How to Trade Forex with Japanese Candlesticks

May 16, 2013 08:03 AM

Japanese candlestick charts are thought to have been invented in the 18th Century by a Japanese rice trader known as Munehisa Homma. Each bar of a candlestick chart is able to display the open, high, low and close prices for a given time interval and are thus able to show the trading range for a period of time. Today they are the most popular way of viewing financial data since they are able to convey much more information than other graphs such as line or bar charts.

A candlestick is composed of a body and an upper and lower shadow, known as the wick. The wick demonstrates the highest and lowest prices that the market traded at during the particular time interval, while the body shows the opening and closing prices of the market. If the market closed above the open, the candlestick will have a white or green body, whereas, if the market closed below the open, the body will be black or red. Similarly, if the market closed exactly where it opened, the candle would have no body at all.

In order to trade using Japanese candlesticks, it is essential to know the different candlestick patterns and what they mean.

Spinning top

The spinning top pattern is characterized by a small body and long wick on both sides of the body. It shows that the market has gone up, gone down and then ended up pretty much where it started. It shows the market is undecided and is not sure where to go next.

 

Doji

Dojis often indicate reversals since they represent markets with a lot of uncertainty.

A doji, where the open price matches the close price with a long wick shows a lot of indecision and is called a long legged doji.

 

This is a gravestone doji. The market has been up but has rejected the higher levels and signals a major turning point in the trend may be near.

 

Dragonfly, is opposite to the gravestone doji. The market has gone lower but closes near its highs, meaning the down trend may likely be nearly over.

 

White Marubozu

A white marubozu occurs when the market opens then climbs strongly and finishes the day near its highs. It’s therefore represented by a large white or green body with no wick. It’s a strongly bullish indication.

 

Black Marubozu

Likewise, a black marubozu occurs when the market finishes near its lows and is a bearish indicator since it shows the market is moving in a strongly downward fashion.

 

Hammer

A candle can only be called a hammer when it occurs during a down trend and the market trades down to its lows but then finishes back where it started.  As such, the market is said to be ‘hammering out a bottom’ and is a very good reversal indicator. Although it’s often wise to wait another couple of bars for confirmation before trading on the basis of one candle.

Hanging Man

A hanging man indicates a possible top in the market and could be a sign of a possible reversal in an uptrend. Although the market has finished near its highs, the long tail down, indicates that sellers are coming in and beginning to outnumber the buyers. Once again, the candle should only be acted upon with confirmation from another signal or indicator.

Shooting Star and Inverted Hammer

A shooting star occurs when the price moves higher in the midst of an upward trend but ends the day near its lows. In other words, the market has moved up but has been unable to sustain the move leading to sellers driving the market back down. It’s a strong reversal indicator.

An inverted hammer occurs during a downward market. The market is bought up but sellers are able to bring the market back down. However, there are not enough sellers to keep the market going lower, therefore its likely buyers will regain control of the market soon.

 

Bullish and Bearish Engulfing

A bullish engulfing pattern occurs when a bearish candle is immediately followed by a strong Maribozu or bullish candle. It signals that a strong up trend may be on the cards, since buyers have managed to outnumber sellers strongly.

Similarly, a bearish engulfing pattern occurs when a bullish candle is immediately followed by a strong bearish candle and indicates the trend may change downwards.

 

Three White Soldiers and Three Black Crows

There are triple patterns too. Three white solders occurs during a down trend when markets are declining but are then hit with three solid bullish candles that signals the beginning of a strong upwards move. To be considered valid, the first candle must be a reversal, with the second candle being larger than the first. Additionally, the third candle should be at least as big as the second and all candles should finish near their highs with little shadow showing.

Thee black crows are essentially the opposite of three white soldiers. For the pattern to be considered valid, the crows must occur during an upward trend with the first candle being a reversal. The second candle should finish near its lows and be bigger than the first and the third candle should be at least as big as the second candle. All the candles should finish near their lows with little to no shadow. The less shadow (or wick) that there is, the stronger the move is likely to be.

Morning Star

A morning star needs the following characteristics to be valid. Firstly the market must be in a down trend and have a bearish candle. This should then be followed by a doji of some kind, indicating indecision in the market. The third candle should then be a strong, bullish candle. This is a clear indication that down trend is coming to an end and the market is reversing.

As well as these patterns there are others such as evening stars, tweezer patterns, three inside up, three inside down. Candlesticks should probably not be used to trade on their own but they are excellent tools to have in the armoury.


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