A Simple Approach to Candlesticks by Sam Evans

 

Each and every trader around the world today has their preferred method or technique for tackling the challenges of the Forex market in the ongoing quest for consistent profits. Some pour over the lines of detailed fundamental analysis, using their deep understanding of macro economics to decide the fate of the world's currencies. Others, like myself, are purely technical traders using the power of charts and patterns to scan the market for low risk, high reward signs of opportunity. As we all know, there are a whole host of different techniques available to us to help or even hinder the decision making process in our trading, including the numerous technical indicators across the growing number of charting platforms. In the ongoing Extended Learning Track (XLT) program, I like to keep things simple and while we like to employ a level of consistency in our approach to finding opportunities in the markets, we do from time to time, look at other ways of doing things.

Recently, one of my new students in the sessions asked me about candlestick patterns and if I used them in my own trading. In response to the question I said that I believed candlestick patterns were of great importance in successful and consistent trading and offer a further level of odds enhancement to a trade, only if used in the correct manner. Like anything else, candlestick patterns will provide some powerful clues to what is going on in the market, but only if used in conjunction with another reliable strategy, as well. Let me explain.

There are hundreds of different candlestick patterns which form over and over again in the market. This should be of no real surprise considering that these patterns are just the result of human emotions and actions and all human beings are simply creatures of habit. There are books and entire websites devoted to candlestick charting methods and it is a very popular study among many traders in Forex today. When I first started trading, I tried out pretty much everything I could get my hands on and candlesticks were the object of my attention for a while. I memorized as many of the different patterns as I could, and made sure I knew the names of the setups and what they should mean, sitting at my computer anxiously waiting for one to present itself to me and give me a shot at a winning trade. I knew all about the Harami, the Bullish and Bearish Engulfing patterns, Morning Star Dojis, Island Reversals and Dark Cloud Cover. Yes, I had learned them all, but the only problem was that I was spending so much time looking for the candlestick formations on my charts that I was missing some fantastic trades which were setting up right before my very eyes! I was getting too caught up in the micro details, rather than focusing on price in conjunction with the candlesticks.

In essence, I soon found that while there are numerous different candle patterns in charting, the vast majority of them mean the very same thing. In my own trading now, I just pay attention to the basic and most common of them all, the Shooting Star, Hammer, Spinning Top and the Doji. See the example below:

 


Figure 1

 

All of the above patterns are at their most powerful when found at the end of an uptrend or a downtrend – we would describe them as reversal patterns. Notice how the long wicks are present on the candles themselves? This is a key sign of hesitation in the market, with a battle of sorts brewing between the buyers and the sellers. Traditional technical analysis schools of thought would use these candle patterns for signals to go long or short, hoping to buy at the start of the new emerging trend, and in many cases these work out very well; however, used alone, this is a technique which can also lead to very large risk and little rewards. Take the following example:

 


Figure 2

 

As we can see from this example from NZDUSD, a nicely formed Hammer reversal candle formed around 0.6950, igniting an uptrend in the market. Classic methods would have us wait for a confirmation candle to form before taking the trade long. By doing this, however, we would not be taking the trade until 0.7050, a total of 100 pips further up, increasing our risk dramatically and reducing our reward by a huge sum. It would be far safer to take the trade knowing that we are at an area of demand or support where we have the lowest risk, and then use the hammer candle as the confirmation of the buy instead. This makes the trade far more attractive overall. The same can be said in a short selling scenario:

 


Figure 3

 

In this example of a GBPUSD short, we can see another classic reversal candle forming at supply or resistance around 1.5500, this time being a Shooting Star. If we were to wait for the next candle to close below the Shooting Star, then we would not be taking the trade until it reached a price of around 1.5400, again decreasing our reward by selling late in the game and increasing the overall risk on the position. Instead, the consistently profitable trader would look to see at supply and use the Shooting Star as confirmation of the ignition of the downward move.

Whenever I am working with new students of the markets, I always like to drive home the message that above all, price itself should be the first and foremost indicator of a trade. I look to buy low and sell high, scanning the Forex markets for only the highest reward and lowest risk opportunities on offer. Novice traders need to understand that any other pattern or indicator will only present an opportunity to take a trade when it has already happened, and candlestick patterns are really no different from anything else. The more confirmation we wait for in the market, then the greater risk we take on and the more potential reward we sacrifice. Confidence in a solid rule-based trading strategy, will always trump confirmation hands-down, be that from candlestick patterns or any other technical indicator.

Until next time,

Sam Evans sevans@tradingacademy.com

 

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