Welcome to my Masterclass.
In this lesson you will learn what the foreign exchange market is all about and how we are able to take advantage of the worlds biggest exchange.
In this chapter we'll teach you all about the most common (and most traded) candlestick patterns. When certain types of candles are in a certain formation, a deeper meaning can be given to them as they represent sentiment in the market. Because the majority of traders are 'technical traders', meaning they base their trading decisions off the price action that is visible on the chart it becomes a sell fulfilling prophesy and that is why these candle stick formations or patterns 'work'.
Human behaviour is often very predictable and patterned. Understanding why these patterns form and what they mean in terms of market sentiment, will explain their shape and place in the chain of candles that makes up price.
In the previous lesson we focussed on individual candlesticks. In this chapter we will focus on the most common and powerful patterns that are used by the masses.
Note; there are way more patterns than we will describe in this chapter. You can read up on them if you like but you do not need to know them for the strategies that we are going to teach you.
An engulfing bar fully engulfs the previous candle(s). Ideally the engulfing candle fully engulfs the previous candle(s) including their wicks. Although this is not mandatory, an engulfing candle that engulfs the previous candle including their wicks, is more powerful than an engulfing candle that only engulfs the previous candle real-body. Also, the more previous candles it engulfs the more powerful it is. We will discuss in our chapter "multi time frame analyses" why this is. There is a bullish and a bearish version, they behave like opposites:
The bullish version implies buyers dominance.
Buyers (smart money) initially pushed price lower, trapping sellers thinking price would continue to fall. Once these sellers were in the trade, the buyers pushed price back up with momentum. Sellers, who are now in a losing position, are liquidating their selling positions (by buying their position back), which leeds to a flood of extra buying pressure. Once the previous candle high was broken (this is often used as a stop-loss area), more sellers had to buy back their position which leeds to an even greater buying pressure. Result: a bullish candle that completely engulfs the previous candle.
When this pattern occurs in a downtrend it could signal the end of the downtrend, or signal a trend reversal when combined with other 'evidence'.
The bearish version shows us sellers dominance.
Sellers (smart money) initially pushed price higher, trapping buyers who were expecting price to rise even further. Once these buyers were in the trade, the sellers pushed price back down with momentum. Buyers, who are now holding a losing position, are forced to sell their long positions which leads to a flood of sell orders, pushing price down. Once the previous candle low was broken (this is often used as a stop-loss area), even more buyers had to sell their position to cover their loss which leads to an even greater selling pressure. Result: a bearish candle that complete engulfs the previous candle.
When this occurs in an uptrend it could signal the end of the uptrend or even signal a reversal when combined with other 'evidence'.. Try it for yourself, open a couple of charts and look if you can find engulfing patterns for yourself.
Even though this pattern is a nice indication of a trend reversal, it alone is not a signal to trade. We need to build a 'case of evidence' for such a trend change, and this is one of the pieces of evidence that can be used. In this course we'll go over every piece of evidence that contributes to our trading decisions. This is just evidence item #1 (candle shape patterns).
A Doji is one of the best known candlestick patterns. It is a candle that has opened and closed approximately at the same price, and so it looks like a cross. It means buyers and sellers are indecisive, and it is not yet clear what direction the market will go. When it happens in a trend it signals that the trend is slowing down and possibly reversing.
In the bullish example (left) we see price is in a downtrend with sellers dominance. After the doji formed, sellers are unable to keep the price down as buyers buy the price back up, and rice fails to close lower. The beginning of the reversal to the upside was staged by the doji candle at the lowest price point.
This example is oversimplified but it demonstrates the case. In live trading and before every trend change we are seeking for evidence of the current trend slowing down. This can mean various things, which we will get into in the chapter "deceleration".
In the bearish example (right) we see price is in an uptrend with buyers dominance. Once the doji candle formed, indicating the buyers failed to push the price up, sellers pushed it down and price failed to close higher. Again the doji candle was the start of the reversal (in this case to the downside).
After a trend, and at support or resistance, a doji candle is often a reversal signal. In all other situations it is a signal of indecisiveness, a balance (equilibrium) between buyers and sellers.
Dragonfly doji candlestick
A bullish Dragonfly doji signals a strong support level. At this price point sellers are unable to push prices lower, before buyers are stepping in to prevent this support level from being broken.
Price probed down that level, but was bought back up by the buyers, as it failed to close lower. It means demand is starting to outweigh supply. This kind of doji is an even stronger indication for trend reversal or end of the trend than the regular doji.
In a downtrend it is a bullish signal, indicating that lower prices are rejected. Again this candle shape is just one "piece of evidence" when trying to pin point a reversal area. As with all candle shapes, it is only valid when it occurs at a support or resistance level. The dragonfly doji candle looks like the hammer candle, which we shall discuss later on in this chapter.
Gravestone doji candlestick
Mirroring the dragonfly candle and price action horizontally we get the gravestone candlestick.
Opposite to the dragonfly doji, this is gravestone doji is a bearish signal. Again open and close levels are (approximately) the same, but the tail is to the upside. It indicates price tested a resistance zone, but failed to stay up as sellers brought it back down.
In an uptrend it is a bearish signal indicating that higher prices are rejected, and price might be ready to change direction. Again this candle shape is just one "piece of evidence" when trying to pin point a reversal area. As with all candle shapes, it is only valid when it occurs at a support or resistance level. The dragonfly doji candle looks like the hammer candle, which we shall discuss later on in this chapter.
Many traders find the hammer candle stick, and its inverted brother, the shooing star, the most powerful reversal candle of them all. Certainly if two of them sit right next to each other. Although the official name for this candle is the hammer, we often like to call it a "low-test candle". Because that is what it is doing, it is testing the lows for support.
A hammer candle consists out of a very short real-body and a long wick to the downside. The hammer candle is quite similar to the dragonfly doji candle, with the difference that the open en close prices are not quite the same. A hammer candle with a green body, signaling that price closed higher than it opened, is more powerful than a red hammer candle, where prices still closed lower than it opened with. In the example below we see a hammer candle with a reds body, which is still valid but has less weight than a hammer with a green real-body.
The same goes for a hammer candle after an uptrend, which is called a "shooting star". It is a candle shape that tested some kind of support and failed to close above it. A shooting star candle is also called a "high-test candle", as that is what is it doing; testing the highs for resistance.
A shooting star candle consists out of a very short real-body and a long wick to the upside. The shooting star candle is quite similar to the gravestone doji candle, with the difference that the open en close prices are not quite the same. A shooting star candle with a red body, signaling that price closed lower than it opened, is more powerful than a green shooting star candle, where prices still closed higher than it opened with.
A hammer, or low-test candle represents price falling but hitting some kind of "resistance". Resistance when price is falling, but fails to close below is called "support". This could mean price has come down to a level where sellers are looking to take profit for instance (because this level was rejected before). As we know by now, as sellers close their position for a profit, they buy back the position they "lend" from their brokers. This equals buying the currency pair - hence prices go up.
Another reason could be that, as this level was reject before, new buyers are stepping in, expecting price to turn from bearish to bullish and make some money off the rally that might follow. It is probably the combination of both reasons why this candle pops up at a respected area of support. We'll get into what support and resistance means, and how to spot and use it later in this chapter.
Morning star candlestick pattern
The morning star candlestick pattern is a reverence to the sun coming up in the morning and rising above the horizon (as symbolized by the lowest reversal candle) and is a bullish reversal candle shape pattern:
It happens in a downtrend and consists of three candles:
First a bearish candle, long enough to indicate sellers are still in control;
Next a small or doji candle or a low-testing hammer candle indicating sellers lost momentum. This can be a bullish or bearish candle;
Lastly a bullish candle, long enough to indicate buyers convincingly took over control.
Like with singe candles, this pattern is only reliable if it happens in a downtrend and at a support level.
Evening star candlestick pattern
The evening star candlestick pattern is a reverence to the stars standing high up in the sky at nigh (as symbolized by the highest candle in the formation) and is a bearish reversal candle shape pattern. It looks like the morning star, but flipped horizontally:
It often occurs in an uptrend and like the morning star formation the pattern also consists out of 3 candles:
The first candle is a bullish candle;
The second candle is a doji or shooting star candle. This candle can be bearish or bullish. It indicates the buyers lost strength and a possible end of the trend or trend reversal is near;
The third candle is a bearish one, long enough to indicate sellers convincingly took over control.
Like with single candles, this pattern is only reliable when it happens in an uptrend and at a resistance level.
Harami candlestick or “Inside-bar” Pattern
The Harami or Inside-bar candlestickpattern is a two candle formation. The body (and preferably the wicks) of the second candle is contained within the body of the first candle. In japanese Harami stands for “pregnant”, as the first candle is large and is called “the mother candle” and it contains the second smaller candle called “the baby candle”.
Again there are both bullish and bearish versions of this pattern. The most important property of this pattern, is that the second candles closes within the real-body of the first candle. This formation is also a sign of indecisiveness as price often consolidates at this level.
But be aware, this doesn’t mean price will reverse, it can also signal a pause in momentum, whereafter price will just continue its trend.
Tweezer Tops and Bottoms
Tweezer tops or bottoms are the holy grail in candle shapes if they occur at a key support or resistance level. Tweezer tops are two high-test candles next to each other, and are formed when buyers push prices higher only for sellers to push prices back down again. During the interval of the next candle, buyers once more try to push prices higher but fail again. This is is very strong signal that the buyers (bulls) are not in control of price any more and the bears could take over, resulting in a decline of price. As you will learn to understand later, tweezer tops are actually a double top pattern on a lower time frame, which is a strong reversal price pattern.
The inverse of the tweezer top pattern is the tweezer bottom, which consists out of two low-test candles right next to each other. This candle shape pattern signals the end of a down trend when they form at a key support level. The bears tried to push prices below the support level during the first candle but were unable to do so. During the second candle they tried again but failed once more. The failed second attempt is seen by many as the end of the down trend and the beginning of prices going up.
As you will learn to understand later, tweezer bottoms are actually a double bottom pattern on a lower time frame, which is a strong reversal price pattern.
One thing to note is that the color of the body of both tweezer candles irrelevant and is still valid in all combinations. However it is most powerful if the second testing candle is in the color of the expect trend. As per the example above; in a tweezer bottom formation, the first candle is preferably red and the second candle is preferably green. All this means is that after the second rejection of support price was able to close higher than it opened, signaling strength.
In this chapter we have shown you the most popular and powerful candlestick patterns. There are many more candle shape patterns and feel free to read up on them if you have the desire. With our trading strategies however you will not need to be able to recognize any other. But as you might have noticed while reading this chapter, the candle shapes themselves and the candles that reside right next to them tell you exactly what buyers and sellers are "thinking". This raw and naked way of looking at price, is the very basis and most important in trading any asset class and is called price-action based trading.
Although candlestick patterns are very powerful indeed, as many traders trade based on these patterns, we would never use them without any other technical analysis and confluence such as support and resistance.
In the next chapter we will talk about support & resistance and how it plays an important role in trading.