Contents

Introduction. How to read Japanese Candlesticks. The Doji candle and how to trade it. The Bullish Engulfing pattern and how to trade it. The Bearish Engulfing pattern and how to trade it. The Hammer Candlestick and how to trade it. Summary.

Part 2: https://bbod.io/post/how-to-trade-with-candlesticks-part-2-3

Part 3: https://bbod.io/post/how-to-trade-with-candlestick-patterns-part-3-3

1. Introduction to Candlesticks

This article will teach you four out of the twelve most important candlestick reversal signals that have been used for hundreds of years, originally by Japanese rice traders in the 1700s. Certain candlestick patterns have high a probability of predicting a reversal in the trend, therefore it is very profitable to be able to spot these signals. This article will not only outline each reversal pattern but also offer a guide on how to enter and exit trades when these signals are seen.

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It is very important to note that candlestick trade signals can be very abundant if used by themselves. To focus your capital in trades with the highest possible probabilities of success, you should combine candlestick analysis with other forms of technical analysis such as supports & resistances, RSI Indicator, Volume, MACD, and Elliott Wave analysis, and Moving Averages.

2. How to read Japanese Candlesticks

Fig. 1 below shows how a candlestick displays the opening, closing, high, and low prices during a specific time period. You can customize the time frame so that each candle shows anything from one minute to one month. A red candle means that the closing price was lower than the opening price, thus price decreased. The green candle means that price closed higher than it opened, so the price increased. The upper and lower wicks show the high and low prices for the day and if a green candle, for example, has no upper wick, this means that the high of the day was the same as the closing price.

Fig. 1 How to read candlesticks

3. The Doji Candle

The Doji is one of the most important candlesticks and you should always take note when it appears in the market. This candle is formed when the opening and closing prices are the same and this creates indecision in the market between the bulls and the bears.



A Doji candle is a great alert that a trend is about to reverse as it puts doubt in the minds of the investors that the current trend will continue. If a Doji is seen at the top of an uptrend, you should close long positions and enter a short instantly. If you see a Doji form at the bottom of a downtrend, you should wait for a bullish candle to close after the Doji in order to confirm that the trend has reversed. This is because the weight of the market will often pull prices further down.

Fig. 2 Doji Star (left) Gravestone Doji (middle) Dragonfly Doji (right)

In Fig. 2 above, there are three different forms that the Doji can take. The Doji star is the most indecisive candle as it’s upper and lower wicks are roughly the same length with the same opening and closing prices. Thus, there is a perfect equilibrium between buyers and sellers.



The Gravestone Doji is formed as the open, close, and low are all the same or very similar. Prices move strongly upwards from the open of the candle, but by the time the candle has closed, all the gains have been lost. This candle works best at identifying a bottom reversal, although it shows indecision no matter where it is seen.



The Dragonfly Doji is formed when the open, close, and high of the candle are all the same or very similar. Prices fall down from the opening price, but by the time the candle closes, all the losses are bought back up. If you see this candle with a very long wick at the bottom of a trend, it is very bullish.

Factors that increase the chance of a reversal after a Doji:

If there was a large volume during the Doji candle.

If the Doji is seen after a relatively long candle body.

A great example of a Doji that predicted the reversal in the biggest bull market in history is shown in the blue circle in Fig. 3 below. The Doji appeared on the daily chart, just before the price in Bitcoin (BTCUSD) fell by over 40% between the 18th and the 22nd of December 2017.

Fig. 3 A Doji (as shown in the blue circle) warned that the uptrend in Bitcoin was over

An example of how to trade a Doji in a downtrend:

Fig. 4 How to trade a Doji during a downtrend

Wait for a Doji candle that has closed (as shown in the blue circle in Fig. 4). Wait for a bullish confirmation candle after the Doji, as shown by candle number 3. Enter a ‘long’ position (buy) after the bullish confirmation candle (candle 3) has closed. Set a stop-loss slightly below the low of the Doji. It is recommended to wait for a bearish candle to close, e.g. candle 6, and use this as a signal to take profit. However, the profit-taking price is subjective and you may wish to choose a different place to take a profit.

An example of how to trade a Doji in an uptrend:

Fig. 4.1 How to trade a Doji during an uptrend

Wait for a Doji candle to close (see candle 1 in Fig. 4.1). Enter a short position immediately as there is no need to wait for confirmation when a Doji forms during a strong uptrend. Set a stop-loss slightly above the high of the Doji. Profit can be taken when a bullish green candle forms as shown by candle number 6 in Fig. 4.1.

4. The Bullish Engulfing Pattern

A Bullish Engulfing candle is formed at the end of a downtrend and is a great signal that the trend could be reversing (see Fig. 5.1). The open is lower than the previous candle’s close, and the close is higher than the previous candle’s open, so the green candle engulfs the red one. The open can be the same as the previous candle’s close, or the close can be the same as the previous candle’s open, but not both.

Fig. 5.1 The Bullish Engulfing Pattern

Factors that increase the chance of a reversal after a Bullish Engulfing candle:

If a large Bullish Engulfing candle engulfs a smaller candle body this shows that the downtrend was weak and the new uptrend has started with good force. Large volume during the Engulfing candle. If the engulfing candle engulfs more than one of the previous candles.

An example of how to trade a Bullish Engulfing pattern:

Fig. 5.2 How to trade a Bullish Engulfing pattern

As shown in Fig. 5.2, identify a bullish engulfing candle (candle 2) that has closed after a downtrend in price. Go long (buy) and set a stop-loss slightly below the low of the engulfing candle. Wait for a bearish candle to close and use this as a signal to take profit. In Fig. 5.2 candle 6 would have offered a signal to take profit.

5. The Bearish Engulfing Pattern

A Bearish Engulfing candle is formed at the end of an uptrend and is a great signal that the trend could be reversing (see Fig. 6.1). The open is higher than the previous candle’s close, and the close is lower than the previous candle’s open, so the red candle engulfs the green one. The open can be the same as the previous candle’s close, or the close can be the same as the previous candle’s open, but not both.

Fig. 6.1 The Bearish Engulfing Pattern

Factors that increase the chance of a reversal after a Bearish Engulfing candle:

If a large Bearish Engulfing candle engulfs a smaller candle body this shows that the uptrend was weak and the new downtrend has started with good force. Large volume during the Engulfing candle. If the engulfing candle engulfs more than one of the previous candles.

An example of how to trade a Bearish Engulfing pattern:

Fig. 6.2 How to trade a Bearish Engulfing Pattern

Identify a Bearish Engulfing candle that has closed after a strong uptrend (see candle 2 in Fig. 6.2 for an example). Enter a short position (sell). Set a stop-loss slightly above the high of the engulfing candle. Wait for a strong bullish candle to close and use this as a signal to take profit. As shown in Fig. 6.2, candle 4 would have signaled that the buyers were taking control and may have caused you to break even. Another bearish engulfing candle formed as candle 6, so this was a good place to re-enter a short position. The stop loss would have needed to have been slightly above the high of candle 6 and then a good place to take profit would have been either candle 10 or 13.

6. The Hammer

The Hammer is a single candle with a small body and a lower wick that is at least two times the length of the body. A Hammer is found at the bottom of a downtrend and shows that the bulls (buyers) are starting to step in. The color is not very important, however, a green body is more bullish. The hammer requires a strong bullish candle to close afterward to confirm that this is a signal to buy. A Hammer should have a very small upper wick or no wick at all.

Fig. 7.1 The Hammer candlestick

Factors that increase the chance of a reversal after a Hammer:

A long lower wick. If the candle after the Hammer is a strong bullish candle this confirms that this is a signal to buy. Large volume during the Hammer candle.

An example of how to trade a Hammer:

Fig. 7.2 How to trade the Hammer candlestick

Identify a Hammer that has closed at the bottom of a downtrend (see candle 1 in Fig. 7.2). Go long (buy) and set a stop-loss slightly below the low of the Hammer candle. Wait for either an indecision candle (e.g. a Doji) or a bearish red candle to form and use this as a signal to take a profit. A Doji candle formed as candle 5 in Fig. 7.2 which would have been a good place to take profit. Price did continue higher, however, Doji candles will more often than not precede reversals when they are seen at the top of long uptrends. Sure enough the third candle after the Doji in Fig. 7.2 was a very large bearish engulfing candle.

7. Summary

To improve your skills trading, be sure to also read about RSI, Elliott Wave Theory, Volume, and Candlesticks Part 2. By combining all of these methods together, you can develop a great trading strategy to help you gain financial freedom.



Thank you for reading and I warmly invite you to send any feedback or questions to luca@bbod.io.



If you would like to read about candlesticks in more detail then I highly recommended that you should follow BBOD Blog for the next part of the article and our trading group on Telegram.



Written by Luca Williams

References

Ideas from this article have been taken from the book of Stephen W. Bigalow. (2010). Profitable Candlestick Trading: Pinpointing Market Opportunities to Maximize Profits. 2nd ed. New Jersey: John Wiley & Sons, Inc.

Disclaimer

This article has been prepared solely for informative purposes and should not be the basis for making investment decisions or be construed as a recommendation to engage in investment transactions or be taken to suggest an investment strategy in respect of any financial instruments or the issuers thereof. BBOD will not be liable whatsoever for any direct or consequential loss arising from the use of this publication/communication or its contents.