Table Of Contents
Reading a Forex Chart with Candlesticks
4
Pros and Cons of Using Candlestick Charts Compared to Line and
Bar Charts
5
Different Types of Candlestick Patterns Convey Different Messages
5
Candlestick Chart Reading Like a Pro
9
Combining Technical Analysis Indicators with Candlestick Patterns
12
Conclusion
13
Hammer Pattern In Technical Analysis
13
Bullish Hammer Candlestick Examples
15
Inverted Hammer Candlestick
17
Trading Hammer Candlestick Pattern
18
Forex Hammer Candlestick Trade In NZDJPY
19
Forex Hammer Candle Trade In AUDJPY
20
Summary
22
Shooting Star Pattern In Technical Analysis
22
Bearish Shooting Star Candlestick
24
Shooting Star Trading Strategy – Counter Trend Setup
26
Shooting Star Trading Example – Counter Trend Setup
27
Shooting Star Trading Strategy – Pullback Setup
29
Shooting Star Trading Example – Pullback Setup
30
Summary
31
What Is The Doji Candlestick Pattern?
32
Types Of Doji Candlestick Patterns
33
Double Doji Trading Strategy
38
Bullish Doji Candlestick Trade Setup- GBPUSD
39
Bearish Doji Candlestick Trade Setup – USDCAD
40
Final Thoughts
41
What is the Japanese Engulfing Candlestick Pattern?
41
Potential of the Engulfing Candlestick Setup
42
Types of Forex Engulfing Patterns
43
Bullish Engulfing
43
Bearish Engulfing
44
Engulfing Trading Pattern Confirmation
45
Engulfing Trading Strategy
45
Engulfing Pattern Trade Entry
45
Engulfing Pattern Stop Loss
46
Engulfing Pattern Take Profit
47
Engulfing Pattern and Price Action Strategy
47
Engulfing Patterns at Support and Resistance
48
Dark Cloud Pattern In Technical Analysis
51
Psychology Behind The Dark Cloud Pattern
53
Bearish Dark Cloud Cover In Uptrend
54
Dark Cloud Cover At Horizontal Price Resistance
55
Dark Cloud Cover At Upper Bollinger Band
56
Trading Dark Cloud Cover Candlestick Pattern
57
Dark Cloud Trading Example
58
Summary
59
Candlestick Reading
60
Why Are Candlesticks Important?
61
Piercing Line Candlestick Pattern Example
61
Bullish Piercing Line Pattern Example
63
How To Trade The Piercing Line Pattern
63
Piercing Line Pattern with Indicators
64
Bearish Piercing Line Example
66
Bearish Piercing Line With RSI
68
Final Thoughts
69
Morning Star Candlestick Pattern
69
Bullish Morning Star At Key Support
71
Bullish Morning Star With Stochastics
73
Morning Star Trading Strategy
74
Morning Star Pattern Strategy Example 1
75
Morning Star Candlestick Setup Example 2
76
Summary
77
Evening Star Candlestick Pattern
78
Bearish Evening Star Candle Pattern At Resistance
79
Bearish Evening Star With RSI Indicator
80
Evening Star Trading Strategy
81
Evening Star Trade Setup Example 1
83
Evening Star Setup Example 2
84
Summary
85
Learning to read candlestick charts is a great starting point for any technical
trader who wants to gain a deeper understanding of how to read forex
charts in general. As you may already know, Candlestick charts were
invented and developed in the 18th century. The earliest reference to a
Candlestick chart being used in nancial markets was found in Sakata,
Japan, where a rice merchant named Munehisa Homma used something
similar to a modern Candlestick patterns to trade in the Ojima rice market in
the Osaka region.
Although bar charts and line charts were quite popular among Western
traders, Japanese Candlestick charts and additional patterns were
introduced to the Western nancial markets in the early 1990’s, by a
Chartered Market Technician (CMT) named Steve Nison. The popularity of
Candlestick charts has soared among Western market analysts over the last
few decades because of its highly accurate predictive features. Candlestick
charts can play a crucial role in better understanding price action and order
ow in the nancial markets.
Reading a Forex Chart with Candlesticks
Before you can read a Candlestick chart, you must understand the basic
structure of a single candle. Each Candlestick accounts for a speci ed time
period; it could be 1 minute, 60 minute, Daily, Weekly exc. Regardless of the
time period, a Candlestick represents four distinct values on a chart.
. The opening price at the beginning of the time period
. The closing price at the end of the time period
. The highest price during the time period
. The lowest price during the time period
As you can see in gure 1, when you read a candle, depending on the
opening and closing prices, it will provide you information on whether the
session ended bullish or bearish. When the closing price is higher than the
opening price, it is called a Bullish Candlestick. By contrast, when the closing
price is lower than the opening price, it is known as a Bearish Candlestick.
And the upper and lower shadows of the Candlestick represent the highest
and lowest price during the time period.
Pros and Cons of Using Candlestick Charts Compared
to Line and Bar Charts
Compared to Western line charts, both Bar and Candlestick charts offer
more data to analyze.
Although the same four values are also found in Western-style bar charts,
the bar chart uses horizontal lines on the sides of a vertical line to project the
opening and closing prices. But, a series of Candlesticks on a chart can help
traders identify the character of price action more de nitively, which helps in
the decision-making process.
With Candlesticks, it is much easier to interpret the price action during the
time period because a Bullish Candlestick shows a full body with a pre
designated color and a Bearish Candlestick a full body with a different pre
designated color. As a result, many professional traders have moved to using
Candlestick charts over bar charts because they recognize the simple and
effective visual appeal of candlesticks.
However, while Candlestick charts make it much easier to interpret price
action, it lacks the smoothness of the line chart, especially, when the market
opens with a large gap. Hence, professional traders often end up using a
short time period moving average to get the “feel” of a smooth trend, or lack
of trend, in the market. So, it can be a good idea to add a moving average to
the chart while using Candlestick charts.
Different Types of Candlestick Patterns Convey Different
Messages
Each Candlestick represents an Open, High, Low, and Close value. The
location of the opening price, how high or low price reached during the
candle session, and where the price closed at the end of the time period are
all factors in understanding candlestick charts.
Over the years, Japanese traders had developed various Candlestick
patterns based on historical price movements. Every trader should invest
their time and learn these patterns as it will provide a deeper knowledge
and understanding of reading forex charts in general. Candlestick patterns
can help you interpret the price action of a market and make forecasts
about the immediate directional movements of the asset price.
While there many different patterns, we will discuss some of the most
popular Candlestick patterns that can help in reading a price chart like a
professional trader.
A candlestick reading can provide us with information on the three market
sentiments: bullishness, bearishness, and a neutral or tentative market
condition.
Below are some candle formations that can help us gauge market
sentiment:
Figure 2: Various Types of Simple Candlestick Formations
Referring to the above illustration, A bullish Candlestick like the Big White
Candle indicates bullish trend continuation, while a bearish Candlestick like
the Big Black Candle indicates bearish trend continuation. On the other
hand, a Doji Candlestick represents a neutral or tentative market condition.
So when you are reading candlestick charts, you need to keep in mind
which Candlestick patterns indicate additional bullishness and which ones
indicate further bearishness, as well as which ones indicate a rather neutral
market condition and act accordingly.
The list of simple Bullish Candlestick Patterns include Big White Candle,
Hammer, Inverted Hammer, and so forth. By contrast, the list of simple
Bearish Candlestick Patterns includes Big Black Candle, Gravestone Doji,
Hanging Man, Inverted Black Hammer, etc.
If you are chart reading and nd a bullish candlestick, you may consider
placing a buy order. On the other hand, if you nd a bearish candlestick, you
may choose to place a sell order. However, while reading Candlesticks if you
nd a tentative pattern like the Doji, it might be a good idea to take a step
back or look for opportunities elsewhere.
When you are reading a Candlestick price chart, one of the most important
things to consider is the location of the Candlestick formation. For example,
a Gravestone Doji appearing at the top of an uptrend can indicate a trend
reversal. However, if the same pattern appeared during a longstanding
downtrend, it may not necessarily mean bearish trend continuation.
We will further discuss the importance of location of Candlestick patterns in
some example trades later.
In the next section we will discuss some complex candlestick patterns. Let’s
take a look at the illustration below:
Figure 3: Examples of Some of the More Complex Candlestick Patterns
Once you have mastered the identi cation of simple Candlestick patterns,
you can move on to trading more complex Candlestick patterns like the
Bullish and Bearish 3-Method Formations.
The main difference between simple and complex Candlestick patterns is
the number of Candlesticks required to form the patterns. While a simple
Candlestick pattern, like the Hammer, requires a single Candlestick, the
more complex Candlestick patterns usually require two or more
Candlesticks to form.
For example, the Bullish Harami requires two Candlesticks, the Three White
Soldiers pattern requires three Candlesticks, and the Bullish 3 Method
formation requires 4 candles.
Once again, remember that regardless of the complexity, the location of all
these simple and complex Candlestick patterns is one the most vital
aspects of reading forex charts while using Candlesticks.
Candlestick Chart Reading Like a Pro
By now, you should have a good idea about what a Candlestick is and how to
read simple and complex Candlestick patterns. So, let us now try to read
trading charts to see how we can trade using these patterns.
Figure 4: Forex Chart Reading Using a Simple Engul ng Bullish Candlestick
Pattern
In this example in gure 4 of the GBPJPY daily chart, we can see that the
GBPJPY price was bouncing around a strong support level but failed to break
below it. On the third try, the GBPJPY did penetrate the support level, but
the market swiftly reversed and formed an Engul ng Bullish Candlestick
pattern that signaled further bullishness in the market.
At this point, some beginner traders may recognize the bullish setup and
immediately enter a buy order. However, professional traders are not only
waiting for Candlestick patterns to form around key pivot zones, like this
support level in gure 4, but they will also wait for the proper con rmation to
enter the trade.
The next day, the GBPJPY price penetrated above the high of this Engul ng
Bullish Candlestick, which con rmed that there would be additional
bullishness in the market over the next few days.
Professional traders wait for this con rmation because they understand the
concept of order ow and self-ful lling prophecy.
You see, most large banks and hedge funds also watch key market levels
and price action around critical levels. Once the Engul ng Bullish
Candlestick formed around this crucial support level, it prompted a
signi cant number of pending buy orders just above the high of this
Engul ng Bullish Candlestick. Once the price penetrated above the high, it
triggered those orders, which added the additional bullish momentum in
the market.
Hence, waiting for the price to penetrate above the Candlestick pattern can
help you increase the odds of winning on the trade.
As you can see in gure 4, once the buy order con rmation came, it did
trigger a large uptrend move over the next few days.
As we brie y discussed earlier, the location of the Engul ng Bullish
Candlestick for this particular trade was the most important factor. First, it
formed around a major pivot zone, where the GBPJPY Bears had failed to
break the support area in the previous two attempts.
When you apply Candlestick patterns with additional technical con uence,
it provides for a powerful combination of factors that can help increase your
odds of winning. And this is exactly what professional traders try to do.
If the same Engul ng Bullish Candlestick pattern appeared at the top of a
longstanding uptrend, it would have also signaled additional bullishness in
the market, but that signal would be much less powerful. Since the market
was already in an uptrend, it may not have had the legs to push the price
much higher.
However, on this instance, the market was already trading in a range for
several days. As you may know, when the market consolidates for a while, it is
basically setting up to breakout in one direction or the other. The formation
of this bullish Candlestick pattern provided a signal as to of which way the
market was about to break.
If you knew how to read a simple Candlestick pattern like the Engul ng
Bullish pattern, you could have entered this trade at the right time and
earned a handsome pro t with this high reward to risk ratio setup.
Figure 5: Three White Soldiers Candlestick Trend Reversal Pattern
In gure 5, we can see two different Candlestick patterns triggering two
different trades. On the rst occasion, the Engul ng Bearish Candlestick
pattern appears during a downtrend that provides traders with a trend
continuation signal. On the second occasion, a Three White Soldiers
Candlestick pattern emerges at the bottom of the downtrend, which
triggers a new bullish trend.
In the rst trade, the AUDUSD was already moving to the downside. Once
the Engul ng Bearish Candlestick broke below the support level, it opened
up the possibility of a trend continuation. The next day, AUDUSD price
penetrated below the low of the Engul ng Bearish Candlestick and
con rmed the trade, which triggers the sell order.
It is strongly recommended that beginning traders stick to using Engul ng
Bearish or Bullish patterns to con rm a trend reversal, as those tend to be
higher probability trades. However, this particular example in gure 5
demonstrates that if you know how to use the con uence of support and
resistance levels along with Candlestick patterns, these can be used to
trigger trend continuation signals as well.
In the second trade, the Three White Soldiers Candlestick pattern emerged
near the bottom of this downtrend. At this point, professional traders for
preparing for the market to reverse the prevailing downtrend. The prudent
course of action would be to wait for the market to con rm this signal, which
means that unless the price broke above the high of this Three White
Soldiers Candlestick pattern, you would not have entered the trade.
Combining Technical Analysis Indicators with
Candlestick Patterns
Candlestick chart reading is largely based on the principle of technical
analysis, which assumes that regardless of the underlying fundamental or
economic conditions, the current market price re ects “all known
information” regarding the asset.
Hence, the reason why an asset is moving in a certain direction is often not
necessarily important to technical traders. Instead, they are more interested
in interpreting what the price action is doing at the current moment and
how they can take advantage of that. Furthermore, technicians know that
the underlying reasons for market uctuations over time can be many, and
often the market does not always act “rational.”
Candlestick chart reading can be most useful during these volatile periods of
irrational market behavior.
Traders can apply overbought and oversold technical indicators like
Stochastics or Relative Strength Index (RSI) to nd out when such irrational
market conditions may be present.
For example, by using oscillating technical indicators, a trader will rst wait
for a signal that the market has moved into an overbought or oversold
condition. At that point, they would look for a reversal signal of the prevailing
trend. Many times, this reversal signal will come in the form of a candlestick
formation.
Formation of a simple or complex Candlestick pattern during such market
condition con rms and veri es the impending contrarian price action for the
trader. Placing their order in the market using this combination of technical
factors can signi cantly improve the accuracy of their trades.
Once you learn how to correctly read Candlestick patterns and combine this
skill as part of a broader trading strategy, then you will likely improve the
consistency of your market entries and your overall performance as a trader.
Conclusion
By now, you should be able to see the value of investing your time to learn
how to read a Candlestick chart, and how to interpret the various simple and
complex Candlestick patterns that we discussed. So before you start trading
with Candlestick patterns, it is important to understand why and how these
patterns work.
Once you master the basics of Candlestick chart reading, it can help you
integrate this unique knowledge into your existing trading strategy and lead
to better accuracy and improve your trading performance in the long run.
Hammer Pattern In Technical Analysis
The hammer pattern is one of the rst candlestick formations that price
action traders learn in their career. It is often referred to as a bullish pin bar, or
bullish rejection candle. At its core, the hammer pattern is considered a
reversal signal that can often pinpoint the end of a prolonged trend or
retracement phase. We will dissect the hammer candle in great detail, and
provide some practical tips for applying it in the forex market..
The hammer pattern is a single candle pattern that occurs quite frequently
within the nancial markets. It is often seen at the end of a downtrend or at
the end of a corrective leg in the context of an uptrend. Hammer candlestick
patterns can also occur during range bound market conditions, near the
bottom of the price range. In all of these instances, the hammer candle
pattern has a bullish implication, meaning that we should expect a price
increase following the formation.
Let’s take a closer look at what the actual hammer candlestick appears like.
Below you will nd the illustration of a hammer candle.
The hammer formation has a few important characteristics that we need to
keep in mind in order to label it correctly as such. The rst characteristic is
that lower shadow or wick as its often called, is relatively large in comparison
to the body of the candle and the upper wick. Typically we want the lower
wick to represent at least two thirds the length of the entire candle
formation.
Additionally, the body of the hammer candlestick will appear towards the
upper range of the formation and represent approximately one third or less
of the entire formation. The upper wick should be relatively small or
nonexistent within this entire structure.
Now that we understand the essential structure of the hammer chart
pattern, what can we gauge from this particular formation? Well, let’s take a
look at the market psychology inherent within the hammer candlestick. The
relatively large lower wick within the structure can be viewed as a price
rejection. That is to say that what is actually occurring behind the scenes is
sellers make an attempt to push prices lower, which they are able to do, but
only on a temporary basis.
This is because the buyers step into the market to take the other side of
that order ow and eventually overwhelm the sellers orders. This causes the
price to close near the upper end of the candle formation. As such, we can
say that during the speci c time interval in which the hammer candlestick
formed, demand from the buyers exceeded supply from the sellers,
signaling a strong potential for an upside price move.
Price action traders typically utilize the hammer candlestick in two primary
functions. The rst and more popular use of this formation is as an entry
technique. When you see a hammer candlestick form around a key support
level such as a trendline, a horizontal price line, a Fibonacci retracement level,
a round number, or an important moving average line, it can be used as a
signal to enter a long position in the market. In addition to this, candlestick
traders who may be in a short position also watch out for this formation,
using it speci cally as a signal to exit their short position. So in this sense, it
can be used as part of a trade management strategy.
So far, what we have described is the traditional hammer candlestick. This
should not be confused with the inverted hammer candlestick pattern
which has a different type of appearance, but wherein the implication is the
same. That is to say that an inverted hammer candlestick also has a bullish
implication. We’ll be taking a closer look at the inverted hammer candle a bit
later.
Bullish Hammer Candlestick Examples
Let’s now take a look at a few examples of a bullish hammer as seen on a
forex price chart. Below you will nd the candlestick chart for the GBPUSD
currency pair shown on the daily timeframe.
Starting at the far left of the price chart, we can see that the price action
here has been carving out a downtrend. After some period of consolidation
and a minor upside retracement, prices resume their downward descent
and eventually a bullish hammer candlestick pattern emerges. After the
bullish hammer candle completes, a price reversal occurs in the market, and
prices began to rise steadily.
If you look closely at the bullish hammer within the circled area, you can see
that this candle meets all of our required characteristics for a hammer
formation. More speci cally, notice how the length of the lower shadow is at
least two thirds of the entire formation. Additionally you can see that the
body of the hammer candle is relatively small and closes near the upper end
of the range. Finally, notice the relatively small upper wick within this
formation.
Let’s now turn to another example. This time we will illustrate the hammer
candlestick in an uptrend. Below is the chart for the AUDNZD forex pair
shown on the daily timeframe once again.
Notice on this chart, the price starts off by forming an uptrend with
successively higher highs and higher lows. Towards the center of the chart
we can see that the momentum of the uptrend begins to wane, and the
price subsequently moves lower within a corrective or retracement phase.
You can see the three distinct price legs within that retracement lower. It’s a
down, up, down sequence. Can you see that? This is often referred to as a
zigzag correction or ABC correction.
Eventually we can see that the nal candle within this corrective structure
forms a bullish hammer formation. That would have provided us with an
early notice that the corrective phase is nearing an end, and we should
expect prices to move higher in the direction of the larger trend.
Immediately after the bullish hammer formation, we can see two strong
bullish candles form that propel the price of this currency pair higher.
One thing that we should note as it relates to hammer formations is that it is
dif cult to gauge the extent of the price move resulting from the bullish
hammer formation. Nevertheless they can provide for an excellent timing
signal for entering a long trade, as we have seen in the above two examples.
Inverted Hammer Candlestick
The inverted hammer chart pattern is a variation of the traditional hammer
pattern. Essentially, it appears as an upside down hammer formation. That is
to say that within the inverted hammer candlestick, the relatively long wick
appears above the candle’s body, and it is typically at least two thirds the
length of the entire formation. You can see an illustration of the inverted
hammer formation below.
If you’re familiar with different candlestick patterns, you will recognize the
above formation as being similar in appearance to the shooting star
formation. The primary difference between the inverted hammer and the
shooting star is the location in which it appears. A shooting star formation
typically occurs near the top of a trading range, or at the top of an uptrend.
The inverted hammer pattern on the other hand is usually seen in the same
locations as the traditional hammer formation we studied earlier. That is to
say that the inverted hammer will occur at the bottom of a price range in a
range bound market, at the bottom of a downtrend, or during the end of a
bearish correction within the context of a larger uptrend.
Now although the inverted hammer candlestick is one that candlestick
traders should be familiar with, it is the traditional hammer candlestick that
provides the more reliable and powerful trading signal. As such, it’s best to
focus on the hammer pattern because it will provide us a better probability
of success compared to the inverted variation.
Trading Hammer Candlestick Pattern
Let’s now build upon our knowledge of the hammer candlestick pattern.
We’ll create a price action strategy for trading this pattern. We will rely only
on the naked price chart for this strategy, and thus not need to refer to any
trading indicators or other technical study. Although this hammer trading
strategy may appear overly simplistic, it is nevertheless, very effective when
traded under the right market conditions.
This strategy is best traded on the higher timeframe charts such as the daily
and weekly time frames. You may consider going down to the 480 or 240
minute chart, but keep in mind that the best and highest probability signals
will occur on the higher time frames noted. Additionally, it can be applied to
any currency pair or nancial instrument, so long as it is fairly liquid.
So here are the conditions for entering a long position using this Hammer
strategy:
Locate a hammer candlestick on the price chart.
A well-de ned downtrend should be in place prior to the formation of the
hammer candle.
The hammer candle should be at least equal to or larger than the average
length of the candles within the downtrend.
Enter a long position immediately following the hammer candle’s formation,
assuming the above conditions have been met.
The stoploss should be placed just below the low of the hammer candle.
The take pro t target will be equal to the length of the hammer candle
measure from the high of the hammer candle.
Forex Hammer Candlestick Trade In NZDJPY
Now that we have clearly outlined the hammer candle trading strategy, let’s
illustrate an example on a real price chart. Below you will nd the daily chart
of the New Zealand Dollar to Japanese Yen currency pair.
As we can see from the price action, there was a steady decline in the price
of the NZDJPY currency pair. Towards the middle part of the chart, we can
see that the prices began to compress in a tight consolidation structure.
Soon afterwards, another price leg ensued to the downside which ended
with the formation of a hammer candlestick.
Notice how the hammer candle meets all of the three requirements that
validates its pattern. The lower shadow within the hammer formation is at
least two thirds the length of the entire candle. The body of the candle is
relatively small and is situated in the upper third of the candle’s range. And
the upper shadow is nonexistent, or minimal compared to the size of the
lower shadow. With these three requirements met, we can con rm that the
candle that we are analyzing is a valid hammer formation.
Now, we can move on to the next step to see whether or not a viable trading
opportunity exists. To do so, we have to con rm that a prior downtrend was
in place prior to the hammer candlestick formation. Obviously we can see
here that this condition clearly exists. Let’s now go back to the hammer
candle itself to study it’s size in relation to the average candle size within the
progression of the downtrend.
We can do this quantitatively by using an indicator such as the Average True
Range, ATR indicator. However, keep in mind our strategy does not explicitly
call for utilizing any type of indicator study. As such, if we just eyeball the
hammer formation, we can be pretty con dent that it is larger in size than
the average candle within the downtrend. And with that piece of
con rmation, we can prepare for a long trade in the NZDJPY currency pair.
Now that all of our conditions have lined up, we can immediately place a
market order to go long. The stop loss for this trade would be set at a level
just below the low of the hammer formation. This is noted on the price chart
and shown below the entry. Finally, we will utilize a one-to-one measured
move technique for exiting a pro table trade. More speci cally, the target
will be set at a length equivalent to the size of the hammer pattern
measured from its high.
This measurement is illustrated using the two vertical brackets shown on
the price chart. The lower vertical bracket represents the length of the
hammer candle, while the upper vertical bracket represents its equivalent
length projected upward. Soon after the entry was initiated, the price
retraced a bit before resuming to the upside ultimately reaching our target
and taking us out with a pro table result.
Forex Hammer Candle Trade In AUDJPY
Let’s now move on to a second example that demonstrates the hammer
candle strategy outlined earlier. Below, you will nd the price chart for the
Australian Dollar to the Japanese Yen cross currency pair shown on the daily
timeframe.
Again here the idea is to look for a potential reversal of a downtrend using
the hammer formation as our primary signal. So what can we gather from
this AUDJPY price chart? Well, starting from the far end, the price appears to
have put in a swing high. Shortly thereafter we can see a series of red
candles which forms the beginning of this downtrend. A short consolidation
forms after this rst leg, and then the price continues lower sharply within
the second leg of this downtrend.
Then the price makes a fairly deep retracement against the downtrend and
ends that correction in what appears to be an evening star candlestick
formation. Soon after, the third and nal leg within this downtrend resumes
leading to the hammer formation that we can see near the bottom of the
price chart.
If we take a moment to analyze the characteristics of this hammer formation,
we will notice that it meets all of the necessary requirements. That is to say
that the lower wick is at least two thirds the size of the entire formation, the
body is relatively small and situated near the top one third of the range, and
the upper wick is relatively small in relationship to the lower wick.
As such, we can con rm that this candle is a valid hammer formation. We’ve
also seen that the hammer candlestick occurs in a downtrend which ful lls
another condition for entering into this trade setup.
Lastly we want to make sure that the size of the hammer formation is at
least equal to or larger than the average candles within the downtrend.
Again, if you visually look at the length of the hammer candle and compare it
to the other candles within the bearish trend, you can easily surmise that its
length is indeed larger than the average. That ful lls all of the requirements
for initiating a long trade based on this hammer trade set up.
The entry order is noted on the price chart and should be placed
immediately following the con rmation of our conditions above. The
stoploss would be set at a level that is just below the low of the hammer
candle as noted by the black dashed line below the entry.
And as for target, it will be set at a level that is equivalent to the length of the
hammer candle itself. That measurement is shown using the orange vertical
brackets. The price action following the entry signal traded in a sideways
manner for about two weeks before breaking to the upside and reaching
our measured target level.
Summary
The hammer formation is one of the most reliable reversal patterns within
the entire library of candlestick patterns. It is also one of the easiest to
recognize, and simplest to trade. But although it’s a fairly simple pattern to
trade, it does require a good deal of discipline and fortitude to execute
properly.
That is because it is essentially a countertrend signal. When the market is
trending lower it can be especially dif cult to buck that trend and take an
early long position. Nevertheless, when traded with prudence and strict risk
control measures, the hammer pattern does offer a solid contrarian trade set
up with a viable edge.
Shooting Star Pattern In Technical Analysis
There are dozens of different candlestick patterns that are available to
market traders. Some of these patterns come in the form of a single candle,
while others are seen as double and triple candle formations. In our
discussion here, we will focus on a speci c single candle pattern referred to
as the shooting star. It is a reversal pattern that is most often seen after a
price rise. It’s a powerful pattern that will often call market tops, and the end
of rallies within an overall downtrend.
The shooting star formation is a single candlestick that is often seen after a
prolonged price move to the upside. Additionally, it also forms after a
corrective phase within the context of a larger downtrend. We will be taking
a closer look at both of these scenarios in this lesson, but for now, it’s
important to understand a few primary characteristics of the shooting star
pattern. And that is, that it is a single candle formation with bearish
implications and that it occurs after a price rise. Some technical analysts refer
to it as a bearish pin bar as well.
Let’s now take a moment to dissect the anatomy of a shooting star
formation.
In the illustration above you can see what the shooting star candlestick
appears like. Notice the long upper wick within the shooting star formation.
This is often referred to as a shadow or a price rejection to the upside.
Additionally, note how the open, and the close occur near the bottom third
of the price range.
There are no exact rules as it relates to the labeling of a shooting star pattern,
however, as a general guideline, we want to see a long upper wick, a
relatively small body, and a short lower wick.
If we take a moment to understand the dynamics behind the shooting star
candle, it will strengthen our resolve when it comes to trading the pattern.
So what is going on behind the scenes in a shooting star candle?
Let’s refer back to our illustration above for further clari cation. Notice how
the price opens near the lower one third of the range, and then the bulls
push the prices higher, which is represented by the upper shadow of the
shooting star pattern.
The bulls, however, could not maintain the price move higher, as sellers
came in and overwhelm the buyers with their supply-side orders. This leads
to a sharp move lower as the sellers are the ones that are truly in control of
the market during this time.
This is evident from the closing price within the shooting star, which occurs
within the lower one third of the price range. So essentially, we consider a
shooting star pattern to be an upside rejection pattern. The implication of
which is that the supply in the market is higher than the demand, thus, a
continued price decline should ensue.
It’s important to note that the most reliable shooting star patterns are the
ones that occur on the higher timeframe price charts. We want to focus on
timeframe such as the four hour, eight hour, daily, weekly and monthly when
scanning for shooting star formations. The daily timeframe chart offers the
best combination of reliability and frequency as it relates to the shooting star
candlestick formation.
Bearish Shooting Star Candlestick
Anytime that you nd this formation on the daily chart and wherein it occurs
in context of an uptrend, you will want to pay close attention to the price
action of the next few bars following it. If price breaks out below the low of
the shooting Star formation, it will often lead to further downside
momentum.
Another way to play the shooting star pattern, is to wait for a 50%
retracement of the candle’s range before initiating a short position. There are
a few risks associated with this type of entry technique. The rst being that
the market could move lower immediately, and without a signi cant
retracement that triggers at our required level.
This would mean that we would miss out on the opportunity to trade the
shooting star set up in this case. Alternatively, the other risk is that by
entering at a retracement of the shooting star’s range rather than the break
below the low of the shooting star candle, we run a bigger risk of prices
moving higher and potentially hitting our stop loss.
Depending on your comfort level and style of trading, you may choose one
entry method over the other or choose some other variation altogether. In
any case these are just a few of the ways in which we could structure a short
trade following the bearish shooting star candlestick.
Let’s now take a closer look at two typical scenarios wherein the shooting
star formation is often seen. The rst scenario is when the market is
exhibiting a clear uptrend, and the second scenario is when the market is
correcting to the upside within a larger downtrend.
We’ll start off by taking a look at a price chart that prints a shooting star
candlestick in an uptrend.
On the price chart above you can see that the price action was moving
higher. Notice how the market is making higher and higher swing lows, and
making higher and higher swing highs as well. This is a clear indication of a
bullish trend in progress. At some point during the uptrend, the momentum
behind price action began to wane. This can be seen by the overlapping
price action leading up to the shooting star candle.
The overlapping price action is indicative of a slowing trend. After this
sluggish price action higher, we can clearly see that a shooting formation
prints on the price chart. The actual shooting star candle has been
magni ed for easier viewing. Notice that it meets all of the criteria for
correctly labeling it as a shooting star formation. Firstly, it occurs as the price
action is moving higher. Secondly, the upper wick is very prominent, and the
open and close are both at the lower end of the range.
A corrective phase is essentially a price move that occurs against the primary
trend. So, if the primary trend is up, then the corrective phase would occur as
prices are moving lower. Similarly, if the primary trend is down, then the
corrective phase would occur as prices are moving higher.
As it relates to the shooting star pattern, will often nd that it occurs within
the context of the latter. That is to say that it can occur as prices are moving
higher in a corrective phase against the larger downtrend. Let’s take a look
at an example of such a scenario.
If you look closely at the price chart above, we can see that the major trend
of this market leading up to the shooting star formation is bearish. At some
point, the sharp bearish price move began to subside, as the price action
started to move higher. This upward price move is considered as a correction
or pullback trading opportunity. The shooting star chart pattern that
emerges at the termination of the upside correction has been magni ed for
easier viewing.
Notice that immediately following the bearish shooting star formation, that
the price continues to move lower, in concert with the larger bearish trend.
This is an example of a shooting star forming within the context of a larger
bearish price move. The implications are the same as our previous example.
And that is to say that we should expect downward price pressure following
a con rmed shooting star pattern.
Shooting Star Trading Strategy – Counter Trend Setup
Now that we have a good understanding of the shooting star pattern and
when it is most likely to occur, let’s build upon that knowledge, and see if
they can create a trading strategy around it. We’ll start with the of
countertrend variation of the shooting star set up.
We want to build a simple yet effective strategy for trading the shooting star
that will be easy to implement in the market. Firstly, we want to con rm that
an uptrend exists prior to the shooting star formation. This is an important
requirement because we know that a valid shooting star pattern should
occur in a rising market.
As long as we can see that the price action is moving higher, with
successively higher highs and higher lows, then we can be con dent that an
uptrend is in place. Once this condition has been con rmed, along with all
the requirements for a valid shooting star pattern, then we will prepare for a
potential short trade.
In order to do this, we will need to draw an uptrend line that connects the
lower swing points within the rising trend. The shooting star pattern must
occur above this uptrend line, and the price must break below this trendline
within ve bars of the shooting star formation. The actual sell signal will be
triggered upon a candle close below this upsloping trendline, assuming that
the other conditions have been met.
The stop loss on the trade will be set at the high of the price bar that breaks
below the trendline. Essentially, that is the bar that acts as our entry
con rmation signal. Finally, we will need a way to monitor the price action if it
moves in our favor to the downside, and exit the trade when the weight of
evidence is pointing to an upside reversal. In this case, we will employ the
nine period simple moving average as the mechanism for trailing the price
action and issuing our buy exit signal. More speci cally, when the price
crosses above and closes above this nine period simple moving average line,
we will exit the position completely.
It’s important to note that there is nothing magical about the nine period
simple moving average line. You could just as well use a slightly shorter or
longer variation as well. The point is that whichever exit mechanism that you
use, you should be consistent in your application of it. So there you have it. A
simple yet robust method for trading the shooting star formation as a
countertrend setup.
Shooting Star Trading Example
– Counter Trend Setup
Let’s now illustrate the shooting star trading strategy that we just outlined. If
you refer to the price chart below you will nd the price action for the
GBPJPY currency pair as shown on the daily timeframe.
Let’s see what we can gather from this price chart. Firstly, we can see within
the magni ed area near the top right of this image, a clearly de ned forex
shooting star candlestick. Remember, a valid shooting star candle pattern
should meet a few important guidelines. Firstly, the upper wick within the
shooting star should be quite noticeable and prominent in relation to the
lower wick or shadow of the candle.
Secondly, the open and close of the candle should occur near the bottom
one third of the price range. And also, the body of the shooting star
formation should be relatively small. If we analyze our shooting star
formation here, we can see that all of these important guidelines have been
met. As such, we can con dently label this candlestick as a shooting star
pattern.
Now that we have recognized a shooting star formation on the price chart,
we need to con rm whether or not it occurs in the context of a rising
market. Obviously, we can see that the price action preceding the shooting
star was clearly bullish.
Notice how the price moves higher in a nice stairstep fashion with
successively higher highs and higher lows during its progression. With the
uptrend con rmed, we can now draw a trendline connecting the swing lows
within the upward moving price action. You can see the upward sloping blue
line that we have drawn as our trendline.
Now all there is left to do is to wait for the price action to show its hand. That
is to say that if the price breaks below this uptrend line within ve bars
following the shooting star pattern, then we will have a signal for a short
trade.
Looking closely at the number of candles following the shooting star
pattern, we can see that the third candle broke below and closed below the
upsloping trendline. As such, that event served as the con rmation for a
short entry based on this trade set up. You can see that con rmation bar
noted as Entry on the price chart above. We will place a market order to sell
immediately following the close of that candle.
The stop loss should be placed beyond the high of the breakout candle. You
can see the stop loss noted accordingly. So now we have protected the
position in case the trade begins to move against us. Fortunately for us, the
price action started to move lower precipitously following the breakout
signal. Our exit plan calls for monitoring the price action closely and waiting
for a candle close above the nine period simple moving average line.
The light blue line shown on the price chart is our nine period moving
average line that serves as the exit signal. After a sharp drop from the
shooting star candle, the price started to print a few consecutive green bars.
This upper price momentum continued until one of those bars nally closed
above the nine period SMA line. That event served as the exit signal, which
would have closed out this trade with a pro t.
Shooting Star Trading Strategy –
Pullback Setup
Let’s now explore another example of the shooting star trading set up. This
time we will look at trading the shooting star candlestick when it appears
within the corrective phase of a larger down trending market. As such, we
consider this as a shooting star pullback set up.
Here, we will be looking for a valid shooting star pattern that occurs in the
context of a downtrend. The shooting star pattern must still occur after a
price move higher, however in this case, that price rise should be a
correction to the larger downtrend. Once we have identi ed these
conditions, then we will prepare for a short trade.
One of the best ways to trade a rejection pattern such as the shooting star
formation within a corrective phase is to rst locate a market that is trading
within a clearly de ned bearish channel. Once we have found such a market,
then we would wait for a shooting star formation to form during one of the
pullback legs. We want the shooting star to either touch or penetrate the
upper line of the bearish channel. This event would serve as our con rmation
for the shooting star pullback set up.
The entry signal from this pattern set up would occur immediately following
the close of the shooting star candle. That is to say immediately following
the shooting star formation, we will place a market order to sell. The stop loss
placement would be just above the high of the shooting star candle itself.
Since the high of the shooting star candle serves as a potential level of
resistance, this would serve as a logical level at which we would want to exit
our trade with a small loss.
If however the price begins to move in our favor following a short entry, then
we will watch the price action closely as it trades within the bearish channel.
The exit signal would be triggered upon the price touching the lower line of
the bearish channel. Once this occurs, we would immediately exit the trade.
Shooting Star Trading Example
– Pullback Setup
Now that we have outlined the rules for the pullback variation of shooting
star set up, let’s now go to the charts and illustrate it in more detail. Below
you will nd a price chart of the Canadian Dollar to Swiss Franc currency pair.
The price action shown is based on the daily timeframe.
First and foremost, we will need to spot a potential shooting star formation
on the price chart. Referring to the upper magni ed area on this price chart,
we can clearly see the forex shooting star candle formation. It has all of the
characteristics that we like to see within the structure.
That is to say that the upper wick of this candle is very prominent in
comparison to the lower wick. Additionally, the open and close of this
formation occurs near the bottom of the range. And nally, the size of the
body within the candle should be relatively small. If you examine the
shooting star formation here, it’s quite evident that all of these
characteristics have been met.
Now that we have a valid shooting star formation identi ed on our price
chart, we need to check whether or not the price action is in an overall
downtrend, and trading within a relatively well de ned channel. We will plot
a bearish channel by connecting the most prominent swing highs within
the downtrend, and then run a parallel of that line off of the lower swing
points. You can see the created bearish channel that is plotted with the two
downward pointing trendlines.
With these conditions met, we should go back to the shooting star
formation for further analysis. We want the shooting star pattern to have
either touched or penetrated the upper line of the bearish channel. If you
look closely at the shooting star formation once again, you will notice that
the upper wick did in fact penetrate the upper line of the bearish channel
plotted. And with that, we have con rmation of shooting star pullback set
up.
Our entry calls for entering a short position immediately following the close
of the con rmed shooting star pattern. You can see the entry signal noted
on the price chart. From here, we would immediately place a stop loss order
just above the high of the shooting star formation. Once we have done that,
we will need to monitor the trade carefully and watch for a touch of the
lower line of the bearish channel. This event would serve as the exit signal.
You can see when the exit signal was triggered on this trade by referring to
the magni ed area at the lower right of the price chart.
Summary
As we have seen, the shooting star pattern is an important candlestick
formation that can help us pinpoint the end of a major uptrend or a minor
pullback within a downtrend. It’s important to not only study the anatomy of
the shooting star pattern, but also to realize the conditions under which it is
most effective.
Unfortunately, some traders do not take that extra step in gauging the
market context around a shooting star formation. This can lead to a higher
rate of false signals, and lower overall pro tability when using the pattern.
Those that do take the time to understand the market environment in
which the shooting star pattern should be traded, will be better rewarded for
their efforts.
What Is The Doji Candlestick Pattern?
One of the most common subsets of price action trading involves the use of
candlestick patterns. Candlestick patterns offer valuable insights into the
market action and can help traders position for the next price move. There
are literally dozens of different candlestick patterns that traders can follow.
One of the more common formations within this class of patterns is the Doji
candlestick, which will be the focus of this article.
Within technical analysis, a Doji is classi ed as a single candlestick pattern
wherein the open and close of a speci ed instrument for give period is
essentially the same or very close to it. As a result of this the appearance of a
Doji often takes the shape of a cross or some variation of it.
Because the Doji candle opens and closes in virtually the same location, that
is indicative of indecision in the market. The bulls and bears are battling it
out to take control of the market, however, neither was successful in their
attempt to overwhelm the other and move the market in their direction.
Below you can see an example of a Doji pattern.
Unlike most candlestick patterns that either have a bullish implication or
bearish implication the Doji pattern is somewhat different in that the
formation does not provide any clear insights into the future price
movement of a security. Essentially, the Doji candlestick pattern is a neutral
pattern. Sometimes they can appear as a continuation pattern suggesting
further price movement in the direction of the trend, or they can appear as a
reversal pattern suggesting that a trend reversal is most likely.
When the Doji formation is coupled with the underlying trend in the market
or some other technical based tools, we can in fact gather quite a bit of
information from that and arrive at some bias for future price movement.
And so, Doji candlesticks by themselves are not of much practical use,
however, when coupled with other tools it can be quite useful.
There are several variations of the Doji candlestick. The major types of Doji
patterns include the Doji Star, Gravestone Doji, Long Legged Doji, Dragon y
Doji, and the Four Price Doji. We will be describing each of these Doji
variations in the upcoming sections and illustrate the structure of each.
Since each of these can have a different potential depending on the market
context, it’s important to study them so that you can recognize and label
them correctly on your price chart.
Some traders nd the Doji formation to be a bit frustrating to trade, because
there is no clear bullish or bearish signal provided from it as a standalone
pattern. But as you will learn shortly, there is a great deal of value that this
pattern can offer traders if it is evaluated and implemented correctly. This is
particularly true when the market displays a Double Doji or Triple Doji
formation, wherein there are subsequent Dojis appearing in the price series.
Types Of Doji Candlestick Patterns
Doji patterns can appear in all major markets including the foreign exchange
market, the futures market, the equities market, and more. And they appear
across all different time frames from the very smallest to the very largest. As
we noted earlier the Doji pattern will have approximately the same opening
and closing price. This is a very important component of a Doji pattern.
Traders need to use some common sense and judgment when de ning
how much differential between the opening and closing price they will
accept for identifying a valid Doji pattern. This is because the exact opening
and closing price for any given session is quite rare, therefore, we have to
make room for some leeway in this area.
Because of the close proximity between the opening and closing price, the
Doji will appear to have a very small body and resemble some variation of a
cross. Let’s now introduce each of the different Doji patterns and its
characteristics.
Doji Star – The Doji star pattern appears as a cross shape formation. The
opening and closing prices will be virtually the same, with the upper and
lower wicks within the candle appearing relatively small and equal in length.
The Doji star pattern indicates indecision in the market, wherein the bulls
and bears are ghting for control however the market at the current
juncture is at a level of equilibrium. You can see an illustration of the Doji star
pattern below.
Gravestone Doji – The Gravestone Doji pattern appears as an upside down T
pattern. Candlestick traders will recognize this pattern to be somewhat
similar to the shooting star pattern. However, the Gravestone Doji pattern is
a more powerful bearish reversal signal, as the open and close are at or near
the low after prices were rejected to the upside.
This is particularly true when the Gravestone Doji pattern appears in the
context of an up trending market condition. In this case, it signals a potential
change of trend from bullish to bearish. Below you can see an example of
the Gravestone Doji chart pattern.
Long Legged Doji – The Long Legged Doji pattern has a similar appearance
to the traditional Doji star pattern. They open and close occur at or near the
same level, however, within the Long Leg Doji pattern, the wicks on either
side are larger and extend out further. This suggests that the market is more
volatile as prices were able to extend relatively far both to the upside and
downside.
The implication is still one of indecision in the market, but wherein there is
heightened volatility. This can often lead to large moves as prices break out
from one side or the other.
You can refer to the image below to see an illustration of the Long Legged
Doji pattern.
Dragon y Doji – The Dragon y Doji pattern is the inverse of the Gravestone
Doji pattern. That is to say that it appears as a T formation. The open and
close occur near the high of the candle, with a relatively long wick to the
bottom, suggesting rejection of lower prices, and a strong close for the bulls.
Dragon y Dojis appear similar to a hammer candlestick; however, the
Dragon y Doji can prove to be more powerful of a signal, particularly when
they Dragon y Doji appears near the bottom of a down trending market.
The expectation is for higher prices following the completion of the
Dragon y Doji pattern. An example of the Dragon y Doji pattern is shown
below.
Four Price Doji – The Four Price Doji is a unique structure in and of itself. It
appears as a horizontal line with very minor or nonexistent upper and lower
wicks. As such, this pattern suggests that there is indecision in the market,
and the market is displaying characteristics of a low volatility environment.
This is because prices open and close at or near the same area with very little
movement to the upside or downside during that session.
The Four Price Doji is seen much less frequently than the other types of Doji
patterns presented earlier. Regardless, traders should take heed when such
a formation appears on the price chart. Here is what the Four Price Doji looks
like.
Double Doji Trading Strategy
As we’ve noted earlier, the Doji pattern is one that is characteristic of
indecision in the market. As such, most Doji patterns by themselves are not
very telling. However, when the market you are trading forms multiple Dojis
in consecutive fashion, this can be an extremely opportune time to take
advantage of a breakout trade.
More speci cally, remember that most Doji patterns are generally indecision
patterns, and thus when we have two or three Dojis appearing one after
another, then that is indicative of a prolonged period of indecision, which is
likely to propel prices in the direction of the eventual breakout. This is
because the markets ebb and ow through periods of low volatility to high
volatility, and from periods of high volatility to low volatility.
With this backdrop, we will create a strategy for trading the Doji pattern that
will take advantage of these periods in the market. Our strategy is based on
a double Doji pattern, which is essentially any two consecutive Dojis
appearing on the price chart. They should preferably be of a similar Doji
variation; however, this is not a requirement. This double Doji system is a very
simple price action based strategy that requires nothing more than the
presence of two consecutive Doji patterns.
So here are the rules for trading the Double Doji set up:
A Double Doji pattern must appear near the top of an uptrend or the
bottom of a downtrend.
Plot a support line at the low of the double Doji pattern, and a
resistance line at the high of the Double Doji pattern.
Place an OCO order, one cancels the other order, one pip above the
resistance high and one pip below the support low.
Wait for a breakout either above the resistance level which will execute
the buy side of the order, or below the support level which will execute
the sell side of the order. If the buy order is triggered rst, then place a
stop just below the low of the double Doji pattern. If they sell order is
triggered rst, then place a stop just above the high of the double Doji
pattern.
We will utilize a two-tiered exit strategy. That is to say that target one
will be placed at a level that is equivalent to the height of the Double
Doji pattern. We will close out 1/2 the position at Target 1. Target two will
be placed at a level that is equivalent to twice the length of the Double
Doji pattern. We will close out the second 1/2 of our position at Target 2.
Bullish Doji Candlestick Trade Setup- GBPUSD
Let’s now shift our attention to highlighting some actual examples of the
Doji pattern set up on a few price charts. We’ll look at a few Double Doji
patterns in the Forex market.
As we can see from the price chart below, the price of GBPUSD was trading
lower, and then we see a period of consolidation before another price level
lower that ultimately leads to the formation of a double doji pattern on the
price chart. You can see the double doji pattern circled in green. As such, the
rst condition of this Doji trading strategy has been ful lled. Speci cally, a
double doji pattern has formed at the bottom of the downtrend.
We will now draw the support and resistance lines for the double Doji
pattern. Notice the second candle within this double Doji pattern put in
high of the entire pattern, and also the low of the entire pattern. As such, we
will plot our support line at the low of this candle, and the resistance line at
the high of the candle creating our breakout levels.
Now that our breakout levels have been plotted, we will place an OCO order,
one cancels the other order, with a buy stop one pip above the high and a
sell stop one pip below the low of the support line. Once we’ve done this,
we’ll wait to see which way the price action breaks out.
As we can see, the third bar following the formation of the double Doji
pattern signaled the breakout to the upside executing the buy side of our
OCO order putting us into a long position in the currency pair. And so, we will
place a stop loss just below the low of the double Doji pattern as noted on
the chart.
We will be using a two-tiered target as an exit strategy which calls for the
rst exit to be taken upon price reaching an equivalent distance of the
double Doji pattern. Notice the second orange bracket which represents Exit
1. Price easily reach this level and continued to move higher. Exit 2 can be
seen just above Exit 1 and represents a length of twice the double Doji
pattern. Here again, price reach that level quite quickly after Exit 1 was
achieved taking us out of the position entirely with a great result.
Bearish Doji Candlestick Trade Setup – USDCAD
Let’s now look at another example of this strategy in action. This time will be
referring to the price chart for the US Dollar to Canadian Dollar Forex pair as
seen on the daily timeframe.
Looking at the lower left of the price chart, we can see that prices were
moving higher, forming an up trending market scenario. Towards the middle
of the price chart, we can see a Double Doji pattern form, which is circled in
green. This Double Doji pattern was quite clear and would have clued us into
a potential trade set up using the strategy. Unlike the previous example, this
Double Doji pattern appears at the top of an uptrend.
With these conditions being met, we can now go ahead and plot our
support and resistance lines for the Double Doji pattern. Note that within
this double Doji structure, the initial Doji pattern creates the high for the
entire pattern, while the second Doji pattern creates the low for the entire
pattern. As such, we will use the rst Doji high to plot the resistance level,
and the second Doji low to plot the support level.
Now we will go ahead and place our OCO order, one cancels the other, one
PIP above the high as represented by the upper black dashed line, and tone
PIP below the low as represented by the lower black dashed line. Once
we’ve done that we would go ahead and wait until price either breaks above
the resistance level or below the support level to enter into the position.
In this case, price immediately breaks lower on the very next candle
following the double Doji formation. You can see that sell entry noted on the
price chart. Now that we are in this position, we will make sure to protect
ourselves in case of an adverse price move by placing a stop loss order in the
market. Based on our strategy rules, the stop will be placed just above the
high of the double Doji formation.
Our two-tiered exit strategy calls for placing a target at a length that is
equivalent to the double Doji pattern projected lower from the breakout
point. This will serve as our target for Exit 1. Notice how two candles following
the breakout Exit 1 was reached providing us some pro ts on this trade.
However, soon after Exit 1 was reached prices traded slightly lower, and then
began to reverse to the upside.
As a result, our target 2 was never reached on this trade. Remember target 2
is set at a level that is equivalent to twice the length of the double Doji
pattern. Instead, as the price reversed and move higher, our stop loss was
eventually triggered, taking us out of the position. In this trade, we wound
up with a breakeven situation, because we were able to reach the reach Exit
1, however, we gave back those pro ts when our stop loss was hit.
Final Thoughts
Candlestick analysis is at the heart of many price action based trading
strategies. There are a myriad of candlestick patterns that chart traders
should be aware of. In this lesson, we’ve covered one of those important
candlestick patterns – the Doji pattern. And as we learned, there are different
variations of the Doji pattern as well.
Beginning traders and students of the market should take some time to
practice recognizing this important pattern as it is commonly seen within
the price chart. Knowing when and where the Doji pattern occurs can give
traders some insights on what is occurring behind the scenes in the market.
What is the Japanese Engulfing Candlestick Pattern?
Candlestick patterns are an essential component of price action analysis.
Candlestick formations can provide high probability signals about a potential
outcome on the price chart. Therefore, Forex traders should be aware of the
various candlestick setups that can occur in the market. Today we will
discuss one of these candlestick formations. This candlestick structure is
called the Engul ng candlestick pattern. We will go through the functions of
this chart gure and we will discuss a strategy for combining it with other
forms of price action analysis.
The Engul ng candlestick pattern is formed by two candles (two periods).
For this reason, it falls in the category of double candlestick patterns.
The pattern has a pretty easy-to-recognize structure. It consists of a candle,
which gets “engulfed” by the next candle on the chart. To get a valid
Engul ng pattern, the rst candle should completely t inside the body of
the next candle. See below, an illustration of an engul ng formation:
This is how the Engul ng pattern appears on the chart. Notice that the
bearish candle is fully engulfed by the body of the next candle which is
bullish. The opposite scenario is possible too. The engulfed candle could be
bullish and the engul ng candle could be bearish.
Potential of the Engulfing Candlestick Setup
The Engul ng candlestick setup has a strong reversal character. If the price
is increasing and an Engul ng pattern is created on the way up, this gives us
a signal that a top might be forming now.
The opposite is in force too. If the price is decreasing and an Engul ng
pattern appears on the chart, this suggests that the price action might be
forming a bottom.
Types of Forex Engulfing Patterns
As you may have probably guessed, the Engul ng trading pattern has two
variations depending on its potential. The rst one is the bullish Engul ng
pattern, and the other is the bearish Engul ng pattern. Let’s now go
through each of these two Engul ng types:
Bullish Engulfing
The bullish Engul ng pattern could be found during bearish trends. It starts
with a bearish candle on the chart. Then this candle gets fully engulfed by
the body of the next candle on the chart, which is bullish. This pattern
creates a bullish potential on the chart and it could reverse the current
bearish trend. Take a look below at the sketch of the bullish Engul ng
candle pattern:
Notice that the rst candle of the pattern is bearish and it is fully contained
by the body of the next candle, which is bullish. This creates the bullish
Engul ng, which implies the trend reversal. A valid bullish Engul ng would
be the beginning of a bullish move after a recent decrease.
Bearish Engulfing
The bearish Engul ng pattern has exactly the opposite functions compared
to the bullish Engul ng. The bearish Engul ng formation on the chart could
be found during bullish trends. The pattern starts with a bullish candle. This
candle then gets fully contained by the body of the next candle, which is
bearish. This pattern creates a strong potential for a price reversal on the
chart. In this manner, the current bullish trend might turn into a new bearish
movement on the chart. Now have a look below at the sketch of the bearish
Engul ng pattern:
This time the engulfed candle is bullish and the Engul ng candle is bearish.
The body of the second candle fully contains the rst candle, which
completes the shape of the bearish Engul ng pattern on the chart. A
bearish Engul ng setup could indicate the beginning of a new bearish move
on the chart.
Engulfing Trading Pattern Confirmation
The con rmation of the Engul ng pattern comes with the candle after the
pattern. It needs to break the body level of the engul ng candle to con rm
the validity of the pattern.
A valid bullish Engul ng pattern continues with a third candle (bullish),
which breaks the body of the engul ng candle upwards. A valid bearish
Engul ng pattern continues with a third candle (bearish), which breaks the
body of the engul ng candle downwards. This is how the Engul ng
con rmation appears on the chart:
See that this time we have added the con rmation candle after the pattern.
When you see this candle behavior after an engul ng pattern, this will
con rm its validity.
Engulfing Trading Strategy
We have gone in detail through the structure of the Engul ng formation.
Let’s now discuss a trading strategy related to this chart pattern.
Engulfing Pattern Trade Entry
The opening of your trade comes with the con rmation of the Engul ng
pattern. This is the third candle – the one that comes after the engul ng
candle – and it is supposed to break the body of the engul ng candle in the
direction of the expected move. When a candle closes beyond this level, we
get the con rmation of the pattern and we can open the respective trade.
If the Engul ng scenario is bearish, the price breakout should be through
the lower level of the engul ng candle’s body. In this manner, we should
prepare for a short trade. If the Engul ng scenario is bullish, the price
breakout should come through the upper level of the engul ng candle’s
body. This means that we should react with a bullish trade.
Engulfing Pattern Stop Loss
You should always be in control of the risk you are taking. As such, your
Engul ng trades should always be protected with a stop loss order. The stop
will secure your bankroll and you will typically know the maximum you can
lose on the trade. Analyzing your risk and reward before initiating any trade
will help in deciding whether to take the trade or not.
The best place for a stop loss order in an Engul ng trade is beyond the
Engul ng pattern extreme. This would mean that if the Engul ng setup is
bullish, the Stop Loss order should be placed under the lower candlewick of
the engul ng candle. If the Engul ng setup is bearish, then the Stop Loss
order should be located above the upper candlewick of the engul ng
candle.
Above you see a sketch which illustrates where you should place your stop
loss when trading bullish and bearish Engul ng patterns. If the pattern fails
to move in the desired direction causing the stop loss to be hit, it will prove
the trade assumption wrong and act to protect your bankroll.
Engulfing Pattern Take Profit
A rule of thumb is that an Engul ng trade should be held for at least the
price move equal to the size of the pattern. This means that the minimum
you should pursue from an Engul ng pattern should equal the distance
between the tips of the upper and the lower candlewick of the engul ng
candle.
When this distance is ful lled by the price action, you can either close the
whole trade, or part of it. If you decide to keep a portion of the trade open,
then you should carefully monitor price action for a potential exit
opportunity. This includes support/resistance breakouts and trend or
channel breakouts. Chart and candle patterns are also very important here. If
you spot a chart/candle pattern which is contrary to your trade, you may
want to close your position.
Engulfing Pattern and Price Action Strategy
Now let’s take our understanding of the Engul ng pattern and illustrate a
price action based trading strategy. Have a look at the chart below:
This is the hourly chart of the GBP/USD Forex pair for Jan 1 – Jan 5, 2016. The
image depicts a bearish Engul ng pattern and some rules to trade it.
The chart starts with a price increase which we have marked with the green
arrow on the image. You will notice that the price action creates only bullish
candles. Suddenly, we see a relatively big bearish candle, which fully engulfs
the previous candle. This con rms the presence of a bearish Engul ng
pattern on the chart.
However, a con rmation candle needs to appear before we can consider
taking a position in this case. The next candle on the chart is bearish again
and closes below the body of the engul ng candle. This is the con rmation
needed to take a trade based on this bearish Engul ng pattern. The stop
loss order for this trade should be located above the upper wick of the
engul ng candle as shown on the image.
The yellow arrows on the chart show the size of the pattern and how it
should be applied as a minimum target on the chart. This target gets
completed with the next candle, which appears after the Engul ng
con rmation.
This trade could be extended for further gains. You can use price action rules
to attain a nal exit signal on the chart. You will note that the price of the
GBP/USD creates another two big bearish candles on the chart. This would
have doubled the gains on the trade. However, the next candle on the chart
is a Hammer Reversal, also referred to as a Pin Bar. and it has a strong bullish
potential. The trade should be closed out when con rmation of the Hammer
pattern appears on the chart. As you see, the next candlestick is bullish and
breaks the upper level of the Hammer pattern. This con rms the validity of
the Hammer Reversal, which creates an exit signal for the short position. The
bearish Engul ng trade should be liquidated at the close of the bullish
candle which appears after the Hammer. This is shown with the second red
arrow on the chart.
This example shows how price action rules could assist in nding the most
opportune exit point on the chart.
Engulfing Patterns at Support and Resistance
Another effective way to trade the Engul ng pattern with price action is by
spotting the pattern at key support and resistance levels.
If the price action approaches a resistance area and at the same time a
bearish Engul ng pattern appears around that zone, this creates a very
strong bearish potential on the chart. The same is in force in the opposite
direction. If the price action approaches a support level and at the same time
a bullish Engul ng pattern appears on the chart, this creates a very strong
bullish potential.
These occurrences offer a high probability of success on the trade. Many
times, when you spot this technical con uence and enter at the right
moment, you can get in early on an emerging trend reversal. Let’s now see
how combining Engul ng patterns with support and resistance levels work:
You are looking at the hourly chart of the USD/CHF for Feb 19 – 24, 2016. The
image shows another bearish Engul ng trade, which takes place after price
interaction with a psychological resistance level.
The black horizontal line on the image is the very strong psychological
resistance of the Swissy at the parity rate of 1.0000 Swiss Franc for 1 Dollar.
After a strong price increase, the USD/CHF meets this resistance level and
tests it two more times afterwards. The third time the price tests the
resistance, it creates a relatively big bearish candle, which engulfs the
previous bullish candle. This creates a bearish Engul ng pattern on the
chart.
The con rmation of the bearish Engul ng comes with the next candle,
which is bearish and breaks the lower level of the engul ng candle’s body.
The closing of the con rmation candle provides the short entry signal.
A stop loss should be placed above the upper candlewick of the engul ng
bar. This is the level right above 1.0000.
The price starts drop afterwards. A couple of periods later, the minimum
target of the pattern is reached (yellow arrows). You could close a portion of
the position here, and keep a portion open in anticipation of a further
decrease in price.
Notice that on the way down the USD/CHF pair continues with lower highs
and lower lows, which provides for con dence in the downtrend. Suddenly,
the price action starts a sideways movement and we mark the upper level of
the range with the thin black horizontal line on the chart. The trade should
be closed as soon as the price action breaks this resistance and closes a
candle above. As you see, this creates a higher top on the chart, which
implies that the bearish run might be interrupted.
Combining Support and Resistance with the Engul ng pattern is an
excellent price action based trading method.
The Engul ng Candlestick pattern is a double candle formation.
It is a two-candle formation wherein the second candle fully engulfs the
previous candle including the wicks.
The Engul ng candlestick pattern has a reversal potential on the chart.
In this manner, we recognize two types of Engul ng candle patterns:
Bearish Engul ng: It could be found at the end of bullish trends. It
starts with a bullish candle and then a bigger bearish candle,
whose body fully engulfs the rst candle of the pattern. This
creates bearish (reversal) potential on the chart.
Bullish Engul ng: It could be found at the end of bearish trends. It
starts with a bearish candle and then a bigger bullish candle,
whose body fully engulfs the rst candle of the pattern. This
creates a bullish (reversal) potential on the chart.
The con rmation of the Engul ng pattern comes with the next candle
on the chart:
If the Engul ng is bullish, the next candle should be bullish and it
should close above the upper level of the engul ng candle’s body.
If the Engul ng is bearish, the next candle should be bearish and it
should close below the lower level of the engul ng candle’s body.
There are the three basic Engul ng trading rules:
Open a trade when the price closes at the con rmation candle.
Place a stop loss order beyond the opposite side of the Engul ng
formation.
Stay in the trade for a minimum price move equal to the size of the
Engul ng pattern, or use price action rules to extend the duration
of the trade.
A high probability price action approach for trading bullish and bearish
Engul ng patterns is to look for the pattern to appear at important support
and resistance levels.
Dark Cloud Pattern In Technical Analysis
Candlestick trading techniques are very popular with price action traders.
There are a countless array of candlestick patterns that appear in the market.
Some of these patterns have reversal implications, while others are
considered continuation patterns. The dark cloud cover is one such
candlestick that has a bearish reversal characteristic.
The dark cloud cover is a two candle formation that is characterized as
having reversal characteristics. More speci cally, it is seen near the top of an
uptrend, or near the top of a trading range. Either way, it has bearish
implications. The dark cloud cover is comprised of two candles, wherein the
rst candle is a bullish candle, with a relatively long body. The second candle
gaps higher, but then reverses and closes below the halfway point of the
body of the rst candle.
Below you can see an illustration of the dark cloud cover candlestick pattern.
Notice on the above price chart how the rst candle is a bullish candle, and
then how the second candle gaps above the high of the rst candle, but
ultimately closes below the midpoint of the body of the rst candle. The gap
higher after the rst candle’s close is typically considered as a bullish sign.
But the reversal of price and a close below the central point of the body of
the rst candle is what holds the most signi cance in this formation. It
foretells the change in sentiment, from bullish to bearish.
Often times, the larger the upside gap, the more powerful the potential
reversal will be.
The dark cloud candlestick con rmation will come upon a break below the
low of the second candle within this formation. Typically we want to see an
immediate follow through to the downside.
More speci cally, we prefer that the candle that immediately follows the
completion of this pattern take out the low of the second candle.
Sometimes however we may need to wait for some additional candles to
form before we get this downside break. Nevertheless, the sooner it occurs
the more advantageous it will be from the bearish trade perspective.
Additionally, the best dark cloud cover pattern formations tend to occur after
a prolonged price move to the upside. In these cases, they tend to provide
an excellent reversal signal that can lead to a minor retracement within the
trend, or result in a complete trend reversal. Dark cloud candle patterns
occurring near the top of consolidation ranges can be useful as well,
however, there are not nearly as powerful as when they occur after an
uptrend.
Most traders are advised to use some additional market timing indicator or
technique in conjunction with the dark cloud pattern. Doing so, will provide
for a higher probability trade set up.
Some of the more popular technical tools that can be utilized in
combination with the dark cloud cover formation include momentum
oscillators such as RSI, Stochastics, or MACD, chart patterns such as
rectangles and ag patterns, support and resistance levels such as horizontal
price levels, diagonal trendlines, or moving averages. These are just some of
the technical methods that can be used alongside the dark cloud cover
formation.
Also as a point of interest, the dark cloud cover is sometimes confused with
the bearish engul ng pattern. Although both of these patterns appear
similar and have bearish implications, there are some distinct differences
between the two that traders should be aware of.
The most important of which is that a bearish engul ng pattern is a two
candle formation wherein the second candle completely engulfs the body of
the rst candle. Contrary to that, the second candle within the dark cloud
cover pattern is only required to close below the center point of the body of
the rst candle.
Psychology Behind The Dark Cloud Pattern
So what is going on behind the scenes within the dark cloud cover
formation? As we’ve noted, this is a reversal pattern that occurs near the top
of the up trending market, or near the top of a range bound market
environment. In either case, the prices have been rising and as such there is
bullish complacency in the market. This sentiment is also fueled by the gap
up that occurs following the rst candle within this formation.
However, that upside gap is quickly met with strong supply, which pushes
the prices lower, ultimately closing below the middle point of the initial
candle. This marks an important turning point in the market. The bulls were
in control and now the bears are starting to take control. The dark cloud
cover formation marks this subtle but important transition point, which will
often be followed by a sharp market reversal to the downside.
Now, those bulls who were long the market are starting to feel the pain of
the bearish price reaction. Many of them will act to minimize their losses by
exiting their long positions with sell to close orders. This is in addition to
traders with long positions who have placed a hard stop or trailing stop in
the market. As these additional sell to close orders get triggered, it will add
fuel to the re pushing prices lower.
It’s important to note that while the dark cloud cover can appear on any
price chart regardless of timeframe, it is most useful when seen on a daily or
weekly chart. The price action on the daily chart is particularly important, and
as a result, when you see the dark cloud appear on this timeframe, you
should pay very close attention to it.
Bearish Dark Cloud Cover In Uptrend
Let’s now look at an example of the bearish dark cloud cover candlestick
pattern within the context of an up trending market. Below you can see the
price chart of Qualcomm stock shown on the one day timeframe.
As you can see from the above chart, the price was moving steadily higher
forming a nice uptrend. Towards the upper right section of the chart you can
see the dark cloud cover pattern within the magni ed area. Notice the rst
candle is a green candle, which represents a bullish close. The price action at
the start of the next candle gaps higher, and then starts to selloff, pushing
prices lower below the halfway point of the body of the rst candle. Can you
see that? These conditions con rm that the structure is indeed a dark cloud
cover pattern.
The expectation following the completion of this pattern would be for prices
to start heading lower retracing a portion of the uptrend, or potentially
reverse course entirely and began a new downtrend phase. It is dif cult to
know which of these two scenarios is likely to occur at the completion of the
pattern. However, the price action should help us in gauging the more likely
scenario.
More speci cally, if following the dark cloud cover there is a very sharp
reversal, then there is a higher tendency for a complete trend change to
occur. If however, the reversal following the dark cloud cover formation is
relatively sluggish and you can see overlapping candles as the price moves
lower, then there is a higher chance that the bearish reversal will more likely
be a minor correction to the uptrend.
Dark Cloud Cover At Horizontal Price Resistance
As we noted earlier, it’s recommended that when trading the dark cloud
cover candlestick formation that you do not do so in isolation. That is to say
that an additional technical study or indicator should be utilized in
conjunction with this reversal pattern. One of the best ways is to look for the
dark cloud cover formation at critical horizontal price levels. When you’re
able to identify such a scenario, you will increase the odds of a winning trade.
Below is an example of the dark cloud cover seen at a major price resistance
zone.
Notice the swing highs near the top of this price chart. Prices are attracted to
this level. However as soon as it enters within that zone, the supply from the
sellers pushes the price back lower. You can see the dark cloud cover near
the upper right of this price chart. Notice just as soon as the price nears this
level and forms the dark cloud cover, it gets rejected to the downside as the
selling pressure intensi es near the horizontal price level.
It’s important to note that when we’re talking about a key horizontal price
level, we need to keep in mind that these are areas of interest or a zone
rather than a xed price along the horizontal axis. As such, you should be
thinking of horizontal price resistance, and support for that matter, in these
terms and not become overly rigid in trying to plot the exact tting line.
Dark Cloud Cover At Upper Bollinger Band
Let’s now look at out another example of combining a technical study with
the dark cloud cover formation. In this example we will combine the
Bollinger band indicator with the dark cloud cover. The Bollinger band is a
volatility band that can help locate overbought and oversold conditions in
the market. Essentially, we can use the Bollinger band to create a mean
reversion strategy to nd potential reversal points.
So in this way, when the price touches or penetrates the upper Bollinger
band, that event could provide a selling opportunity. Similarly, when the
price touches or penetrates the lower Bollinger band, that event could
provide a buying opportunity. In our particular case, with the dark cloud
cover, we are primarily interested in the upper Bollinger band, since we
would be looking to con rm a bearish signal.
Below is a chart image of Facebook stock based on the daily timeframe.
We can see that the market has been on a steady uptrend since the swing
low seen at the bottom left of the chart. Scrolling to the upper right of the
chart we can see the nice dark cloud cover pattern that forms. Notice also
that this pattern occurs and completes near the upper line of the Bollinger
band. As a result, the dark cloud formation at the upper Bollinger band
provides con uence for a short trading opportunity. The more evidence that
we can stack on our side, the better chance we will have for achieving a
positive result on the trade. The dark cloud cover, and Bollinger band
combination is an excellent way to combine two non-correlated technical
studies for market analysis.
Trading Dark Cloud Cover Candlestick Pattern
Let’s now build a trading strategy based on the dark cloud cover formation.
This strategy will be based on a mean reversion methodology that uses two
primary technical studies. The rst will obviously be the dark cloud cover
formation, and the second will be the Bollinger band indicator. We’ll use the
default for the Bollinger band indicator which is a 20 period moving average
centerline, and two standard deviations for the bands. The strategy will seek
to capture a high likelihood bearish reversal point in the context of an
uptrending market condition.
So here are the rules for entering a short position using this strategy. The
recommended timeframe for this strategy is the daily chart.
An uptrend must be clearly present on the price chart.
A dark cloud cover formation must be present.
The second bar within the dark cloud cover must be outside the upper
Bollinger band line.
Enter a sell order at the break and close of the low of the second candle
within the dark cloud cover. This sell order must be triggered within a
maximum of three bars following the completion of the dark cloud
cover.
The stoploss should be placed above the high of the second bar of the
dark cloud cover formation.
The exit will occur when one of these conditions is met: The price
crosses below the Bollinger band centerline and then closes above it or
the price touches the lower Bollinger band line. Whichever condition
occurs rst will trigger the exit.
Dark Cloud Trading Example
It’s now time to look at an example of this strategy. The price chart below is
the daily chart of Facebook, and is the same chart that was shown earlier in
the Bollinger band section above. What we have done, however, in this case
is that we have zoomed in to the area of the dark cloud cover set up to
better illustrate this trade example.
So let’s begin. As you can see, the price action has formed a dark cloud cover
formation. Notice the rst candle which is a bullish candle with a relatively
sizable body, and the second candle which gaps higher, and then manages
to close below the midpoint of the body of the initial candle. This validates
the dark cloud cover formation.
Next, we want to ensure that the dark cloud cover occurs in the context of
an uptrending market. Although it’s not clearly visible on this price chart
which has been zoomed in for illustration purposes, you can refer to the
same chart shown earlier which clearly shows that the price of Facebook was
trending higher leading to this dark cloud cover formation.
Now that we have con rmed these two important elements of this trading
strategy, we want to make sure that the Bollinger band condition is also met.
More speci cally, based on our strategy rules, the second bar within the dark
cloud must extend beyond the upper Bollinger line. This provides evidence
of an extreme overbought market condition, which will increase the chances
of a price move lower. As we can see from this price chart the second bar
opened above the upper band, thus con rming this requirement.
Now with all of these items in place, we can prepare for a short trading
opportunity. We would place a market order to sell once the price crosses
below and closes below the second candle within this formation. You can
see the yellow horizontal line marked which shows this signal line.
Additionally, we must keep in mind that in order for this to be a valid trade
set up, that breach and close below the signal line must occur within a
maximum of three bars following the dark cloud cover formation. If you look
closely at the price chart, you can see that the third candle was the charm,
and was the one that broke and close below the important signal line.
With that, we would’ve entered a sell order at the market. Once the sell
entry order was lled, we would turn to the trade management process. The
rst thing we would need to do is to place a stop loss order in the market to
protect the trade. The stoploss would be placed above the high of the
second candle of the dark cloud cover formation.
We can see that immediately following the sell entry, prices began to move
lower sharply and thus, our stoploss was never in any jeopardy of getting hit.
As the price was moving lower, we would need to be cognizant of where our
exit signal would occur. Remember, that the exit for this trade would be
executed upon either the price moving below the centerline and then
closing back above it, or upon the touch of the lower Bollinger band,
whichever of these two conditions occur rst.
As we can see from the chart, the price did cross below the centerline quite
easily, however it was not able to close above it, and instead kept moving
lower until it interacted with the lower Bollinger band as shown by the blue
arrow marked Exit. Therefore, this event would have triggered the exit on
the trade closing us out with a pro table position.
Summary
In this lesson we learned all about the candlestick reversal pattern known as
the dark cloud cover. It is similar in appearance and has the same
implications as the bearish engul ng candlestick, however, there are some
distinct differences as we’ve noted. Both are extremely powerful trading
signals, particularly when they occur after a prolonged period of rising prices.
Some traders mistakenly believe that they can simply use candlestick
patterns in isolation. Using dark cloud cover formations, or any candlestick or
for that matter by itself is not recommended.
The higher probability trade occurs when you are able to nd an additional
layer of con uence that supports taking a short position. We illustrated a few
such techniques of incorporating this type of hybrid method using
horizontal support resistance or Bollinger bands.
As a nal note, the dark cloud cover chart pattern is most often seen in stock
prices, and the in the futures market. Within the Forex market this
formation is more likely to occur at the start of the trading week, since that is
the time when weekend gaps tend to occur.
Candlestick Reading
One of the reasons why technical analysis continues to be such a popular
method of analysing and trading the markets, is because of the vast range of
different methods available to traders. From raw price action reading to chart
patterns and indicator analysis, traders are able to explore and change
methods until they nd a system that works for them. In this article, we will
discuss an important candlestick pattern. Speci cally, we will learn how to
identify and go about trading the Piercing line candlestick pattern.
One area of technical trading in particular that features a wide and exciting
range of options, is candlestick reading. Candlestick reading is at the very
core of technical analysis. Within candlestick reading, there is a large
selection of options to choose from including analysing individual
candlesticks through to complex candlestick patterns. In this article, we are
going to take a look at a mid-level candlestick formation known as the
piercing line pattern.
Before we move onto looking at this pattern and how to trade it, however,
let’s just quickly make sure we are all on the same page with candlestick
reading and why it is so important and useful to traders.
Why Are Candlesticks Important?
Candlesticks are one of the most popular ways of displaying the price
information on trading charts. The reason why they are so popular is that
they provide a really quick visual guide which contains a lot of important
information.
Candlesticks are a super useful re ection of what is going on with the
underlying order ow in the market. So, at their very basic level, candlesticks
tell us four things about the movement in price during that session. The
open, the high, the low, and the close. Furthermore, a red candle tells us that
price closed the session lower than it started and a green candle tells us that
price closed the session higher than it started.
Now, along with that basic information, the shape and size of candlesticks
also gives us a lot of information about the underlying order ow action
during that session. For example, a large green candle tells us there was
heavy buying over that session because price closed much higher than it
opened. Similarly, a large red candle tells us that there was heavy selling over
that session because price closed much lower than it opened.
Now, once we have developed a foundational understanding of what
individual candlesticks are telling us about underlying order ow action, we
can then start to step things up and look at what combinations of
candlesticks, or candle stick patterns, are telling us about the market and
from there we can start to form a trading idea. So, without further ado let’s
take a look at the piercing line pattern.
Piercing Line Candlestick Pattern Example
We identify a bullish piercing line pattern as follows. Following a bearish
candle, the next candle (which is a bullish candle) gaps lower (opens below
the close of the previous candle) and then closes back above the 50%
retracement of the prior candle (closes above the midway point of the
preceding bearish candle). The forex piercing line candle formation is simply
a two-candle pattern.
That’s it, very simple to spot. Essentially what this piercing line chart pattern
is highlighting for us is a sharp shift in sentiment in the market. So, we know
that sellers were in control initially, driving price lower over the course of the
bearish candle. Price then gaps lower at the next candle, telling us that was
an intensi cation of selling.
However, at the low of that next candle, buyers stepped in, in force, and
drove price sharply higher to the extent that price closed above the midway
point of the prior candle. This tells us there has been a sharp shift in
sentiment and alerts us to the potential for a continuation higher, offering us
buying opportunities.
Bullish Piercing Line Pattern Example
So, in the image above you can see a very clear example of this pattern
occurring on the charts. Price is moving in a clear downtrend initially and
near the lows of the move we see a bearish candle form. On the next candle,
we then see price gapping lower (opening below the low of the prior candle)
before buyers step and price reverses higher. This bullish candle then closes
above the midway point of the prior candle, con rming our piercing line
candle pattern.
How To Trade The Piercing Line Pattern
So, in terms of how we would trade this pattern, we can set a buy order as
price breaks above the high of the bullish candle and our stop goes below
the low of that entry candle. From there we then look to target a minimum
of twice our risk to ensure positive risk-reward.
The beauty of this pattern is that it acts as an early warning sign to a
potential bullish reversal. Additionally, because the market is moving lower
at the point the pattern occurs, unless you are trained in reading
candlesticks and know this pattern, then this trade idea wouldn’t occur to
you. As such it can be a great way of gaining a unique entry point in the
market that only certain traders would know about.
This is one of the best things about candlestick reading. Because you are
learning to analyse the raw price action itself and what it is telling you about
the underlying order ow in the market, you will very often nd that you are
able to gain a better entry point to a move.
For example, if you are looking at a bearish trend and waiting for price to
break above a trend line in order to take a bullish reversal trade, very often
you will nd that you are gaining entry quite late in the move. However,
learning to read candlestick patterns such as this one, you are able to be
much more reactive to and in tune with changes in the market.
Knowing this pattern helps you understand the underlying order ow action
driving the market. Knowing the shift that needs to have occurred in order
for this candlestick pattern to form, we are able to establish a buy position
built on a solid trading premise. And we can do so relatively early. This gives
us a much tighter stop and means that if we are looking to keep our trade
open, perhaps if using a trailing stop method, we have the potential to
secure a much bigger pro t.
Now, along with just trading this pattern as a stand-alone system, we can
also look to use it in combination with other technical elements.
Establishing con uence between technical methods is one of the best ways
of analysing and trading the market as it gives us an increased chance of
success with our trade idea.
Piercing Line Pattern with Indicators
So, because we know this is a bullish reversal pattern, we want to look to
identify the pattern at areas where we would expect to nd a bullish signal
such as a test of support, or a retest of broken resistance, or even a test of a
bullish trend line. Another way of establishing con uence, however, is by
using technical indicators. If we look to combine our piercing line pattern
with a bullish signal on a technical indicator, we know the pattern has a
much higher chance of playing out in our favour.
So, looking at the image above you can see a great example of this system in
play. On this chart, we have the stochastics indicator turned on. The
stochastics indicator is a tool that measures momentum in the markets and
tells us when price moves are either overextended to the downside, and
price is therefore vulnerable to a reversal higher, or when price moves are
overextended to the topside and therefore vulnerable to a reversal lower.
So, you can see that as our piercing line pattern has formed, the stochastics
indicator is giving us a bullish signal. The indicator was moving lower as price
was moving lower, then at the point that the pattern occurs, the stochastics
indicator crossed below the lower threshold and then crossed back above.
So, we know that momentum in the market was overextended to the
downside and therefore price is vulnerable to a reversal higher, and we then
see our piercing line pattern form, telling us there has been an order ow
shift.
Once we see these two signals occurring at the same time, we know we
have a solid bullish signal in place, and we can anticipate a reversal higher is
coming. So, once again we can go ahead and enter a buy trade as price
breaks above the bullish candle high, with our stop placed below the low of
the bullish candle. We want to target a minimum of twice our risk to ensure
a positive risk reward on the trade.
Now, as we pointed out at the start, the piercing line candlestick formation
can also be used as a bearish setup. In the bearish example of the pattern,
the parameters are simply the inverse of those found in the bullish pattern.
So, we identify the bearish version of the pattern by rstly, seeing price
trading higher within an uptrend. At the peak of the move, we see a bullish
candle followed by a candle which gaps higher (opens above the close of the
prior candle) and then reverses to close below the mid-way point of the prior
candle. And this serves as the piercing line candlestick con rmation for the
bearish variety.
So, the presence of this candlestick formation tells us that buyers were in
control initially, driving price higher. There was then an intensi cation of
buying causing the gap higher before sellers stepped in, in force, and drove
price lower to the extent that price closed below the midway point of the
prior candle. Once again, this pattern highlights a sharp shift in sentiment in
the market, this time alerting us to the potential for a continuation lower
and a broader bearish reversal to play out.
Bearish Piercing Line Example
So, in the image above you can see an example of this pattern forming in the
charts. Price is moving higher but at the peak of the up move, we see price
gapping higher only to reverse and close heavily lower. So, once we have
established our bearish piercing line pattern, we can go ahead and enter a
sell trade as price breaks below the low of the bearish candle. Once again, we
place our stop above the high of the bearish candle this time (because we
are in a sell trade this time) and we then target at least twice our risk.
As with the bullish version of this pattern, we are able to gain a great entry to
the ensuing reversal. Because we understand that there has been a strong
bearish shift in the market in order for this pattern to form, we know that
there is a strong chance that price is going to continue lower in the wake of
the pattern forming. From there we can capitalise on the bearish reversal.
This is the beauty of the piercing line pattern in technical analysis
As with the bullish version of the pattern, we can look to enhance our
chances of success when trading this pattern by looking to establish
con uence between the pattern and an indicator reading. We saw earlier
how we can use an overextended reading on the stochastics indicator to
identify a trading signal which is con rmed by the presence of the piercing
line pattern.
Another indicator we can use is the RSI indicator. Similar to the stochastics
indicator, the RSI indicator can be a very useful tool for establishing
con uence to place a sell trade. Instead of just identifying when momentum
is overextended, another way we can use momentum indicators such as the
RSI or stochastics to identify divergence.
Divergence refers to a situation where the moves happening in price aren’t
being supported or con rmed by the indicator.
Bearish Piercing Line With RSI
So, in the image above you can see an example of a bearish piercing line
candlestick in an uptrend with the RSI indicator in the sub-panel below.
Now, notice what is happening with the RSI indicator at the point this
pattern forms.
We can see that price is in an uptrend and is also testing a resistance point (a
former swing high). You can see that the RSI indicator is actually putting in a
lower peak against the initial peak, telling us there is bearish divergence in
the market (bullish momentum is weakening) and alerting us to the
potential for a reversal lower. At this point, we then see our piercing line
pattern form. Because we know what the pattern tells us about the
underlying order ow shift in the market, we can go ahead and place our sell
trade as price breaks below the low of the bearish candle.
Final Thoughts
So, now you can see just how simple and effective the forex piercing line
candlestick pattern can be when looking for unique trading points in the
market. Because of what the pattern signi es about the underlying order
ow shift in the market, we can use this piercing line trading in any market
(forex, stocks, equities, commodities) and we can also use it to trade on any
timeframe. So, whether you prefer to trade on the higher timeframes or
prefer to scalp on the lower timeframes, this setup is valid.
As always, the best advice is to spend time identifying the pattern and train
your eye because sometimes the gaps which occur during the formation of
the pattern can be quite slender so you might miss them at rst. And
remember, when taking trades, always use a stop loss and focus on looking
to achieve positive risk-reward by targeting a minimum of twice your risk.
Morning Star Candlestick Pattern
The Morning Star pattern is a candlestick formation that is often seen within
the price action. It has a bullish implication and can often pinpoint a major
swing low in the market. In this article, we will take an in-depth look at this
pattern, along with some of the best practices for trading it effectively.
The Morning Star is a candlestick pattern that is comprised of three candles.
A completed Morning Star formation indicates a new bullish sentiment in
the market. It is considered a reversal pattern that calls for a price increase
following a sustained downward trend. The Morning Star candlestick
structure starts off with a relatively long red candle, followed by a small
second candle that can either be red or green, and then the third candle
which con rms the structure will be a relatively long green candle.
Below you can see the illustration of Morning Star candle pattern
Notice on the illustration above, how the rst candle is a bearish candle that
is relatively large in size, followed by a smaller inner candle, and a nal third
candle which is a relatively large bullish candle. The rst candle within the
structure con rms the bearish sentiment within the downtrend, the second
candle indicates indecision in the market, followed by the third candle which
con rms a potential reversal to the upside. As such, the Morning Star candle
formation is a bullish reversal pattern. And the implication is that the price
should continue higher after the Morning Star structure has completed.
It’s important to note that within the Morning Star formation, the center
candle plays a critical role. The central candle will be a relatively small candle
in relation to the other two candles adjacent to it. Additionally, it is often
seen as a doji candle. A doji candle is essentially a relatively narrow candle
pattern wherein the body is extremely small and there exists a noticeable
wick on either side of the candle’s body. This formation within the Morning
Star pattern indicates hesitation or indecision in the market.
In terms of identifying a valid Morning Star pattern on the price chart, it’s
important that the structure be analyzed in the context of the current price
action. That is to say that a valid Morning Star pattern will generally occur
after a downtrend has been in place for some time. This is what gives the
Morning Star pattern the characteristics of being a bullish reversal signal. The
pattern is indicating that the bearish price trend is in jeopardy, and that an
upside price reversal is imminent.
There are several ways that a trader can execute a buy entry using the
Morning Star formation. One of the more widely used techniques for
entering into a long position following the Morning Star formation is to wait
for a breakout above the high of the third candle within the structure. When
this occurs it provides con rmation of continued upside momentum
following the Morning Star formation, which should lead to additional price
gains to the upside.
Another technique that some traders utilize for entering into a long position
following the Morning Star pattern is to wait for a minor retracement of the
third candle. Typically this retracement will be a 38 to 50% retracement level.
The logic here is that the market should subside a bit following the Morning
Star formation, providing a better entry for the long position.
Although this is a viable entry method for trading the Morning Star pattern,
it does come with some additional risks. The primary risk being that the
minor retracement could lead to a further price decline, and thus there
exists a higher chance of getting stopped out. Unlike the breakout entry
mentioned above, this retracement entry does not require the market to
provide additional con rmation of bullish momentum.
Generally speaking, the stop loss for the Morning Star pattern should be set
below the low of the central candle within the formation. This will usually be
the lowest low within the structure, and as such provides an excellent area
for placing the stop loss. Prices should not move below this level, and if it
does it will typically invalidate the bullish potential of that speci c setup.
Bullish Morning Star At Key Support
When trading the bullish Morning Star pattern, it’s best to focus on the
highest probability set ups. One of the ways to do that is to take those trades
wherein a bullish Morning Star pattern occurs at a key support level. When
this occurs, it provides additional con rmation and con dence on the trade.
This is because at a critical support level, sellers could overwhelm the buyers
leading to a breakout below the level or buyers could overwhelm the sellers
leading to a reversal to the upside from the key level. Since we know that
the Morning Star pattern is a bullish reversal pattern, it can be an excellent
buy signal when it occurs near a major support level.
Let’s take a look at an example of a Morning Star at a support level using the
daily chart of the EURJPY pair.
Notice on the chart above, the two important swing lows that occur prior to
the formation of the Morning Star pattern. These two swing lows should be
connected with a horizontal line to create the key support level. Once price
returns to this level, we will want to watch the price action closely for any
clues of a potential breakout or reversal.
As prices move higher following the second swing low, we can see a third
test of the key support level. And this third test results in the formation of
the Morning Star pattern. Because of this, we would favor an upside reversal
and expect the key support level to hold. As expected, the price begins to
rise following the completion of the Morning Star formation.
When entering into a long position using the Morning Star pattern, it can
sometimes be dif cult to gauge where the price target should be placed.
This is because the Morning Star pattern does not provide any clues as it
relates to the extent of the price move that will follow. As such, you will need
to use some other technical tool for exiting the trade. One such technique
could be to use a three bar low as a trailing stop after the price has moved in
your favor by a certain amount. That is to say that your exit order would then
be triggered when the price breaches the low of the last three completed
bars.
Bullish Morning Star With Stochastics
Let’s now look at another lter that works well with the Morning Star set up.
More speci cally, when you incorporate an oversold reading from a
momentum based oscillator, such as the Stochastics indicator, you will
increase your chances of a successful trade.
The Stochastics indicator is a popular oscillator that provides oversold and
overbought readings based on a default look back period of 14 days. The
Stochastic oscillator has two primary lines, the faster percent K line which is
more sensitive, and the slower percent D line which is less sensitive.
And so, when the percent D line of the Stochastics indicator is in oversold
territory, then that is usually a signal that prices are more likely to reverse to
the upside. When you couple that oversold reading with a candlestick
pattern like the Morning Star, that can provide for a high probability play to
the long side.
Let’s take a look at an example of the Morning Star with the Stochastics
oscillator using the daily chart of the GBPJPY pair.
On the candlestick chart above you can see there is a strong downtrend
leading up to the Morning Star formation. At the time the Morning Star
reversal pattern was forming, the Stochastics percent D reading was below
the oversold threshold as can be referenced by the lower blue arrow on the
chart.
As such, our expectation would be for a price increase following the
completion of the Morning Star pattern. As is clearly evident, after a few bars
of sluggish upward price movement following the completion of the
Morning Star, the price moved higher quite sharply, surpassing an important
swing high level.
Now, although we’ve demonstrated this set up using the Stochastics
oscillator, it would work equally well with other momentum oscillators such
as the Relative Strength Index and the Williams %R indicator.
Morning Star Trading Strategy
Let’s work on building a strategy that incorporates the Morning Star trading
pattern. We’ve looked at how we can use key support levels, and
momentum based oscillators to add con uence for the Morning Star trade
set up. Now, we will describe a full Morning Star pattern strategy that
includes the entry, stop loss and exit. The strategy includes the Morning Star
pattern along with the Bollinger band indicator.
The Bollinger band indicator is a volatility based study that is very useful in
nding overextended price moves. More speci cally, when the price reaches
the upper line of the Bollinger band, that is typically a good time to look for
selling opportunities. Similarly when the price reaches the lower line of the
Bollinger band, that is often a good time to look for buying opportunities.
Now, trading the Bollinger band in this manner can be effective by itself,
however when you combine these conditions with the Morning Star candle
structure, you will dramatically improve your trade results.
Since the Morning Star is a bullish reversal pattern, we will only seek long
trade set ups within the strategy.
So here are the rules for a long trade using the strategy:
A Morning Star formation must have formed on the price chart.
An easily recognizable downtrend must be present prior to the
Morning Star pattern formation.
Enter a market order to go along upon completion of the Morning Star
pattern.
The stop loss should be placed below the lowest low within the
Morning Star pattern.
Exit rule if the entry price is below the centerline, and the Morning Star
pattern does not touch the centerline. — The price must cross above
the centerline of Bollinger band within 10 bars following the long entry.
If this condition is not met, then exit the trade on the next bar. If met,
then, Exit the trade upon a close back below the center line of the
Bollinger band.
Exit rule if the entry price is above the centerline, or the Morning Star
pattern touches the centerline. — Exit the trade upon a touch of the
upper Bollinger band.
Morning Star Pattern Strategy Example 1
Let’s now turn to an actual example that demonstrates the Morning Star
strategy shown on the price chart. Below you will nd the British Pound to
Japanese Yen currency pair based on the daily chart.
We can see towards the bottom of this chart there was a Forex Morning Star
pattern. Notice the strong bearish candle as the rst candle within the
structure, the smaller middle candle which illustrates indecision in the
market, followed by the relatively strong bullish candle that completes the
pattern.
Once we have con rmed the presence of the Morning Star pattern, then we
would look to the previous price action to con rm that there was an easily
recognizable downtrend in place leading up to the pattern itself. As we can
clearly see the price was moving lower in a stairstep manner creating a
downtrend in the price action.
Now with these conditions met, we can focus on executing a long entry on
this currency pair. The long entry would be initiated at the beginning of the
candle immediately following the completion of the Morning Star pattern.
You can see where that entry would’ve occurred by referencing the blue
arrow following the Morning Star formation.
The stop loss would be placed below the lowest low within the Morning Star
structure as can be seen by the black dashed line drawn below the long
entry point.
At this point, we would turn to the trade management process to try to
manage the existing trade as the price moves in our favor to the upside. The
rst thing that we would want to watch is the price in relation to the
centerline of the Bollinger band. More speci cally, based on our strategy
rules, the price must exceed the centerline within 10 bars following the long
entry. This condition will allow us to stay in the trade for further upside
potential.
As we can clearly see the price moves above the centerline within three bars
of the entry signal. As such, will continue holding the trade and utilize the
same centerline as our trailing stop mechanism now.
That is to say that the exit signal would occur when the price closes back
below this centerline of the Bollinger band.
Referring to the far right of the price chart you can see when that event
occurred, which would have taken us out of the position, resulting in a
pro table trade.
Morning Star Candlestick Setup Example 2
Let’s now look at a second example of the Morning Star set up. Below you
will nd the price chart of the Euro to Yen currency pair shown on the daily
chart.
If you refer to the bottom portion of the price chart, you will nd a wellde ned Morning Star candlestick. Notice how the rst candle within the
formation is a relatively long bearish candle, followed by a Doji type candle,
and then nally a strong bullish candle. These three candles combine to
form the Morning Star structure. Now that we have identi ed a Morning Star
pattern, we must con rm that it exists within the context of a down
trending market condition. If you take a close look at the price action leading
up to this Morning Star, you can see that a clear downtrend was in place.
Now that we have con rmed the Morning Star pattern, we can turn to the
trade entry. As per our rules, we would enter a long position immediately
following the completion of the Morning Star pattern. As such the long entry
would be triggered at the start of the following candle as shown on the price
chart.
In order to protect ourselves in the case of an adverse price move, we will set
a stop loss below the lowest low within the Morning Star structure. Since,
the Morning Star pattern touches the centerline, our exit rule calls for closing
out the trade upon the touch of the upper Bollinger band. You can see
where that rst touch occurred following the entry signal. This event would
have required us to close out the trade.
Summary
The Japanese Morning Star candlestick pattern is a three candle formation
that has a bullish implication. It is a powerful pattern when it occurs in
conjunction with some other technical based studies particularly a support
level, or an oversold market condition as can be seen using a momentum
indicator such as Stochastics, or a volatility indicator such as Bollinger bands.
Adding this additional layer of con uence to the Morning Star set up will
help to increase the probability of success.
Evening Star Candlestick Pattern
Among the many different types of technical analysis techniques available
to traders, one of the more popular methods includes candlestick analysis.
Candlestick patterns can be classi ed as continuation patterns, or reversal
patterns. In this lesson, we are going to examine a popular reversal
candlestick formation known as the Evening star pattern.
The Evening star pattern is a candlestick formation that has three candles
within it and is classi ed as a reversal pattern. The structure can be seen near
the end of an uptrend, typically after a prolonged price move. The pattern
has bearish implications, and traders would seek to position to the short side
of the market upon con rmation of the pattern.
The Evening star pattern starts off with a strong bullish candle, followed by a
central candle which is relatively smaller in size, and then the third candle
will be a strong bearish candle which will close beyond the halfway point of
the rst candle. The bodies of the candles are most important within this
formation, and the shadows or wicks within the formation are of less
importance.
Looking at this from the price action standpoint, the initial bullish candle
indicates strong upside momentum within the market, which is then
followed by a period of neutrality as seen by the smaller body of the middle
candle. This middle candle is often a doji candle or a spinning top formation.
However, there is no requirement for the middle candle to be either type.
Finally, a decisive price move occurs to the downside which re ects a
noticeable shift in sentiment which is likely to lead to further price
decreases. Sometimes, we will notice that the third and nal candle within
this formation opens as a gap down price move. When this occurs, it is
indicative of increased supply in the market further con rming a bearish
stance.
The Evening star candlestick pattern can be seen quite frequently on the
price charts; however, the best formations will generally be those that
appear at the top of an uptrend. These would be considered the most
reliable types of Evening star formations.
Traders that are familiar with candlestick pattern analysis will recognize the
Evening star pattern as having the opposite structure to the Morning star
pattern. Within the Morning star pattern, the initial candle is a long bearish
candle, which is followed by a smaller body central candle, and then the third
and nal candle is a bullish candle that closes above the halfway point of the
rst candle within the formation. As such, the Morning star pattern has
bullish implications.
A simple way to think of an Evening star pattern is that the formation
re ects a battle between the bulls and bears, wherein the bears take control
of the market. Conversely, a Morning star pattern re ects a battle between
the bulls and bears, wherein the bulls take control of the market.
Bearish Evening Star Candle Pattern At Resistance
Now that we have laid out the structural elements within the Evening star
candle formation, let’s not discuss some of the higher probability
occurrences for the pattern. As we touched upon earlier, this formation can
generally be seen after a prolonged price move higher within the context of
an uptrend. However, it’s not always a good idea to fade the trend,
particularly when there is strong persistent momentum behind the price
move. One way to resolve this is by looking for the Evening star formation
within an area of resistance.
Resistance can come in many forms such as from a swing high, a
psychological round number, a Fibonacci level and more. Any of these would
work well with the Evening star formation. Let’s illustrate the Evening star
formation that occurs in the context of an uptrend and where a resistance
level has formed.
The price chart above displays the daily price action for the Euro futures
contract. Notice that starting at the bottom left, you can see the prices were
moving higher, and where the majority of the candles can be seen as green
bullish candles. As such, there is no denying that this market was trending
higher.
Sometime later, we can see a major engul ng pattern which thwarts the
upward price move, causing prices to back off and retrace lower. From here,
prices consolidate and move in a sideways manner. A clear swing high
resistance level can be recognized at this point. This resistance level has
been marked near the top of the price chart by the red horizontal line.
Notice later as prices move higher towards this resistance level, that an
Evening star pattern completes. The completed pattern can be seen within
the yellow circled area. Immediately following the completion of the Evening
star set up, prices began to trade lower quite sharply. This example illustrates
the power of combining traditional price action with candlestick pattern
analysis.
Bearish Evening Star With RSI Indicator
Let’s look at another practical application of the Evening star candlestick
reversal pattern. This time, we will combine it with the popular Relative
strength index indicator. The RSI indicator is a momentum indicator that is
quite useful in gauging the extent of a price move. More speci cally, it can
tell us whether a market is overstretched and has become oversold in case
of a bearish price move, or one that has become overbought in case of a
bullish price move.
The default look back within the RSI indicator is 14 periods, and an
overbought condition occurs when the indicator registers a reading over 70.
When the indicator registers a reading below 30, the market can be
considered oversold.
Let’s refer to the price chart of Gold and take a look at the Evening star chart
pattern with the RSI indicator in action.
Starting from the far left within this price chart, we can see that the prices
were moving higher in a stairstep manner. In other words, the prices were
creating a series of impulsive price moves up, followed by corrective price
moves lower. Moreover, it’s quite obvious that the general trend of the
market was up.
Notice that during the entire price sequence higher, the RSI indicator was
rising. This is indicative of a healthy bullish price trend. But towards the peak,
we can see that an Evening star reversal pattern formed on the price chart.
This can be seen within the yellow circled area. Just as this reversal
candlestick pattern was completing, we can take note of the RSI reading.
Notice that around the same time that the Evening star pattern was nearing
its completion, the RSI reading had emerged into overbought territory,
exceeding the upper threshold of 70. This would have provided an excellent
opportunity to short the market immediately following the completion of
the Evening star formation. Even though prices consolidated a bit after the
pattern completion, the price ultimately moved lower as we would have
anticipated.
Evening Star Trading Strategy
Let’s now move on and see how we might go about building a complete
trading strategy that includes the Evening star trading pattern. The strategy
that we will describe is a simple yet effective method for trading the Evening
star signal. The strategy works on all time frames across most liquid
instruments. But it should be noted that the higher time frames such as the
eight hour, daily, and weekly tend to perform the best. Additionally, markets
that are displaying mean reversion characteristics tend to outperform as well
using this methodology.
The strategy incorporates three simple technical elements. First, we will
need to con rm the presence of an Evening star pattern on the chart.
Secondly, we will be looking for the Evening star formation to occur at or
near a resistance level. And nally, will be utilizing the 50 day simple moving
average within the strategy.
However, we will be using the 50 day SMA in a very different way than we
would normally. Under most circumstances, traders would use the 50 day
SMA as a trend lter and trade only in the direction of the larger trend. In this
case, will be utilizing the 50 day SMA as a mean reversion mechanism, and
seek to fade the price action above the 50 day SMA.
Since the Evening star pattern is a bearish reversal pattern, we will only be
taking short trades with the strategy. So here are the rules.
An Evening star pattern must be present on the price chart.
The Evening star pattern must occur at or near a resistance level.
The Evening star pattern must complete above the 50 day SMA.
Enter a short position on the open of the following candle once all
these criteria have been met.
A stoploss would be placed just above the highest high within the
Evening star formation.
The take pro t level will be based on the size of the entire Evening star
formation from high to low. Speci cally, the target will be set at twice
the length of the entire Evening star formation.
As you can see the rules for this Evening star trading system are quite
simple. But do not let the simplicity of this system fool you. It is an effective
robust trading strategy that works very well given the right market
conditions.
One thing to note regarding the strategy above is that some more
conservative traders may want to scale out of their positions rather than hold
for the full two to one reward to risk ratio. One way that they can achieve this
is by exiting half their position at the 1X mark, and then exit the balance of
their position at the 2X mark.
Evening Star Trade Setup Example 1
Let’s now illustrate our previously outlined Evening star trading strategy in
action. Below you will nd the price chart for the British Pound to US Dollar
Forex pair based on the daily timeframe.
As we can see from the far left corner of the chart, the price began trading
sideways creating a W shape formation. We can see that there are three
clear peaks within the price action. If we draw a best t line among these
three price peaks, we can plot a key resistance level. This resistance level will
be something that we will watch closely as price returns to it at some point
in the future.
Following the W shape formation, prices began to move lower sharply and
eventually stalled as a bullish pin bar formed near the bottom of the price
action. The bullish pin bar was followed by a strong price move higher and a
bullish Marubozu candle breaks through the 50 period SMA to the upside.
Prices then begin to consolidate a bit and then after a few tests of the 50
SMA support line, prices move higher once again. This time we can see that
the price approaches the resistance level and then backs of a bit. A
subsequent push higher breaches the resistance level, but then price gets
rejected to the downside. If you look closely at the price action here, you can
see that an Evening star candle formation has completed.
At this point, all the conditions for this trade set up have been met.
Speci cally, we have a completed Evening star formation occurring at or
near a resistance level, and price is trading above the 50 SMA at the time the
Evening star formation completes. We would place a sell entry order on the
candle immediately following the Evening star pattern completion.
The stop loss would be placed just above the highest high of the Evening
star formation as can be seen by the black dashed line noted as, Stop. From
here, we would project a price target based on the size of the Evening star
formation. Remember we will be projecting downward from the lowest low
of the pattern.
You can see the maroon brackets noted as 1X and 2X, which represent a
price move of one times the size of the formation, and two times the size of
the formation, respectively. Our target, based on the strategy rules would be
set at the 2X level. The green horizontal line marks the level at which we
would have exited this position with a handsome pro t.
Evening Star Setup Example 2
Let’s look at another example of this Evening star trading method. This time
we will be using the daily chart for the EURUSD currency pair. You’ll nd this
chart below.
Here, we can see that the price started lower and began to steadily move
higher. Notice the number of strong green candles representing upward
price closes, in comparison to the number of red candles representing
downward price closes. There is no mistaking that the overall trend within
this market was bullish. After a brief consolidation within the EURUSD pair,
the prices continued higher until we see a bearish pin bar formation, also
referred to as a shooting star pattern.
This is another signi cant candlestick pattern that has bearish implications.
The price move lower following the shooting star formation would warrant us
to view the high of that candle as a signi cant area of supply, and thus we
would mark a resistance level there.
Now, after a handful of candles following the shooting star pattern which
pushed the prices lower, the market once again begins to gain upward
momentum. As a price moves into the resistance level, the market forms
another bearish reversal candlestick pattern. This time it’s an Evening star.
And so, once we recognize the completed Evening star forex pattern we
could prepare for a short trade in this market. But before we do, we would
want to con rm that the price is trading above the 50 SMA at the
completion of the Evening star formation. A quick glance of the chart
con rms this condition and thus we would have the go-ahead to place a sell
entry order at the start of the following candle.
You can see the entry-level marked, and the stop loss placement just above
the high of the Evening star structure. Our exit strategy calls for setting a
target at the level where price reaches two times the length of the entire
Evening star structure. You can reference the lowermost maroon bracket
which represents our intended target level and exit point. Once again, this
Evening star reversal strategy provided for a pro table trade.
Summary
The Evening star candlestick is a great reversal pattern to add to your
trading arsenal. It is a three candle formation that generally occurs after a
sustained price move higher. It has the same characteristics as the Morning
star candlestick, but in reverse. Moreover, the Morning star candlestick is a
bullish reversal pattern, whereas the Evening star technical analysis pattern
is a bearish reversal pattern.
There are many different techniques for trading the Evening star set up. We
have described a few here in this article, but that is just the tip of the
iceberg. In any case, the examples and illustrations provided should give you
an excellent starting point from which to build your own techniques for
trading this important reversal formation.