Candlesticks were created to help traders understand what is responsible for price movements and get a better view of the market’s trajectory. This is why candlesticks on a chart move up and down in response to price changes, and although these movements may look random, they often move in a way that allows traders to properly analyze the market. These movements are called candlestick formations.
Candlestick formations or patterns involve using one or more candlesticks to assist forex traders in predicting the future price movement of a given currency pair. Presently, there are 42 recognized candlestick formations, and here are the best three formations that every forex trader needs to have in their arsenal.
Best Candlestick formations
Candlestick formations are divided into two main categories: bullish and bearish. The bullish formations show a tendency for the price to rise, while the bearish patterns show a high tendency for the price of the currency pair to fall.
With that in mind, these are the top 3 candlestick formations for forex trading:
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1. Bullish Harami Pattern
The bullish harami pattern is a Japanese candlestick formation that forms at the end of a downward or bearish trend. It is a trend reversal pattern that signifies that there will be a potential increase in the price of an asset.
The bullish harami pattern consists of two candles: one bearish candle followed by a bullish one. The bearish candle comes first with a long body, followed by a bullish candle. The bullish candle is usually 25% of the bearish candle, and the candles appear side-by-side.
Traders learn how to identify the bullish harami pattern because it indicates profitable entry points at the beginning of a potential uptrend. The bullish harami pattern is also one of the easiest patterns for beginners to spot, and it has a much better risk-to-reward ratio when compared with some other patterns like the bullish engulfing pattern.
Before this candle pattern can be used in forex trading, it must meet certain rules and requirements:
- It must be at the bottom of a clear downtrend. If this pattern is at the top of the chart, it becomes a bearish harami pattern rather than a bullish one.
- A bullish hammer pattern may appear before the bullish harami pattern.
- The formation of the pattern cannot be used for trading alone. Since it is a trend reversal pattern, momentum indicators like the CCI indicator, RSI, and MACD should be used to confirm the formation.
When the formation has been confirmed and the analysis complete, you can enter a long position, and stop-loss orders can be placed near the start of the new uptrend. Along with the stop-loss orders, profit targets can be set at different levels of the uptrend to help you make the most profit out of the uptrend.
2. The Hammer
While candlestick patterns typically involve three or more candlesticks, a candlestick pattern may also contain just one candlestick, and the hammer pattern is an example of that. The hammer candlestick pattern is a trend reversal pattern and happens to be one of the most popular candlestick patterns in forex trading.
As a trend reversal pattern, it signifies a potential change in a bullish trend and looks like a hammer with a short body and a longer wick. Since it is a bullish reversal pattern, it usually appears at the bottom of the chart. There are 2 variations of the hammer pattern:
− Inverted hammer candlestick: The inverted hammer has a long upper wick, a small body, and very little or no lower wick. This variation shows that there was an effort on the buyer’s part to raise the price of the asset after the price was lowered due to the action of sellers.
Seeing this type of hammer in a forex chart shows that there is a potential reversal of an existing bearish trend.
− Bullish hammer candlestick: This is the typical candlestick we see on a forex chart, and along with a long lower wick, it has little or no upper wick. The bullish hammer candlestick occurs when The lower price of a currency pair is rejected, and the sellers enter the market when there is a price decline.
In this case, the price of the asset drops lower than its opening price but just like the inverted hammer, the buyers push the price close to the opening price.
Hammers are great tools for forex trading when they come after three or more consecutive declining candles. In addition, they inform traders of the best time to close their existing position with the possible reversal underway.
However, the hammer candlestick pattern doesn’t take the present trend into consideration, and using it alone, opens up the door to working with false signals, which could possibly lead to losses. That’s why the hammer pattern is never used alone, as additional information is required to provide a confirmation of the trend reversal.
To get a confirmation of the trend, traders can use technical indicators like stochastic indicators, RSI, CCI, and Fibonacci levels. While confirming the trend reversal, traders can prepare to buy and open new positions by setting stop-loss orders below the lower wick or directly under the main body of the hammer.
3. Shooting Star
The shooting star candlestick formation is regarded as a bearish reversal candlestick pattern. It is typically found at the end of uptrends, and it occurs when the opening and closing price of an asset is the same or at least nearly the same thing. To identify whether or not a candlestick is a shooting star, it must have a small body, with the upper wick being twice as big as the body and little or no lower wick. It must also appear during an uptrend.
The shooting star pattern tends to be more accurate when it appears after 2 or more successive rising candles, and whenever it forms on a chart, it shows that buyers are in a losing position and will not make any gains from the asset since the closing price is dropping back to the opening price.
If the present trend is an uptrend, seeing a shooting star may not hold much importance because prices are always changing in the forex market. So, like other candlestick patterns, further confirmation with technical indicators is needed before a trader can use the shooting star.
Before entering a trade based on the shooting star, there has to be a bullish trend with increased market volume, and stop loss orders should always be put in place to mitigate losses in case the pattern was a false signal.
You should also wait a day after seeing a shooting start to determine whether you should sell or close your short position. For instance, if there is a down day after the pattern forms, it can be taken as a sign that a potential price reversal is happening, and traders can proceed to make decisions based on that information. It is still possible for the price of an asset to continue to rise after the formation of a shooting star, and when this happens, the pattern can be used as a resistance level.
However, this pattern is another great tool for traders, especially novice traders, because it is easy to spot and reliable for making profitable trades as long as it is not used alone.
Japanese candlestick formations help determine the state of the market, and they are easy to spot and use if you take some time to learn about them. However, analyzing candlestick formations for forex investments isn’t guaranteed to work all the time because of the volatile nature of the market, and the best way to give it significance is to back it up with technical analysis.