Basic candlestick anatomy

Whenever you look at a price chart, you will select a timeframe for that chart – perhaps it’s
a minute … or an hour … or a day.

Rather than simply plotting the open or close price for that time frame, the candlestick gives
you information about what went on during that period of time …

Having all this extra information, gives you a heads-up about market sentiment – and can
offer invaluable clues about the way the market will move.

The Doji

The Doji is a candlestick where the opening and closing prices are the same (or almost the
same). It can take many forms, as shown here, depending on what the trading activity was
in that period.

What’s key with a doji is that neither the bears

nor the bulls have gained control, and that the
price has ended where it began. It’s a sign of
Applying doji candlesticks: a good trick is to
look out for a doji near the edge of a price
channel (i.e., if a doji appears at the top of a
channel it could indicate a bearish correction.)
Here are a couple of examples:

This bullish harami shows the sellers

beginning to
dominate as they come back into the market:

This bearish harami has a shadow that extends

beyond the body of the previous candle – some
traders wouldn’t regard this as a “true” harami.
However, it’s body is entirely within the previous
green candle, and a reversal follows:

!
A hammer: is found in a downtrend, and signals a bullish reversal. The long
lower wick shows a period in which sellers where in control, but the body shows
buyers coming back in. From this we can tell that there is strong buying by bulls
as the period of sell-off declines.

As with all single candlestick patterns, we should wait for next candle to confirm
that buyers are in control.

Here’s a chart for Eur/USD. Note how the strong selling action and increased
volume (indicated by the long lower wick) on the candlestick is reversed as
buyers come back in, and that this coincides with an oversold indicator on
Stochastics. The green candlestick opening above the body of the hammer
confirms the bullish trend.

A hanging man: is the same shape as hammer, but found in an uptrend. We

don’t expect to see strong selling pressure (seen in the long lower wick on the
candle) in an uptrend, so here it suggests a change of market sentiment and a
reversal to downside.
 Here’s an example from a FTSE 1-minute chart.

In this case, the hanging man shape coincides with the Stochastics showing the
price to be overbought, and the next candle confirms the move.

There's no hard and fast rule about what colour a hammer or a hanging man
should be – the fact that they have a short body already means that there's
indecision coming into the market. However, a green (or white) hammer and a
red (or black hanging man) are stronger indicators.

(The chart above is quite a good illustration, because you’ll probably be able to spot
a couple of hammers on there, too – see what you can find!)
 A shooting star forms after an
uptrend or at the top of a period
of consolidation.

Inverted hammers and shooting stars can have green or red bodies – what’s
important here is that the body size is small, that the upper wick is at least
twice the length of the body, and the lower wick is negligible.

Engulfing (Bullish & Bearish)

An engulfing pattern signals a reversal, and can be bullish or bearish. It

comprises two candles. The body of the second must engulf the body of the
first, and must be the opposite colour to the first.
 For a bullish engulfing candle, we have a
smaller red candlestick, followed by a
green candlestick, the body of which is
greater in size that the previous candle.

For a bearish engulfing candle, the first

candlestick is smaller and green, followed
by a red candlestick, the body of which
engulfs the previous candle.

In this example of a bearish engulfing pattern, we have a

clear uptrend, where the final candle has a red body,
which engulfs the body of the previous candle. This
suggests that strong selling pressure has come into the
market, and could indicate a reversal or period of
stagnation.

!
As you can see, we have a strong upward candle, in the direction of the trend,
followed by a gap up to a small candle, showing indecision. The next candle,
moving strongly downwards confirms the morning star signal. And traders who
spotted this evening star reversal signal will have enjoyed a big downward
swing.

Three White Soldiers (Bullish) & Three Black Crows

(Bearish)

Here’s a great example of three black crows I spotted on the AUD/USD chart …

Three long red (or black) candlesticks with lower and lower closes appear within
an upward trend (in this case, a rising triangle). They show powerful selling
action which strongly suggest that more selling is imminent. And, as we see,
the price continued downwards through longterm support at 10536.
 The flip - side to three black crows are three
white soldiers – three strong green (or white)
candlesticks within a downtrend. These are a
bullish signal of strong buying ac tion at work.

Piercing Line (Bullish) & Dark Cloud Cover (Bearish)

The piercing line and dark cloud cover are reversal signals similar to the
engulfing pattern except the second candlestick doesn’t completely engulf the
body of the first – it should close at least halfway into the real body of the first.

A piercing line pattern occurs in a downtrend. A strong red candlestick is

followed by a candlestick that opens below its close, which perpetuates the
downtrend. However, the price then moves up and closes above the midpoint of
the previous candle. This suggests to the bears that a bottom could be forming.
Dark cloud cover occurs in an uptrend, when a red candle opens above the
previous candle’s closing price, but then the price retreats to below the
midpoint of the previous candle.

As a reversal signal, these are not as strong as engulfing candles. The further
the close of the second candle cuts into the body of the first candle, the more
valid the signal. What piercing line and dark cloud cover do offer traders is
cause to pause – a minor top or bottom may be about to form, or you may be
entering a period of consolidation.
downtrends – bullish and bearish legs, respectively. When price remains closely within a diagonal range
bounded by two parallel lines, this small price range is often delimited with “trend channels,” indicating
the upper and lower boundaries of the trend. When price moves within a horizontal range without
moving in a clear directional trend, the price’s action is said to be in the “trading range.”

There are a few basic rules to bear in mind when drawing trendlines:

1. Tentative trendline - A diagonal line the market bounces off of twice. This trendline is indicative of

a potential trend, but is not confirmed and actionable just yet.

2. Confirmed trendline - The market has bounced off this trendline three times. Conventional analysis
regards this as a sign that the trendline is real, and that the market will react around it.
It is easiest to trade from a trend when its highs or lows hew closely to a recognizable diagonal line,
since this line may be used to predict future highs or lows. Opinions vary on whether trendlines should
be drawn from the highs and lows of candles or from the body of the candle, the open and close prices;
successful traders can be found employing either approach.

Support and Resistance

The price action trader pays particular attention to pivotal price levels, often “drawing” these lines
horizontally as Support and Resistance levels. The theory behind employing these lines is that the
market has a sort of memory: price behaves with respect to certain levels that have previously been
significant turning points in the historical narrative of the price’s action, and other market participants
are likely

to also be trading with consideration for these levels. When the levels are below the current price, they
constitute “Support,” a potential buffer against bearish movement; when the levels are above the
current price, they appear as “Resistance,” a potential barrier to bullish movement. As price comes close
to these levels, traders often wait until the levels have been tested and either broken or defended
before they are confident enough in the direction of price’s movement to enter into a trade riding
internal legs within larger general trends to achieve smaller-scale, more reliable profits.
In general, price action traders buy at Support and sell at Resistance, relying on these previously-tested
levels to make safer bets on the future behavior of price. The most significant Support and Resistance
levels are those closest to the current price level, as they are the most likely to be taken into
consideration in the immediate developments of price movement – for this reason, some traders will
only draw in the nearest reliable level of Support and Resistance to simplify their charts.

Key Candlestick Patterns: The Timeliest Indicator

Since candlesticks are the basic visual unit of the price action chart, recognizing their implications within
the greater narrative of price is crucial to the price action trader’s ability to enter and exit positions at
the most advantageous times. The relationships between the four price levels that make up each candle
– open, close, low, and high – have strong implications about the future direction of price. Candlestick
patterns can often be the most timely indicator of the balance between buying and selling demand.

Long Wick Patterns

Long wicks indicate areas where price can be pushed quickly in a short amount of time and potential
reversals in the direction of price. We can deduce from a long wick that price made a big move after the
open, but it was pushed back before the candle closed; for example, a long wick underneath a candle
implies that sellers were able to push price down considerably, but the pressure from buyers pushed
price back up before the close of the time period. If this power struggle between bears and bulls is
conclusive, it may anticipate or initiate a reversal in the direction of price by the triumphant side;
reversals can be the most desirable times to enter or exit trades. If a long wick can also be found
intersecting a major support or resistance level, it may confirm that traders are ready to defend/
challenge that level.

Hammer/Hanging Man
A “hammer” is a candlestick with a small body (a small range from open to close), a long wick protruding
below the body, and little to no wick above. Occurring at the bottom of a downtrend, it’s long wick
implies an unsuccessful effort by bears to push price down; since the bullish movement back up before
the close represents a loss of dominance by the bears, this candlestick suggests the possibility of a
bullish reversal. The “neckline,” often determined by the high of the previous bar, is the level that price
must hit on the next candlestick in order to confirm the hammer’s reversal signal.

The “hanging man” has the same characteristics as the hammer, except it occurs at the peak of a trend
rather than the bottom. In this case, the wick implies the appearance of selling pressure that contradicts
the current trend, and warns of a possible reversal of the uptrend.

Shooting Star/Inverted Hammer

This pair of candlesticks are the inversions of the previous two; both have a small body and a long wick
protruding above it, with little to no wick below. The “shooting star” occurs at the height of an uptrend;
its long wick implies that resistance to further bullish movement has been encountered above the close,
and a bearish reversal may be imminent. In this case, a strong black candle or a price at the level of the
previous bar’s open can act as confirmation or an entry point. Often, shooting stars
are further charac- terized by a gap between the previous bar’s close and the
relatively higher open of the shooting star.

Doji
This candle has zero or almost zero range between its open and close. Rather than implying potential
reversal or the clear dominance of either bears or bulls, these candles suggest indecision or balance
between the two forces. Neither buyers nor sellers are fully in control. A doji that occurs in the context
of a strong trend implies the weakening of the dominant force that resulted in that trend.

A “long-legged doji” has long wicks in both directions, implying strong, balanced pressure from both
buyers and sellers.

The “dragonfly” and “gravestone” doji imply, respectively, that sellers and buyers controlled the market
for most of the trading period, but then the opposite group managed to push price back to the open
before the close. They constitute a warning of the potential influence of the market participants that
have pushed the wick so far from the candle’s body.

3-Candle Reversal Patterns

Rather than anticipating a reversal, the following candlestick patterns imply that a reversal has begun; in
each case, a small “star” candle marks the turning point in a trend where the market pressures that have
driven a trend peter out, forming an ostensible top or bottom.

Morning Star

This bullish reversal pattern plays out over the space of three candles:

1. A long
black (bearish) candle

2. A small-
bodied candle or doji that closes below the first candle

3. A white
(bullish) candle that opens above the previous candle and closes near the center of the first
candle.
Evening Star

This bearish reversal pattern also plays out over the space of three candles:

1. A long
white candle

2. A small-
bodied candle or doji that closes above the first candle

3. A black
candle that opens above the previous candle and closes near the center of the first candle.

Checkmate Patterns

Checkmates occur when price becomes locked in a narrow trading range preceding a reversal in
direction. In a typical bearish checkmate, an uptrend meets a resistance level that is tested and then
rejected due to consequent pressure from holding the level. In these cases, the checkmate begins as the
first candle in the range reaches a high point that the market is unable to break. Price remains
deadlocked in a tight trading range before the range is broken with a long bearish candlestick, indicating
that the reversal has begun. In a bullish checkmate, the opposite occurs, typically at a support rather
than resistance level.

Examples of bullish and bearish checkmates can be found below.

 Risk Management in Price Action Trading
Risk management in price action trading is much like risk management in any other style
of trading; the same basic rules apply:

1. Know your maximum risk tolerance, i.e. the loss you are willing to take on each

trade, before you place the trade. A common rule is that traders will not put more than

2% of their funds in the market at a time.

2. Understand correlation between assets, and to what extent you would like to be

diversified.

3. Know when you will exit before you enter.

4. Know your reward/risk ratio.

5. Identify what you expect to happen and why, and what price point negates that

expectation.

This is the price point at which you should put your stop.

Of course, with risk management, techniques are important, but, ultimately, it is up to the trader
to ensure they are psychologically prepared for all that is involved. Even if a trader is using a
fully

automated system, he/she must still have confidence in the system, and must know when

any losing streak experienced is just a temporary losing streak versus a more

fundamental problem suggesting the system is no longer valid.

In terms of actual techniques, there are a few concepts traders can bear in mind:

1. Enter at support/resistance levels, or levels that suggest turning points in the market

2. Put your stop loss between such levels, or at points where there is no real signs of a

force that will cause a change of direction in the market.

Basically, traders want to enter at turning points. Levels between turning points,

“empty zones,” of sorts, are where stops can be put as they are where ideas are

often disproved. For example, if you entered a trade at a support level expecting

price to rally, you could place your stop at a level sufficiently below the support

level you entered at, provided it was not a support level as well.

support level that the hammers are forming around – and a potential entry point –

and a support level beneath it. We can set our target profit at the previously

established high. As the chart illustrates, this trade would have worked well for

traders who placed it.

Topic 1: Introduction to technical analysis

Technical analysis is the study of the past price

movements of an individual share or
the market as a whole. Charts are the key tool used
in technical analysis.

The argument in support of technical analysis is

that all buying, selling, rumours, and
information is going to be factored into
the price of a share as people act on that
information.

By looking at the prices we can see whether there

is good news associated with a company resulting
in buying and rising prices. We can also see if
bad news has
come out, or if it's expected to be released
because sellers will come into the market and push prices lower.

Forget the idea that charts can predict the future with any
certainty. They can't and
neither can fundamental analysis. So what can charts do
for us?