Candlesticks Lesson 2

Welcome to Trading with Candlesticks Part Two, presented by Daily FX Education.

In part one, you were introduced to candlestick charts and learned why this chart type is
often preferred over line and bar charts. Through examples, we illustrated how candles
provide more information than line and bar charts, providing traders with the opening price,
the closing price, the high price and the low price on each candle. Additionally, we
demonstrated how candles provide speculators with unique visual cues that can help to
comprehend market sentiment. And finally, we pointed out that western technical analysis
patterns often take several months to setup, while candlestick patterns emerge in one to
only a few completed candles. With these benefits, traders can more quickly and accurately
locate price reversals and identify entries and exits for their trades.

After laying this groundwork, we introduced three bullish candlestick patterns and three
bearish candlestick patterns.

And in this video, we’re going to pick up right where we left off. By the end, you should be
familiar with 18 of the most popular candlestick patterns and have plenty of trading
opportunities to work with. So let’s get started.

Single Candlestick Patterns

The first half of this video will focus on single candlestick reversal patterns. Because only
one candle is needed for these patterns to emerge, they are often the easiest patterns to
recognize. This fact is why many traders like trading off of single candlestick patterns.

We’re going to first be looking at reversal patterns, so it’s important to stress that any
reversal pattern found does not necessarily suggest a complete reversal in trend, but often
just a change or pause in direction. That could mean anything from a slowdown in trend ,

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sideways trading after an established trend , or a full turnaround following a reversal candle
pattern.

Let’s get started with the doji.

By definition, a doji forms when a candles opening and closing prices are virtually the same.
Visually, a doji candle will look like a cross or a plus sign and this pattern represents market
indecision. As such, this candle formation suggests a potential for the pair to change
direction as neither buyers nor sellers have been able to establish control.

Now let’s look at a textbook example of a doji formation on a USD/JPY chart.

Remember, by themselves candlestick patterns don’t provide us with much credible

information to work with. But in conjunction with support and resistance lines, candlestick
patterns can provide us with great insight. So, to get things started let’s plot a trend line
here, which you can see has been acting as resistance to the USD/JPY pair. Now, let’s look
for a bearish doji formation to help us locate a solid selling opportunity.

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Continuing to watch this chart, we get what we’re looking for – a doji has formed and the
high of the candle briefly touches the resistance line. Again, because the open and the
close price are nearly equal to each other, we have market indecision. Buyers haven’t taken
control nor have sellers. And what is key here is that this is happening near an established
trend line or resistance line. With this, we can look for a good opportunity to go short and
sell the USD/JPY.

In this example, an aggressive trader could open a trade on the open of the next candle and
place a stop about 25 pips above the resistance line.

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A more conservative trader, knowing that the upper wick on the doji was a bit long would
look for prices to retrace a portion of the wick before entering. A conservative trader may
look for an entry halfway to 2/3rds of the distance up the topside of the wick and place a
stop 25 pips on the other side of the resistance line. In this case, the conservative trader is
able to tighten the stop of the trade, but also risks missing the trade if prices never retrace
up the wick, as you can see it did not in this example.

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Before moving on we’d like to mention that there are two rarer doji formations called a
Dragonfly doji and a Gravestone doji. A Dragonfly doji forms when the opening and closing
price equal the high of the day. A Gravestone doji forms when the opening and closing
price equals the low of the day.

Again, these patterns do not form all that often, however, when located they often suggest
that the direction of the trend may be nearing a major turning point. Here are a few quick
examples to illustrate this. Notice in each example how quickly the trend changes direction
after this candle has formed.

Shooting Star

The next candle formation we’re going to talk about is the shooting star. This bearish
candlestick formation appears when the price of the currency pair has traded well above the
opening price but then closes below the opening price. Buyers have thus succeeded in
pushing the price quite a bit higher during the session but were not able to sustain that
level. Therefore, it is probable that price action may decline in the near future.

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To be considered a shooting star, the formation must be in an upward or bullish trend.

Also, the distance between the high price and the opening price must be more than twice as
large as the shooting star's body. Like all candle formations, this formation becomes most
effective when it appears near a resistance area or resistance line.

Here is a situation where prices began to sell off on the GBPUSD near the 1.7000 mark.
Prices then found a short term bottom at 1.61 on Sept 1. From this point we can draw a
fibonacci retracement to determine where potential resistance might be on an upward
retracement.

Many traders like to look for an entry near the 61.8% retracement level so let’s wait and
see if prices will bounce there or not.

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As the price approaches, we will be on the lookout for a bearish candle formation to confirm
a potential reversal. On September 11, the 61.8% fibonacci retracement line is pierced and
a shooting star forms.

An aggressive trader would enter on the open of the next candle and place a stop 25 pips
above the high of the shooting star. A more conservative trader is going to notice the long
wick to the upside and anticipate a retracement of the wick. Therefore, a conservative
trader may place an entry ½ to 2/3rds up on the distance of the upper wick and place their
stop approximately 25 pips above the high of the shooting star.

Hanging Man and Hammer

The next two formations we are going to discuss are the hanging man and the hammer.
These candle formations can look identical to one another. What separates them is where
they form.

The Hanging Man is a bearish candlestick formation that forms at the top of an uptrend.

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Generally, it forms after a strong sell off at the open but buyers then come back to push the
price back up so that the close occurs near the open. The strong selloff, however, is taken
as an indication that bullish momentum can be fading and that sellers may be taking over.
The color of the candle can be either be red or blue.

The hammer is a bullish candlestick formation that forms at the bottom of a downtrend.

A hammer will occur after a currency pair has been trading lower and declining for a period
of time. Through the course of the candle, the price will trade lower than the opening price

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but will strengthen to close higher than the open. Like the Hanging Man, the hammer can
either be red or blue.

Let’s go back to our previous example where we saw a shooting star on the GBP/USD chart.
Remember, we were looking for a bounce of off the 61.8% retracement. Once the 61.8%
line was pierced, a shooting star formed. After the shooting star forms you can go short. But,
let’s assume you are a bit more conservative and prefer to have more than a single candle
formation to confirm any particular trade.

So instead of jumping straight in, you wait. And look, it pays off. Notice how the next
candle that formed was a hanging man. The hanging man pattern closed slightly higher
than the shooting star, so the conservative trader would now see 2 bearish candle
formations in a row and perhaps open a trade on the open of the next candle.

At this point, I would feel pretty good about this trading opportunity. But let’s assume that
you still hadn’t entered. The next candle it’s another hanging man. So we now have 3
consecutive bearish candle formations occurring near a resistance line. If you were already
in this trade, you’d want to stay in it. This paints a bearish picture and if you were not in
this trade already, I would suggest entering on the open of the next candle to go short. You
could place a stop just above the high of the shooting star in case there is a retest of its
wick. The important point to stress here is that the more consecutive candle formations you
locate, typically the better the trading opportunity. Especially, when these formations
appear near support and resistance levels.

In this example, things played out fairly well. Eventually prices dropped over 800 pips over
the next several weeks.

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Spinning Top

The next pattern is easy to spot and looks similar to the doji. However, there is typically a
long wick above and below the body of the candle. In fact, this is where this pattern gets
its name. Due to the long wicks and the thin body (typically right in the middle of the candle)
this formation looks like a wooden top that children often play with.

A pattern of this nature indicates indecision on the part of buyers and sellers. The opening
and closing prices are quite similar even though prices have demonstrated quite a bit of
movement during the course of the candle’s time frame.

Should this candle appear in an uptrend, it could indicate that the buyers are potentially
running out of steam and a bearish move to the downside could ensue.

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