How to Read Forex Candlestick Charts Effectively
Why Use candlesticks
Candlestick charts are easier to visually observe, and it’s easier to detect patterns on them. They are in my opinion more effective than other types of charts, and I do use them myself. There’s however a misleading industry and methodology around candlesticks, where some of the rules and strategies for identifying trading signals, are confusing, ambiguous or redundant. Nonetheless, you can expect that at least 50% of that theory is useful, and many trading signals are proven correct, especially the ones observed on the daily market charts.
A candlestick chart is made up of a series of time intervals, such as 10 minute or 1 hour or 1 day intervals, where each time interval is indicated by one candlestick, and the price action is recorded as a high, low and whether the close was higher or lower than the preceding candle. They are depicted in color, usually green or white for time intervals where price moved higher, and red where price moved lower.
Candlestick market charts originate from Japan, and have been used by commodity traders for centuries there, they were actually developed by Japanese rice traders! That’s why you see words such as ‘Harami’ which actually means pregnant in Japanese. That’s how traders developed these patterns over the years, and today’s traders still use them, while other traders expanded the research on candlesticks, and use even more patterns.
One candlestick pattern I personally use, which is very useful is the hammer and inverted hammer. It’s still tricky and hard to use sometimes. But a hammer type candlestick indicates support or resistance, and breach of its wick indicates that the market has breached that support or resistance. I personally look for hammer candles where the wick is about twice the length of the body, and I treat these signals as having average importance. I can trade on these signals alone, only if the trade lasts for about 2-3 candles. I want to be using more indicators, but hammers and inverted hammers alone can make a simple trading strategy for most forex currency pairs.
Case in Point – Inverted Hammer Pattern
Upright hammers used on the daily chart, together with the Parabolic SAR and the 10 day SMA.
EURUSD drops below its 10 day SMA but then consolidates, and a series of inverted hammers appears. Because I also use imaginary stops in the time domain, I like counting days, usually 3 days, and if a trade doesn’t make progress I see that as a warning that the market will likely reverse, and I close the trade. And indeed the market here does reverse a little by the 3rd day, goes above the 10 day SMA, then drops back below. Notice that an up and down day together, make up another, inverted hammer, is they were possible to view on a chart where the period would be 2 days. Then we have 2 more hammer days, these hammers are even closer to the ratio I want to see (having wicks which are about twice the length of the candle body). By this time 3 more days have elapsed and the market has not rallied, therefore the probability starts to favor a decline again, according to my imaginary stop strategy. At this point, a candle which would close clearly below the wick of the latest hammers would indicate a sell signal on the daily chart. And if this happens, then the price zone, as defined by the bodies of all those hammers, would become resistance.
You can see how confusing trading can be, when a consolidation zone is in the making, the market doesn’t respect moving averages, not even indicators. I simply use the Parabolic SAR, to estimate where a stop loss order should be placed, while I also use the imaginary stops in time. The hammers as you can see, make it much easier to identify this price zone, and prepare you to expect this price zone to act as a pivot, which will later become support or resistance, for the future.
Very often you will see market price give off such signals, but few days later there may be an opposite hammer, with an opposite signal, and the market will change trend again, at least for few days. Hammers do not provide long lasting signals, except maybe on the weekly charts. But even a hammer formed 10 or more days ago, can indicate support or resistance today, and breach of its wick can give valid signals. So past hammers are always relevant, as long as they indicate that pressure in the market, where price made a high or low, and then came back by around 2/3 of the daily range.
Use of hammers is simple and straightforward, all beginners can use hammers. But other trading tips for the forex market are also useful, and can enhance the use of candlestick charts. Just remember to first try these tips out on the daily chart first, and always consider the latest candle as undone, it’s only useful after and only after the close has been settled, only settled candles can be used in this methodology.
The Simplest Powerful Trick to Simplify Charts
Candlestick charts can be confusing, or signals may seem incomplete. But if you notice on many market charts, 2 adjacent candles that seem incomplete and for example not meeting my criteria of a hammer, that should have about 1/3 body and 2/3 wick. If you did a little imaginary zooming out on the chart, you would picture these 2 candles as one candle, and that single candle may in fact be a solid hammer, having 1/3 of the length body, and 2/3 of the length wick. Your charts may not have many time frame options, but it’s very easy to merge 2 adjacent candles in your imagination, and see what they add up to.
It’s always to zoom out on a chart and see the larger picture, whether you do it through a chart option or in your imagination, it’s very easy. If you trade on shorter time frames, such as the 30 minute chart, you can still apply most of these principles, but it helps to also watch the one hour chart.
Trading Forex through Binary Options and Candlesticks Charts
Binary options are more difficult, in that you have to predict price movement and accurate price targets over a period of time. But it’s not that more difficult than spot forex, because even in spot forex you don’t really have the luxury of time. Because even when the market is going nowhere, in most cases you pay daily interest on your trades. And the more leverage you use, the higher the interest rate you have to pay. So accurate timing of the forex market is essential in all kinds of trading. Binary options can be used in a wiser way by taking into account the natural probability limits of your trade, based on notional stops in the time domain. And this can be used on many time frames. The power of candlestick patterns such as hammers, can be used to identify early breach of support or resistance, and this is often a leading indication, not apparent right away.
This means that the market may for example breach the wick of an inverted hammer formed many days ago, and it may close well above that high for the day, then the following few days it may go down a little, so nothing seems bullish on the daily chart. But because that far away inverted hammer has been breached, a buy signal is in place! This hints that the binary option trades should now be on the long side of the market, and any Put binary options should be closed. You will find that in many cases these kinds of buy and sell signals happen today, then the market pretends nothing has happened, and few days later these signals come true. That’s why watching breach of well formed hammers is important in binary trading. Just because a buy or sell signal happens, it doesn’t mean that the market will execute that signal right away. In fact hammers especially tend to give signals that may come true hours or days later.
Remember that the market is not always right, and it may drop a little just prior to a buy signal, or it may rise a little just prior to a sell signal, and all there is… is confusion. Despite what some people say, the market is not actually right all the time.
Keep Trading Simple – Don’t Use All Candlestick Patterns
You can safely use few candlestick patterns, but there’s no need to use all kinds of patterns that traders have detected over the years. The use of too many indicators and patterns is pointless, since many of the patterns are redundant, and other indicators you already use, will detect the same trading signals. You can use few candlestick patterns, and learn them well, and apply them all the time, on various time frames. That’s about as far as you should go. The problem with using too many candlestick patterns is that it will lead to ambiguities and overloading of information to be analyzed, which doesn’t help.
Candlestick patterns are especially useful in swing trading theory, where you have to study the daily chart of a market and identify highs and lows. You can do it much better with candlestick charts and few hammer patterns, than any trader who is using bar or line charts. Swing trading theory can be greatly improved through candlesticks. And in this case you may want to test many different patterns, and choose the ones you like most.
In classic swing trading theory, signals often act deceptively, and it takes few days for them to come true, just like those delayed signals on hammer candlesticks. Classic swing trading theory identified a market as being either in an up or down trend, but in practice it falls into traps and false signals. These false signals can be detected and avoided through various methods, and through studies on the candlestick charts. Some candlestick pattern is bound to show up, and likely it will show up earlier than the signals of the classic swing trading theory, which are simply based on highs and lows.
Candlestick signals themselves can be assessed in various ways. However due to the delays that they may show up, you cannot use imaginary stops in the time domain, often they will not work, if you simply start counting from the day a hammer candle gave a signal. Stops in the time domain work well, if you start counting days, starting from the day the market made a good move, or from the day it breached some popular indicator, such as a 10 day SMA.
The use of candlestick patterns is peculiar and complicated, but the patterns themselves, when well formed, they can be very powerful. Just remember that all patterns are different versions of some kind of hammer pattern, plotted against time. Candlestick analysis works easier and makes much more sense if one starts all their studies and research from hammer candles, and then investigate further the properties of candles that add up to a single candle, and the ratio of wick to candle body. That’s all the whole theory of candlestick patterns is based upon.
Remember to play devil’s advocate on other people’s point of view and their use of candlesticks. Usually this leads to a deeper analysis and avoidance of mistakes. So given any market chart, that only shows one time frame, no other indicator, and a single candlestick pattern, you can look hard enough, and you will find some conflicting candlestick pattern. So it takes greater wisdom to figure out which one is correct. It may be the pattern seen on the daily or one hour chart, or it may be the pattern seen on another currency pair, which will impact the currency pair under study. In that regard, I personally prefer trading EURUSD over say AUDUSD, because EURUSD is much larger than AUDUSD, and these two are often correlated to one another. So a bullish candlestick pattern on EURUSD, will overpower a bearish pattern on AUDUSD. Other times, AUDUSD will follow the trend of gold, and will ignore all EURUAD patterns, this is why caution is needed.