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Day traders and swing traders use candle formations in trading for entries and exits. Get to know the 7 most important candlestick patterns.
There are many candle formations, but only a few of these trading candles are really noteworthy. Here are 7 trading candlesticks that are worth paying attention to in the context of chart technique and trading indicators.
First of all a short look at the formation of the candlestick charts.
A Japanese rice trader named Munehisa Homma developed the candle formations based on his records of prices on the Japanese rice exchange over several years.
It was important to him that this visualization enabled him to make fairly accurate forecasts of future price trends.
This method has also manifested itself in the stock market world since the 1980s.
The nice thing about the candle illustration is that I can read the price development in the time unit under consideration by means of the candle formation. In addition, I also learn a lot about the volatility and the present trend.
Let’s take a look at how this works now.
What does the present candle body tell me about price development?
Let’s now look at what a closed candle tells me about the price trend.
But before we do this, let’s take a look at the fact that I can display a candle in any time unit (depending on the chart software).
The candle then represents exactly this selected period.
Every chart software will display the candles in two different colors. Here I chose green and red, privately I sometimes use blue and white or black and white.
The different colours show me whether the price of the underlying asset has risen or fallen in the period under consideration, or whether it has closed positively or negatively.
Let’s first look at the left, i.e. the red candle.
The candle opens in point 1, where the first price of the new period is determined. The price then finds its high point in this period (point 2) and then falls back to point 4, where it finds its low point in this period.
From there it can recover a bit and finally closes at point 3. The candle is negative, which means that the closing price of the period is below the opening price.
Now we look at the right-hand side, the green candle.
You can see that here the range and the highs and lows are identical to the left candle. The difference is in the opening and closing price.
The candle here closes positively, so the closing price must be above the opening price. This difference to the previous candle is only revealed by the different colour.
How can I trade based on the trading candles?
In order to be able to trade on the basis of the candle formations, you must first set up your chart software accordingly. The chart of an underlying asset is displayed as a line by default and we cannot do much with that.
Remember that these patterns are only useful if you understand what happens in each pattern.
I can have the candles displayed in different time units. When I look at a 4h candle, I can look at the opening, closing, high and low, but I don’t know much about what happens during the 4 hours.
Especially day traders and scalptraders use lower time units like the 5-minute or 15-minute chart.
The following picture illustrates the connection.
Here we can see that the upper 10 minute chart is showing us a downtrend that we do not see directly on the 4 hour chart of the identical underlying instrument.
Now that we have developed a basic understanding of trading candles and time units, let’s look at individual candlestick formations.
But why are we doing this?
Quite simply. Like the Japanese rice trader mentioned above, we traders also have the desire to be able to anticipate the future price of a security or derivative.
In other words, we want to be able to anticipate the future price of a security or derivative:
If we knew where the price of an underlying asset would be in a minute, an hour, a week, etc., then we would be set for tomorrow… Well, the good old subjunctive.
Since none of us knows where prices will move in the future, we want to use the candles to at least give an idea of the approximate direction and thus improve our risk/reward ratio for a trade.
So be aware that one of the following candle formations should never be the sole reason for a trade.
To increase the likelihood of a winning trade, you need to combine the interpretation of the trading candlestick with other forms of charting techniques such as support and resistance or Fibonacci retracements.
It also makes sense to match the individual time units.
Here the rule of thumb applies:
The higher time unit (e.g. hourly chart) is higher value than the lower time unit (e.g. minute chart).
Fakes occur more often in the minute chart than in the hour chart. Therefore, before every trade from the 15 minute chart, I compare the current trend on the 1 hour chart. Only if both are pointing in the same direction (long or short), I enter the trade.
What candle patterns are there in trading?
The following candle formations are divided into two parts: Bullish trading candles and bearish trading candles.
Their respective shapes are intended to give us an indication of whether the price is likely to rise or fall in the near future.
We start with the first bullish candle formation.
This pattern consists of two candles. The first candle tells us nothing about the pattern yet, except that the downward trend is still intact. The second candle “devours” the previous candle. The buyers have overwhelmed the sellers (demand is greater than supply) and now want to initiate an upward trend.
So here we see a potential trend reversal, from short to long. Traders who want to trade on the basis of the pattern will thus position themselves long after the second candle (i.e. with the third or fourth candle) has been completed.
Bearish Engulfing is the exact counterpart to Bullish Engulfing. It marks the potential end of an uptrend and initiates a downtrend.
The second candle opens with a gap up, encloses the first candle again and then ends in negative territory.
The hammer should also signal an imminent trend reversal. The hammer appears at the end of a downtrend. Ideally this candle has a high momentum and a long wick. This means that volatility was high during this period and at the low point there were many buyers who pushed the price back up.
Note: A hammer is sufficient to deliver this signal. In the picture I have added a second hammer to show that both positive closing price and negative closing price (red) are considered hammers.
Hammers can occur at significant support zones, for example. Various stop losses are then triggered there, which the big boys use for a long entry due to the healthy liquidity. In this article here you can take a look at the topic of stop loss fishing.
The Inverted Hammer has the same conditions as the “normal” hammer. However, the trend direction is exactly the opposite. The Inverted Hammer occurs at the end of an uptrend and signals a possible reversal to a downtrend.
Again, a hammer candle is sufficient to provide the signal, but both types of candles shown (red or green) can occur.
Caution: Danger of confusion! The Hanging Man looks just like Hammer and Inverted Hammer, but the trend is different.
The following picture illustrates the difference between Hanging Man and Hammer candle. The hanging man marks the end of an uptrend, whereas the hammer marks the beginning of an uptrend. The whole thing then applies in reverse to the Inverted Hammer.
The (or that?) doji is also a trend reversal formation. The doji is probably the most popular candle pattern in stock market trading.
The underlying instrument does not really feel like moving during the period under consideration and closes directly at or near the opening price. It represents indecisiveness of the market participants and possibly a low trading volume. Some traders have doubts about the continuation of the current trend, which in the vast majority of cases leads to a trend change.
The formation shown is also known as Morning Doji Star and symbolizes a potential trend reversal.
A “kicker” is sometimes called the strongest candle pattern of all. You can see in the graphic above why this pattern is so explosive. Like most candle patterns there is a bullish and a bearish version.
In the bullish version, the underlying asset moves down and the last red candle closes at the bottom of the range. Then, the next period begins with a significant gap up and closes above the last candle.
This “shock event” forces small sellers to hedge or sell and brings new traders to the long side. Often, market-moving news that is released after the close of the market is crucial to this candle pattern. This is reversed in the bearish version.