterns to set these orders it is then easy for a trader to determine their risk vs reward.

Types of candlestick patterns:

Before we look at the candlestick patterns I need to mention something important, too many Forex traders are OCD about what the name of a specific candle or pattern is when the truth is it doesn’t matter!!! The market does not care about what name you give a pattern or formation, what matters is the forces of supply and demand that are at play during the formations of these patterns,

Stressing about the exact name doesn’t make you money, what makes you money is timing your entries based on the price action/ dynamics of the market. I will still list the most common names of candlesticks here, but I will also explain what the forces at play when these candlesticks are formed which is far more important.

Doji

A Doji candlestick occurs when the open and closing price is the same or very close together. This occurrence represents that the bulls and the bears were indecisive during that time i.e. neither side was dominant, Doji’s are common when there is uncertainty present in the market.

On the left, in the above example, the open and close were at the same price. In the middle, there is a slight bullish close but this is not a strong signal and the same goes for the slight bearish close on the right.

Wicks on Doji’s as well as the small bodies indicate a range during that period. Many traders think a Doji is a good entry signal when it is more of a pause, I would not recommend trading on these triggers.

Hammer and shooting star

Rejection of a certain level or event is what hammers and shooting start show, these signals are great entry opportunities because of the momentum behind them, I will explain using each case.

Hammers are bullish signals, the large wick (tail) shows that sellers tried to take the market lower but failed to do so, buyers then come in and buy to the point where there is a bullish close (body). When this occurs at important support levels, this is a good opportunity to buy since the structure and price action represent demand. Hammers are easy to remember since it looks like a hammer.

Shooting stars are bearish signals, the large upper wick shows that buyers tried to take the market higher but failed to do so, sellers then come in and sell to the point where there is a bearish close (body). When this occurs at important resistance levels, this is a good opportunity to sell since the structure and price action represent supply. Again, it is easy to remember as the pattern looks like a shooting star.

Power bars

Power bars (also called Marubozu candlesticks) are candles with a close at, or near, the high or low of the candle and are large by nature.

Bullish power bars have a close at or near the high of the candle, this means they have little or no upper wick, which signals strong demand. Furthermore, the fact that the candle is large adds to the strong signal to buy, since bulls were able to push the prices up drastically.

Bearish power bars have a close at or near the low of the candle, this means they have a little or no lower wick, which signals strong supply. The size of the candle also contributes to the strong sell signal since bears were able to push the price down so much.

Engulfing candles

Engulfing patterns, as shown, require 2 or more candlesticks. These patterns occur when a candle closes above the previous candle, or series of candles, that acted in the opposite direction. Does that sound confusing? Let us look at each separately and we will focus on the 2-candlestick pattern.

Bullish engulfing patterns occur when a bullish candlestick closes past the high of the previous bearish candle, this is significant because the buyers are showing that they are strong enough to push price past where the bears sold from. On a smaller timeframe, this is also a breakout out of the high of that candle, indicating strength from the buyers that will probably be carried with strong momentum.

Bearish engulfing patterns occur when a bearish candlestick closes past the low of the previous bullish candle, sellers are showing their strength by breaking past this price that the bulls began buying from. Again, this is a breakout on a smaller timeframe which indicates bearish momentum and strength.

Engulfing patterns are great entry signals at important technical areas since the pattern represents a current shift in supply and demand.

Determining the strength of candlesticks

Certain factors that influence the strength of a signal have already been discussed, now it is time to look at them as a whole.

 

1. The size of the body

Candlesticks with large bodies are stronger than there small counterparts because greater price movements show greater supply or demand.

 

2. Size of the wicks

Wicks can represent strong supply and demand, e.g. a bullish candle with a large lower wick shows strong demand (strong signal), as well as indecision, e,g. if a candle has large wicks but a small body then this shows indecision (weak signal).

 

3. Strength of the close

A close at or near the high is a strong bullish signal, a close at or near the low is a strong bearish signal. Candlesticks with strong closes are stronger than those with large wicks, in the direction of the close, sine the dominant side was not strong enough to close price at or near the high/ low.

 

You have probably realized that it is not just one factor that counts, instead all of the above, and the relationship between one another has to be considered when determining the strength of the signals provided by these charts.

 

There you have it ladies and gents, all you need to know about candlesticks. Now you can use this information and apply it in the way you trade trends or reversals, either way, candlestick charts provide great insight into the supply and demand of the Forex market.

 

Improve your timing, improve your profitability.

幸運を (good luck)

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