Candlestick charts are graphical way of representing the open, close, high and low of the price of a market over a given period of time developed in Japan.
Candlestick reversal patterns are one of the most commonly used technical trading signals in futures and forex trading. While they do not represent a magic bullet to trading millions, over time candlestick reversal indications have been found to be a reliable indicator of trend change.
Candlestick charting, originating in Japan over 300 years ago, only became popular in the Western world in the last half century. However, in that time span, candlestick charting has largely replaced bar charting as the technical trader’s tool of choice.
The major advantage that candlestick charting offers is that the candlestick representing whatever given time frame (hourly, 4-hour, daily, etc.) provides a much clearer visual representation of the relation between the opening and closing prices of the time period – i.e. whether price ultimately closed higher or lower for the period.
Candles make it easier for traders to see the most important aspects of the trading action for each period. Candlestick charting also offers a further advantage by virtue of the fact that there are clearly defined candlestick patterns recognised as signals of potential market trend reversal.
The Pin Bar
One of the most widely recognised candlestick reversal patterns is the pin bar. The pin bar is also referred to as the 'hammer pattern' when it occurs in a bearish trend, signalling a possible bullish market reversal, and as the 'shooting star' pattern when it occurs in an uptrend, signalling a potential reversal to the downside.
The above image shows a hammer pin bar that indicates a potential market reversal from downtrend to uptrend. The key element of the pin bar is the elongated tail. The long tail is formed by bears aggressively pushing price significantly lower during the time period – but the fact that the closing price is back up near the opening price indicates that the attempt to push price lower was ultimately strongly rejected. The initial drop in price is followed by a stronger move to the upside that brings price back near, or even above, the opening price.
The “message” of the hammer candlestick pattern is that downside momentum has been exhausted and that bulls have now strongly entered the market to attempt to push price higher.
When the hammer pin bar pattern is an accurate indication of trend reversal, price does not usually subsequently go any lower than the low of the pin bar candlestick. Therefore, traders who buy based on this reversal indication frequently place a stop-loss order just a pip or two below the low of the pin bar.
The shooting star pattern – which indicates a potential market reversal to the downside – is simply the hammer pattern turned upside down. There is a long tail on the topside of the candlestick body, which represents a failed attempt to push price higher, rather than on the bottom side of the body as is the case with the hammer pattern.
Engulfing candlesticks are another candlestick pattern that indicate a possible market reversal. A bullish engulfing candlestick, indicating a possible reversal to the upside, is one where the body of an up candlestick (one where the close is higher than the open) completely encompasses the body of the immediately previous down candlestick. Conversely, a bearish engulfing candlestick that may signal the end of an uptrend completely encompasses the immediately previous up candlestick.
The 30-minute chart of GBP/USD below shows a large bullish engulfing candlestick six candlesticks in from the left-hand side of the chart, that occurs on April 12th – after which the market did move strongly to the upside.
A doji candlestick is formed when the opening and closing price of a candlestick are identical, so that the candlestick has essentially no body, only upside and downside tails that extend on either side of the opening/closing price. Above is what a doji candlestick looks like.
The common interpretation of the doji pattern is that it indicates indecision in the market. Price moves both higher and lower, but ultimately settles right back where it began. Indecision in a market often precedes a trend change, and that’s why the doji pattern is often considered an indicator of possible trend change, although not as strong an indicator as the pin bar or engulfing candlestick patterns.
Candlestick reversal patterns can be key technical indicators of a possible trend change, either from uptrend to downtrend, or vice-versa. When such reversal patterns occur, traders look to other technical indicators – such as moving averages, pivot points, and volume – for confirming indications of a market reversal.