Price action CFD trading strategy: rejection candles

The basis of this CFD trading strategy is to use a Japanese candlestick pattern to find a price level that has been ‘rejected’ by the market. Learn more…

Definition of trading strategy

A ‘rejection candlestick’ communicates the rejection (or reversal from) higher or lower prices. Naturally, it is found when using Japanese candlestick charts. The candlestick shows that the market has pushed in one direction but then been rejected.

 

How it looks

The ‘rejection candlestick’ looks exactly like a shooting star bearish reversal candlestick or the bullish hammer reversal candlestick pattern. It is also known as ‘pin bar’ pattern (short for Pinocchio!). The main characteristic is the long wick in contrast with a short body.

hammer & shooting star

What distinguishes this strategy from the identical Japanese candlestick pattern is where it happens on the price chart. The rejection must take place at a significant high or low in the market.

 

Where will rejections happen?

In this chart it can be seen that the evening star pattern happen at the previous high in the price. What it shows us is that bulls tried to take the market higher but bears took control and forced the price back down again.

The fact that it happened all within one timeframe (whatever timeframe the candle is) shows us that there has been rejection. The previous high in this case shows us that the rejection was of something significant – an attempt by the market to make a higher high - a characteristic of an uptrend.

 

evening star rejection

 

The point of the above chart is to show what is integral to this trading system. The rejection candle must occur at an area on the chart that is worth rejecting.

NOTE: A common mistake by newbie traders upon learning a candlestick pattern is to trade every candlestick pattern they see. A cursory glance at any price chart will quickly show that there are many ‘failed’ candlestick patterns. The point is this – the candlestick reversal pattern will only consistently work at important price levels.

This leads us to the next question. What is an ‘important’ price level?

The list below highlights six areas of the chart in which rejections should happen. So make sure the rejection you are considering as using as a trigger to enter a trade is at one of these areas on the chart in order to increase your overall probability of success.

  1. Round numbers
  2. Previous swing highs and lows
  3. Trendlines
  4. Popular moving averages (50DMA, 200DMA etc)
  5. Fibonacci retracement levels
  6. At the end of a very extended trend

There are other things like pivot points but this strategy is better as KISS (keep it simple stupid!)

 

Good rejection candle examples

The below chart has been picked at random to give some indication as to how this strategy can be employed, giving examples of each of the above price areas.

 

Price Rejections

 

Let's run through the price action ---

  • Two consecutive long wicks reject price moving below the 200-day moving average and after some consolidation the price moves higher.
  • The up-move gets rejected by the 4th touch of a falling trendline and price is send significantly lower to just above the 1.10 round number,
  • where lower prices are rejected and sent back higher again to the moving average, which this time acts as resistance instead of support.
  • The price falls but eventually makes its way back up to the old high where the up-move is rejected and price is sent back down in another large down-leg, which gets very over-extended,
  • which eventually creates a rejection of lower prices and sends the price back higher. The resulting up-move

 

Bad rejection candle examples

No trading strategy works perfectly – and that’s without consideration of important ingredients to trading including risk management and trader psychology. But there are some rules of thumb to increase the probability of each trade by avoiding some common pitfalls.

When looking at good examples, we focused on finding ‘important areas’ on the price chart in which to take the rejection signals. In the bad examples, we are focusing on some reasons that might increase the probability that the patterns fails in order to decide which rejections to ignore.

These are four rules of thumb for which rejections to ignore:

  1. The rejection is against the dominant trend
  2. The rejection happens at a level that has recently been rejected
  3. The wick of the candle is too small to be significant
  4. The rejection happens too far away from important area on the chart

 

Dominant Trend

 

By ignoring trades that meet one of the four previously listed criteria, we can filter out the ‘bad trades’. It’s no mistake that top of the list is going against the trend. Counter-trend trading is very difficult and typically something that should only be attempted by advanced traders with a very fine-tuned system with very well-defined risk: reward criteria for when to take such trades. The other three are really about the 'quality' of the setup in which the rejection is happening. Taking only the highest quality setups means fewer trades but greatly improves the win:loss ratio of the trading system.

 

Final takeaways

  • Understand what the candlestick pattern looks like
  • Only take the very best shaped candles
  • Enter trades following rejections from the listed ‘important area’
  • Filter out bad trades with the 4 rules of thumb
  • Compliment this trading strategy with risk management and psychology techniques

 

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