Technical analysis in trading appeared in the West for the first time and the Western approach was considered to be the only possible way to deal with forecasting future price movements in financial markets.
It was so until the Japanese approach was being made known to the general public and it was embraced in short time due to the power of the candlesticks setups (techniques) it brought along.
Based on the above, it goes without saying that the chart to be used here is a candlestick chart and not a bar or line one and every trading platform is offering the possibility to set up the chart in the candlestick mode.
Before going into more details regarding how to trade with Japanese candlestick techniques, it must be said that the reason they are so popular is simple: they represent strong and powerful reversal patterns, and we all know by now that every trader wants to get into a new trend as early as possible.
Moreover, the whole concepts are extremely simple and easy to understand and yet so powerful, so it is no wonder that the West embraced them pretty fast.
According to the Japanese, a candle is being formed out of a body and a shadow and the implicit colors for a bearish or a bullish candle are red and green, as illustrated in the image below.
The hammer is one of the most powerful reversal patterns and it is a bullish one, in the sense that it is appearing at the end of a bearish trend, so that is the first thing to look for. The whole pattern is based on only one candle and this candle has a long shadow and a small body at the upper side of the candle.
It is not mandatory for the body to be green. It can be red as well, as this will not change the fact that market is preparing for a major reversal. One important thing to consider when dealing with a hammer is the fact that it represents a battle between bears and bulls and after the closing of the candle, bears will try to retake control, so a pullback is to be expected.
If the lows of the hammer are being broken, the whole pattern gets invalidated and usually the bigger the time frame the hammer is forming, the more difficult it is for the pattern to be invalidated.
The opposite of the hammer pattern but having the exact effect of reversing a pattern is being called a Hanging Man and the image below shows you both a Hammer and a Hanging man acting as reversal patterns, one showing the top after a bullish move and the other one showing a bottom after a bearish move.
Other powerful reversal patterns are the morning and evening stars and if in the case of a hammer the whole pattern has only one candle, the stars represent a group of three candles.
An evening star shows bearish outcome to come and it is being formed at the end of a bullish trend. After such a star, we should look to go short with a stop loss at the highs and staying short until a bullish pattern (maybe a hammer or a morning star) is forming or establish the target using a risk:reward ratio bigger than 1:3.
The evening star has a bullish green candle for the first candle in the pattern, with a strong body, while the third candle should be exactly the opposite: a bearish red candle with a red body. The candle in the middle, or the second one, has a small body and the color of it doesn’t matter for the star.
A morning star on the other hand looks exactly opposite to the evening one and the interpretation should be opposite as well. We should look for longs with a stop loss at the lows and with a take profit given either by a bearish pattern that will form or using the rish:reward ratio mentioned above.
Of course, the first candle in a morning star must be bearish with a strong red body, showing the bearish trend, the middle candle is characterized by a small body who’s color can be both red or green and the last candle in the group is a strong green bullish candle with a long body.
Like it was the case with the hammer and hanging man, the morning and evening stars are more powerful reversal patterns the bigger the time frame they appear on. For example, if they form on a monthly chart, then this represents a powerful statement market is giving.
The example below shows one morning and one evening star formations that appear at the end of a bearish, respectively bullish trend, and how to trade such patterns.
Beside hammers and stars, candlestick techniques refer to engulfings and piercings, but more about those in the next article here on ForexGator.com.