Forex markets: an introduction to the use of Japanese candlesticks in forex trading
Japanese candlesticks are a form of plotting price movements on the chart which is far superior to the visual information conveyed by a bar chart. While bar charts concentrate on high and low prices, the candlestick also incorporates the opening and closing prices and gives a visual indication of market sentiment. The technique was originally used by the Japanese in the 18th-century in the rice futures market and this is how it gets its name. One of the most difficult aspects of forex trading to is the ability to predict continuation or reversals of price trends and candlesticks help to spot this quickly. In combination with other tools of technical or fundamental analysis, the trader is also able to determine entry and exit points.
Given below is a typical candlestick chart which you can get from your forex broker:
As you can see, the difference between the opening and closing price is shown by the thick portion or the body of the candlestick. The thin lines at the top and the bottom are called wicks or shadows and represent the high and low prices for the day. If you look carefully, the figure on the left is colored blue signifying an upward movement where did close is above the open. The figure on the right is colored red signifying a downward movement and the close is below the open. Be careful because these colors vary from site to site so get familiar with the convention used by the website from where you get your charts.
The length and breadth of the body will change from session to session depending on the price action as will the length of the shadows or the wicks. Long bodies indicate lots of buying or selling activity while short bodies show that there is little activity in the market. Continuing the above color convention, a long blue candlestick indicates lots of buyers while a long red candlestick indicates lots of sellers. It long shadow indicates a lot of activity between opening and closing whereas a short shadow shows that the activity was mostly confined to the opening and closing.
Here is a bar chart and a Japanese Candlestick Chart side by side. Notice how much easier it is to spot market trends from the candlestick chart.
Because of the usefulness in conveying market sentiment, Japanese Candlestick charts can be a great help in highlighting when the market trends are about to change. These changes may either be reversals when the market trend reverses or continuations when the market trend carries on.
Common candlestick patterns: here are some of the common Candlestick patterns and their interpretation:
-spinning tops: the candlestick with long and lower shadows and a very small body is called the spinning top. The small body indicates that there is no dominance of buyers or sellers though the long shadows indicate that both had tried to dominate the market. The appearance of a spinning top of indicates the end of a downtrend or an uptrend as the case may be. Here is an example:
-Doji lines: a Doji line has a very small body and the open equals the close. This means that buyers and sellers are equal in the market and neither is dominant. When a Doji forms, you should take special attention to the candlesticks that immediately precede. If they are bearish candlesticks, it means that buyers are running out of steam and if they are bullish candlesticks, the reverse is true. Here is an example:
Reversal patterns: for a reversal pattern to happen, a trend must have been established. A bullish reversal has to be preceded by a bearish trend and vice-versa. Here are some of the more common reversal patterns:
-Hammer and Hanging Man: as you can see yourself, these are identical formations except that one is a downtrend and the other is an uptrend.
Both have long lower shadows and virtually non-existent upper shadows. The hammer is a bullish reversal in a bearish trend and indicates that the bottom of the market will soon be achieved. The hanging man on the other hand signifies the bearish reversal in a bullish trend and indicates that the top will soon arrive.
-Inverted Hammer and Shooting Star: once again, these are identical looking candlesticks except that one body is filled and the other is not. One is used in an uptrend and the other in a down trend. Once again, the bodies are small but with a long upper shadow and a very small or non-existent lower shadow. This is what they look like:
The inverted hammer normally signals the reversal when prices have been on a downward trend and the long upper shadow suggests that sellers who wanted to sell have already sold and it is now likely that buyers will dominate the market. The shooting star, on the other hand signals a reversal when prices have been rising and suggests that sellers will dominate the market.
Continuation patterns: as opposed to reversal patterns, continuation patterns are patterns that suggest that the current trend will continue. These patterns could either be:
-bullish patterns which indicate that the market will continue to rise. The Rising Three Methods is one of these patterns and as shown below:
The chart shows trading sessions over five days. On the first day, the candle indicates the trend of hyperactivity and rising prices with small corrections on the next three days all within the range of the first candle. Then on the fifth day, the bullish activity resumes indicating a continuation in the trend of rising prices. There are plenty of other bullish continuation patterns that you should familiarize yourself with.
-Bearish patterns which indicate that the market will continue to fall. Similar to our example above but actually indicating that reverse is the Falling Three Methods which is illustrated below:
This again is a five-day chart with lots of trading action on the first day and prices moving down. Over the next three days that is a modest recovery though prices stay in the range of the first day candlestick. On the fifth day, hectic trading activity and a downward trend in prices appears again suggesting that the trend will continue.
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