Japanese candlestick techniques are really popular among traders because of the simplicity of their interpretation and the power of the message they imply. Like mentioned in the previous articles about candlestick trading, most of these represent reversal patterns and anyone wants to know when the trend is about to end and to pick a top or a bottom.
This is possible with piercing and dark-cloud cover. Both patterns are being formed out of two candles and the first one is bullish while the second one is bearish. This means that the piercing pattern is forming at the end of a bearish trend, while the bearish reversal pattern is forming at the end of a bullish trend.
The piercing pattern is always a bullish one and it is formed out of two candles: one red, the first one, and one green, the second one. Both candles are being characterized as having a strong body and small shadows. The condition for a piercing pattern to form is for the second candle (the green one) to retrace and close beyond 50% of the previous candle’s body.
The dark-cloud cover is the exact opposite of the piercing pattern, only that this time the pattern is bearish and actually we’re looking to sell after a series of two candles, one green and one red that forms at the end of a bullish trend.
The same rule should be respected here as well, namely the second candle should close into the territory of the first one beyond 50% retracement.
There is not a preset target in both cases, but a nice strategy would be to go for a risk-reward ratio of minimum 1:5 giving that the pattern is based on the length of the second candle, which is always smaller than the first one.
The examples below show you the power of these patterns and what a risk:reward ratio of 1:5 really means.
If the second candle retraces entirely the previous one, then the pattern it is transforming into is a bullish or bearish engulfing. Therefore, if the second candle in the piercing pattern is covering all previous candle’s body, the piercing transforms itself into a bullish engulfing and it should be traded exactly the same, using the 1:5 risk:reward ratio.
On the other hand, if the dark-cloud covers the second candle and is totally retracing the previous candle’s body, it is being called that a bearish engulfing is forming and shorts should be taken.
One of the most mysterious candles in the candlestick technique is being represented by the doji.
A doji candle is just one candle and can have multiple interpretations in the sense that it can mean uncertainty or it can mean the trend is reversing. That way, it can be either a continuation pattern or a reversal one, and this makes it difficult to assess.
However, the doji is still a powerful candle and at least it is a warning sign that in a bullish trend bears are awake while in a bearish trend bulls are stepping in.
If the doji is the middle candle in an evening or a morning star, then the stars should be considered more powerful than the regular stars. For more about evening and morning stars, please refer to our other articles in the learning center.
The best way to treat a doji is to use it in combination with a different indicator, either a trend or an oscillator one and take into consideration only the doji candles that fit in the overall perspective.
For example, if the RSI (Relative Strength Index) is showing a bullish divergence and a doji appears in the bearish trend, then it would be a reinforcement that a reversal is about to happen and one should go long.
Or, if you trade with a trend indicator and a doji appears without breaking the rules of the trend, then it means the doji is a continuation pattern and the trend will resume.
It goes without saying that on all the patterns mentioned here, the bigger the time frame, the bigger the price implication and therefore the bigger the distance price is travelling. For example, a bullish engulfing on the weekly chart is far more important than a bullish engulfing on the hourly chart, and so is the target to be set.
Next thing to discuss here is about one of the most popular trading theories that exist: Elliott Wave Theory. Make sure you check ForexGator.com regularly to find new learning center articles.