These 5 Candlestick reversal patterns are one of the quickest ways for beginner traders to develop an edge trading the forex market.
Contents: Candlestick Reversal Patterns
- How do you read a candlestick chart?
- What is a reversal pattern?
- What is a reversal candlestick pattern?
- What is the strongest candlestick pattern?
- What do reversal candles look like?
- Bullish patterns
- How do you spot a bullish reversal?
How do you read a candlestick chart?
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 becoming a millionaire trader, over time candlestick reversal indications have been found to be a reliable indicator of trend change.
History of Japanese Candlestick charts
Candlestick charting, originating in Japan over 300 years ago, only became popular in the Western world in the last half century. Steve Nison, author of ‘Japanese Candlestick Charting Techniques’ is widely credited as the pioneer of candlestick charting, who really helped popularise them alongside the rise of online brokers. Now candlestick charting has largely replaced bar charting as the technical trader’s tool of choice.
Advantages of candlestick charts
Better Visuals: 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 relationship between the opening and closing prices of the time period – i.e. whether price ultimately closed higher or lower for the period.
Recognizable patterns: 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.
What is a reversal pattern?
There are two main types of reversal pattern. The first is a classic charting pattern reversal like a double bottom or Head and Shoulders top. The second is a Japanese candlestick reversal pattern, typically made up of two to three candles on a candlestick chart. Today we are talking about the latter.
What is a reversal candlestick pattern?
The purpose of a reversal candlestick pattern is to give a signal that the short-term direction of the market, over the next several periods is changing. This is as opposed to a continuation candlestick pattern that signals the trend is likely to continue in the same direction.
The “message” of technical analysts take from a reversal pattern is that momentum has been exhausted and is now moving in the opposite direction.
Bullish reversal pattern
This is a signal that a price which is going lower is turning higher.
Bearish candlestick reversal
This is a signal that a price which is going higher is turning lower.
5 Best Candlestick reversal patterns
What do reversal Candles look like? What is the strongest candlestick pattern? We will show you which we think are the most important candlestock reversal patterns.
1) The Hammer
One of the most widely recognised candlestick reversal patterns is the pin bar – because it looks like a pin. You can see it here:
In Japanese candlestick terms, 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 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.
Hammer pattern trading strategy
When the hammer 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, the typical strategy is as follows:
Entry: At market open after hammer candlestick has closed
Stop loss: Underneath the low of the hammer candlestick
Take Profit: Risk: Reward ratio of 2:1
2) Shooting Star
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.
3) Bullish Engulfing Candlestick
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.
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.
Bullish engulfing candlestick trading strategy
When the bullish engulfing pattern is an accurate indication of trend reversal, price does not usually subsequently go any lower than the low of the second bullish candlestick. Therefore, the typical strategy is as follows:
Entry: At market open after second engulfing candlestick has closed
Stop loss: Underneath the low of the second engulfing candlestick
Take Profit: Risk: Reward ratio of 2:1
4) Bearish Engulfing Candlestick
A bearish engulfing candlestick signals the possible end of an uptrend. It is where a bearish down (normally red or black) candle completely encompasses the previous up candlestick (normally green or white).
5) The Doji candlestick pattern
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. This 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.
Doji candlestick pattern trading strategy
If a Doji pattern happens at the end of an over-stretched trend, it can be a good signal that a top or bottom is close. If the doji pattern happens near the beginning of a strong trend, it can act as a second chance to enter in the direction of the existing trend.
Entry: Buy Stop order above the high of the doji or Sell stop order under the low of the doji
Stop loss: Placed at the opposite side of the doji to the entry stop order
Take Profit: Risk: reward 2:1
Candlestick patterns Conclusion
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.