When it comes to using technical analysis to trade Forex, one of the most important tools in your toolbox is a candle stick chart.
Candlesticks are very important in order for the investor to decide whether a trend may be reversing or confirming it. This will allow the trader to decide whether he wants to enter the trade at the given level.
Candlesticks can also provide useful information when they are grouped together. Sometimes a signal candle can provide a clue as to the direction of an asset but it can only be confirmed after more signals are observed.
When candlesticks are used in conjunction with other standard technical analysis indicators such as trends, RSI and volume, the trader can greatly increase his chances of profitable investments.
What is a Candle Stick?
A Japanese candle stick is a graphical representation of important information regarding the price of an asset over a certain period of time. This includes the Open, Close, high and low in the period.
Originally used by a Japanese rice trader in the 18th century, they have proven the test of time through the ages. It was only in the late 19th century did investors from the USA start to incorporate candlestick indicators in their analysis.
A candlestick is comprised of a body and a shadow (or candle wicks). The body is the difference between the open and close of the asset over the period. This can either be a red or green candle body. A candle is red when the open is above the close and the converse is true for a green candle.
Therefore, a candle with a big green body (assuming all else equal) is seen as a bullish or positive indicator. The opposite is true for a candle with a big red body.
The shadows are “wicks” of the candle are the difference from the min and max from the open and close. In other words, they provide a representation of the movements of the asset over the period.
Moving Average with Candle Sticks
As mentioned above, the best use for candle sticks is when they are used in conjunction with other technical analysis indicators. A great “side kick” of the candle stick chart is the Moving Average (MA).
The MA indicator is a rolling average of the most recent asset movements. This can either be a simple moving average or an exponential moving average. We won’t go over the technicalities but you can read about the difference here..
With a MA, a trend is usually in progress when the current prices are above the MA lines of the previous ones. What most traders are usually trying to establish is whether they should invest with the trend or go against it in the anticipation of a reversal.
This is where the candle stick can be a helpful. Let us assume that EUR/USD has been trending up over the past few days. It has currently started to slow and the current price is close to the trend lines.
This means that a reversal in the trend is possible. The trader will then look at the signals that he is receiving from the candlesticks.
If there is a large red candlestick, then it is quite possible that the trend is reversing and the bears have the upper hand in the period. It could however be prudent to wait until the next candle to confirm your view. If the next candle is also a bearish candle then you may want to go short EUR/USD.
Of course, there is also the chance that the trend is not on a reversal but is merely taking an initial pause from its uptrend. If the candle that you are observing is green or is indeed a small red candle then there is not enough of an indication for you to comfortably short the pair. It would be prudent for you to wait for the next candle.
This analysis can also be done on the trend lines on the downside. For example, if a forex pair has been trending down over the past few days, you may want to try and catch a reversal with a long entry.
Multiple Candle Stick Indicators
There are also distinct patterns that can be observed and traded upon when one takes a look at multiple candle sticks. There are quite a few standardised Candle Stick patterns that are well known in the market.
One of these is the Engulfing pattern. With the engulfing pattern, either a red or a green candle is “engulfed” by the candle after it which is much bigger.
If there is a small red candle that is followed by a large green candle, this is said to be a bullish engulfing pattern. Conversely, if there is a small green candle that is preceded by a large red candle, this is a bearish engulfing pattern.
There are also a number of other complex candle stick patterns that the trader should be able to spot quickly in order to take advantage of favourable entry points.
If you are new to trading forex and are beginning to study candle stick patterns, then it may make sense to make use of a signal service. This will allow you to receive the latest signals from professional traders.
As you do your own analysis of the candles in the chart and decide your strategy, it is usually helpful to confirm the view of your candle stick signal with those of others. You can also refine the signals that you have been receiving from these services such that you are only following the most profitable ones.