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Candlestick Patterns – Popular Chart Indicator Explained
Trading simple candlestick formations with binary options is a simple yet effective trading strategy everyone can execute. We explain the strategy and how you can use it to make money with binary options.
In this article, you will learn:
- What Are Candlesticks?
- What Are Simple Candlestick Formations?
- Candlestick Strategy
With this information, you will immediately be able to start trading simple candlestick formations with binary options.
What Are Candlesticks?
Candlesticks are a way of displaying market movements. They are an improvement over the line charts that you see on TV and in the newspaper. To understand the purpose of candlesticks, let’s look at why they were developed.
Line charts display and asset’s price movement in a simple line, which has significant downsides. When you look at a chart that displays the price movements of an entire year, for example, a line chart is unable to include a dot for every single price during that year.
When you look at a price chart that is half the size of your hand, you are not seeing the millions of prices for which this asset traded during the year, you see 50 prices, if you are lucky. Maybe the chart selects one price for each week and connects them, or maybe it uses two prices for each week or only one for each month. In any case, you only see a fraction of what was going on.
Even on shorter time frames, you only see part of the picture. The price of most assets changes every second, and no line chart can display this information. Even in a chart that displays the price movements of the last hour, you only see a fraction of what was going on.
When you miss out on a lot of information, you can make bad decisions. To understand why, assume that an asset was in an upwards movement. Now the movement has stalled. During the last period, the price still began to rise, but eventually turned around and entered a fast decline. Now, at the end of the period, it has fallen to roughly the same level as in the beginning.
In a line chart, this period would be displayed as a simple sideways line. It would be indistinguishable from a period during which nothing happened, and the market has moved sideways. Similarly, a period that started with falling prices and ended with a strong upwards movement that took it back to its opening price would look the same, too. This is problematic because the implications of both periods are fundamentally different.
- In a period where the market moved upwards and then turned around, the market is now strongly moving downwards. It is likely that this movement will continue and that the next period will feature falling prices, too.
- In a period where nothing has happened, the market could have gathered new momentum. Such a period provides little reason to discard your previous predictions.
- In a period where the market started to fall but then turned around, the market is now strongly moving upwards. It is likely that this movement will continue and that the next period will feature rising prices, too.
The bottom line is: in a line chart, very different periods can look the same. This vagueness can lead to bad trading decisions, lost trades, and lost money.
Candlestick Patterns Show Extra Data
Candlesticks solve the vagueness problem by displaying every price of a period in a simple way. A candlestick consists of a thick body and two thin wicks to the top and the bottom.
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- The body represents the price range from opening to closing price.
- The wicks represent the high and the low of each period.
- Candlesticks with rising prices are coloured differently than candlesticks with falling prices.
This simple system tells you everything you need to know about a period. The wicks represent the extremes that the market was unable to hold; the body represents the effective movement of each period.
Candlestick charts consist of hundreds of candlesticks, each of which aggregating the market movements of a specific period.
Typical periods range from 30 seconds (each candlestick aggregates the market movements of 30 seconds) to 1 day (each candlestick aggregates the market movements of an entire day). By changing the period, you can zoom in and out and discover the layers of the market.
What Are Simple Candlestick Formations?
Simple candlestick formations are special candlesticks that allow you to predict future market movements.
Think of our earlier example: where a line chart would have shown you the same sideways for all three movements, candlesticks paint a clearer picture:
- When a candlestick has almost no body but a long wick to the top, you know that the market has moved upwards but then turned around. Currently, prices must be on the decline.
- When a candlestick has almost no body but a long wick to the bottom, you know that the market has moved downwards but then turned around. Currently, prices must be on the rise.
With these simple conclusions, you know what is happening and what will happen next. Take a look at the picture above, for example. At first, the market was falling. In 1980, we had a candlestick with a long wick to the bottom but an upwards body. Even if you look for nothing else, you can immediately conclude that the market fell significantly but turned around and rose again.
This momentum is likely to carry over to the next candlesticks. This is exactly what happened. Whenever you see a similar candlestick after a strong movement, you can conclude that the market will turn around with the next candlestick.
The candlestick in this example is called the hammer. There is also the inverted hammer, which is a sign of downwards momentum.
Here are more simple candlesticks you can use for your trading:
The big candle
The big candle has a large body than its surrounding candlesticks and a small or non-existent wick. It indicates that the market has strongly moved in one direction with little hesitation or doubt. This strong momentum is likely to carry over to the next candlestick. An upwards big candle is a sign of strong upwards momentum, a downwards big candle is a sign of a strong downwards momentum.
Dragonfly doji & gravestone doji
In a dragonfly doji, the opening and closing prices are at the top of the trading day and there is a long wick to the bottom. The gravestone doji is an inverted dragonfly doji with the opening and closing prices at the bottom and a long wick to the top. This candlestick is similar to the hammer: the market has obviously turned around during the period and is now pushing in the direction of the opening and closing prices, but it failed to push far enough to create a hammer.
Consequently, the dragonfly doji indicates an upwards momentum and the gravestone doji a downwards momentum, but these indications are weaker than a hammer.
Doji & long legged doji
A doji is a candlestick with almost no body but a wick to the top and the bottom. Dojis indicate that the market is currently unsure where it wants to go. Dojis often happen near the end of the trading day, when most traders have stopped trading and volume is low. While a doji is a sign of a slow market, long legged dojis are signs of strong forces in balance. You can expect that one force will soon win over the other, pushing the market strongly in one direction.
Other simple candlestick formations
There are hundreds, if not thousands of simple candlestick formations – even the smallest variations have their own names. Instead of learning them all by heart, we recommend understanding the system behind them:
- Body: A long body indicates a strong momentum in the direction of the candlestick. A short body indicates a market with no clear direction.
- Wick: A long wick to one side indicates that the market has turned around. Long wicks to both sides indicate indecisiveness.
Combine these two indications, and you can interpret every single candlestick you see without having to learn any formation by heart. Try to understand the market’s direction and momentum, and you will immediately know what is going on.
Binary options traders can trade simple candlesticks in three ways:
- Trade single candlesticks.
- Paint a larger picture.
- Combine candlesticks with other indicators.
Let’s look at these strategies one by one.
How to trade single candlesticks
Single candlesticks allow for short-term predictions. Since they are based on only one candlestick, they only apply for the next one or two candlesticks. A big candle, for example, predicts that the next candlestick will feature rising prices, but after that, it lacks the ability to paint a clear picture.
If you want to trade a single candlestick, you have a few options:
- High/low options, short expiry: When you trade a single candlestick, you can invest in a high/low option in the direction of the candlestick’s momentum. Search for candlesticks with a clear momentum indication, for example a big candle, and keep your expiry short. You expiry should be no longer than the length of one period. In a 30 minute chart, keep your expiry at or under 30 minutes.
- One touch options: After simple candlestick formations that indicate a strong movement, for example a big candle, you can invest in a one touch option, predicting that the strong momentum will push the market far enough to trigger the target price. Ideally, you would use a target price that is less than one-third of the big candle’s size away from the current market price. Use the longest expiry that offers a target price within this distance.
- Boundary options: For binary options traders, dojis and long legged dojis offer the opportunity to win a trade. During these formations, the market was in the balance, unsure about where to go. This insecurity can’t last long. The market will soon break out of the doji. If you can find a boundary option, you can profit from this prediction. Search for a boundary option that offers target prices within the doji’s price range and use the longest expiry that you can get.
You can focus on a single of these strategies or combine them and pick the one that suits your current market environment.
How to trade the big picture with digital options
Instead of trading single candlesticks, you can also trade the sum of all candlesticks that you see. Typical prices charts have dozens of candlesticks, and their combination can tell you a lot about what is going on.
For example, assume that you see these candlesticks in a row: downwards big candle, upwards hammer, upwards big candle.
These three candlesticks create a vivid picture of what is going on: the market fell in the first period, then turned around in the second period, and continued to rise strongly in the third period.
Compare to trading just the big candle alone; this widened scope increases your ability to predict what will happen. You know that there has been a significant shift in market sentiment, making it likely that the new movement will continue for quite some time.
With this knowledge, you gain more investment possibilities. Since you can predict a longer movement than with a big candle alone, you can invest in a high/low option with a longer expiry. You can also use a one touch option with a target price up two times as far from the current market price as the size of the big candle. If your broker offers ladder options, you might even find a profitable opportunity to get a very high payout.
Of course, you can also combine this strategy with trading single candlesticks. The key is always to be honest about what you know.
- If you can only interpret the last candlestick, limit yourself to a short time investment.
- If the last three or four candlesticks all tell the same story, you can additionally invest in an option with a longer expiry or a higher payout.
- If you have already invested in a movement, won the option, and the next candlestick confirmed your prediction, you can invest again. In this way, a single movement can easily offer four or five chances to win a binary option.
Combine candlesticks with other indicators
Candlesticks can be a great way of finding the right way for trading other indicators. When you are trading trends, swings, or technical indicators, you often know that the market will change direction soon, but you might be unsure when. Candlesticks can be the tool to get your timing right.
When you expect than an upwards movement will soon weaken and turn around, for example, you can monitor the market for an inverted hammer. As soon as you find it, you invest in falling prices. In this way, you maximize your chances of winning a high/low option and even open the door to the possibility of trading a one touch option.
Conclusions On Candlesticks
Simple candlestick formations can help binary options traders find short-term trading opportunities in any market environment. Even newcomers can quickly learn the skills to interpret simple candlestick formations and invest based on their predictions. We recommend understanding the logic behind candlesticks, most importantly the relationship between body size to wick size and placement, and either trading single candlesticks with short expiries or a combination of candlesticks with a longer expiry.
The 5 Most Powerful Candlestick Patterns
Candlestick charts are a technical tool that packs data for multiple time frames into single price bars. This makes them more useful than traditional open-high, low-close bars or simple lines that connect the dots of closing prices. Candlesticks build patterns that predict price direction once completed. Proper color coding adds depth to this colorful technical tool, which dates back to 18th-century Japanese rice traders.
Steve Nison brought candlestick patterns to the Western world in his popular 1991 book, “Japanese Candlestick Charting Techniques.” Many traders can now identify dozens of these formations, which have colorful names like bearish dark cloud cover, evening star and three black crows. In addition, single bar patterns including the doji and hammer have been incorporated into dozens of long- and short-side trading strategies.
- Candlestick patterns, which are technical trading tools, have been used for centuries to predict price direction.
- There are various candlestick patterns used to determine price direction and momentum, including three line strike, two black gapping, three black crows, evening star, and abandoned baby.
- However, it’s worth noting that many signals emitted by these candlestick patterns might not work reliably in the modern electronic environment.
Candlestick Pattern Reliability
Not all candlestick patterns work equally well. Their huge popularity has lowered reliability because they’ve been deconstructed by hedge funds and their algorithms. These well-funded players rely on lightning-speed execution to trade against retail investors and traditional fund managers who execute technical analysis strategies found in popular texts.
In other words, hedge fund managers use software to trap participants looking for high-odds bullish or bearish outcomes. However, reliable patterns continue to appear, allowing for short- and long-term profit opportunities.
Here are five candlestick patterns that perform exceptionally well as precursors of price direction and momentum. Each works within the context of surrounding price bars in predicting higher or lower prices. They are also time sensitive in two ways:
- they only work within the limitations of the chart being reviewed, whether intraday, daily, weekly or monthly.
- their potency decreases rapidly three to five bars after the pattern has completed.
Top 5 Candlestick Patterns
This analysis relies on the work of Thomas Bulkowski, who built performance rankings for candlestick patterns in his 2008 book, “Encyclopedia of Candlestick Charts.” He offers statistics for two kinds of expected pattern outcomes:
- reversal – Candlestick reversal patterns predict a change in price direction
- continuation – while continuation patterns predict an extension in the current price direction.
In the following examples, the hollow white candlestick denotes a closing print higher than the opening print, while the black candlestick denotes a closing print lower than the opening print.
- Three Line Strike
The bullish three line strike reversal pattern carves out three black candles within a downtrend. Each bar posts a lower low and closes near the intrabar low. The fourth bar opens even lower but reverses in a wide-range outside bar that closes above the high of the first candle in the series. The opening print also marks the low of the fourth bar. According to Bulkowski, this reversal predicts higher prices with an 84% accuracy rate.
- Two Black Gapping
The bearish two black gapping continuation pattern appears after a notable top in an uptrend, with a gap down that yields two black bars posting lower lows. This pattern predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. According to Bulkowski, this pattern predicts lower prices with a 68% accuracy rate.
- Three Black Crows
The bearish three black crows reversal pattern starts at or near the high of an uptrend, with three black bars posting lower lows that close near intrabar lows. This pattern predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. The most bearish version starts at a new high (point A on the chart) because it traps buyers entering momentum plays. According to Bulkowski, this pattern predicts lower prices with a 78% accuracy rate.
- Evening Star
The bearish evening star reversal pattern starts with a tall white bar that carries an uptrend to a new high. The market gaps higher on the next bar, but fresh buyers fail to appear, yielding a narrow range candlestick. A gap down on the third bar completes the pattern, which predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. According to Bulkowski, this pattern predicts lower prices with a 72% accuracy rate.
- Abandoned Baby
The bullish abandoned baby reversal pattern appears at the low of a downtrend, after a series of black candles print lower lows. The market gaps lower on the next bar, but fresh sellers fail to appear, yielding a narrow range doji candlestick with opening and closing prints at the same price. A bullish gap on the third bar completes the pattern, which predicts that the recovery will continue to even higher highs, perhaps triggering a broader-scale uptrend. According to Bulkowski, this pattern predicts higher prices with a 70% accuracy rate.
The Bottom Line
Candlestick patterns capture the attention of market players, but many reversal and continuation signals emitted by these patterns don’t work reliably in the modern electronic environment. Fortunately, statistics by Thomas Bulkowski show unusual accuracy for a narrow selection of these patterns, offering traders actionable buy and sell signals.
Putting the insights gained from looking at candlestick patterns to use and investing in an asset based on them would require a brokerage account. To save some research time, Investopedia has put together a list of the best online brokers so you can find the right broker for your investment needs.
5 Popular Candlestick Patterns Explained
Candlestick patterns are special on-chart candle formations, which hint at potential price outcomes. They can be found on the chart of any financial instrument – Forex, Stocks, Commodities, Indices, etc. Therefore, traders carefully follow every candle on the chart during the trading sessions. Today we will meet you with the 5 popular candlestick patterns, which are among the most traded formations on the chart.
Hammer and Shooting Star
The Hammer and the Shooting Star candlesticks are single candle formations on the chart. They have reversal character and tend to hint about a change in price direction.
The Hammer candle has a small body, a short upper candlewick and a long lower candlewick. In this manner, the candle really looks like a hammer on the chart. The Hammer candle could be found at the end of a bearish move implying that the price direction is about to switch.
As you could probably guess, the Shooting Star candlestick is a mirror image of the Hammer candle. It has a small body, a short lower candlewick and a long upper candlewick. This is why the candle is called “Shooting Star” – because it really looks like one. The Shooting Star candle could be found at the end of a bullish price move, speaking about a potential reversal. The image below will show you how do the Hammer and the Shooting Star candles work in trading.
The image above shows you the way the price could reverse after a Shooting Star and a Hammer. The chart starts with a sharp price increase followed by a Shooting Star candlestick. This implies that the price might start a decrease. As you see, right after the candle is completed, the price starts a sharp decrease.
At the end of the bearish tendency we see a Hammer candle. Now we have the opposite scenario. We get a bullish confirmation when the candle is completed. This way, we have an opportunity for a long position. As you see, the price starts increasing after the Hammer candle is confirmed on the chart.
If you are familiar with the Doji candle, you can never confuse it on the chart. This is so, because the candle is very specific. When the price opens a candle at a certain level, and then closes the same candle at the same level, we get a Doji candlestick. In this manner, the candle has a body, which looks like a dash. The Doji has few variations depending on the size of its candlewicks – Neutral, Long-Legged, Gravestone, and Dragonfly.
These are the four Doji candlestick types you can meet on the chart. However, despite of its four different types, the Doji candle has only one meaning on the chart – reversal. When we spot a Doji after a price increase, we expect a bearish move. When we identify a Doji after a bearish trend, we await for an upcoming price increase. Since you are now familiar with the Doji variations and its character, let’s now approach a real Doji example on the chart.
The chart stats with a price increase. Suddenly, a neutral Doji candle appears on the chart. This gives us a signal that the trend might be about to switch. The next six candles on the chart are bearish and relatively big.
Bullish and Bearish Engulfing
The Engulfing pattern on the chart is a double candlestick formation. This means that it is formed by two candles. We have an engulfing when a candle is fully covered (engulfed) by the body of the next candle.
The Bullish Engulfing consists of a bearish candle, followed by a bullish candle which gaps down and closes higher than the opening of the first candle. When we spot a Bullish Engulfing on the chart, we expect the price to start increasing.
The Bearish Engulfing is opposite to the Bullish Engulfing. It starts with a bullish candle, which is engulfed by a bigger bearish candle. After a Bearish Engulfing we expect a price decrease as shown on the image below.
The confirmation of this candle pattern comes with the end of the second candle. When you spot a Bullish Engulfing on the chart, you get an alert that the buyers might be picking up versus the sellers. The opposite is in force for the Bearish Engulfing.
Dark Cloud Cover
The Dark Cloud Cover is another double candle formation. The first requirement of the Dark Cloud is to have a big bullish candle on the chart. The next candle should gap up and should be bearish. At the same time, it should close below the midpoint of the first candle’s body. The image below will make that clear for you.
The second candle on the image gaps up from the close of the first candle. Then the second candle closes below the midpoint of the first candle. This confirms the Dark Cloud Cover candle pattern. After a Dark Cloud Cover, we expect the price to drop as shown on the image below.
On this image you see that the price is increasing initially. Suddenly, the price action forms a Dark Cloud Cover, followed by a price decrease.
Bullish and Bearish Harami
Some people confuse the Harami with the Engulfing patterns. The Harami pattern is another double candle formation, where the second candle is engulfed by the first candle. There are two types of Harami pattern depending on their potential – Bullish Harami and Bearish Harami.
The Bullish Harami starts with a bearish candle, followed by a smaller bullish candle, which is engulfed by the bearish candle. After a Bullish Harami pattern we expect the price to increase.
The Bearish Harami is opposite to the Bullish Harami. It starts with a bullish candle, followed by a smaller bearish candle, which is engulfed by the bullish candle. After a Bearish Harami, we are likely to see a price drop as shown on the image below.
It is important to mention that Harami patterns are good for trend continuation confirmation too. When the price is increasing and a Bullish Harami appears on the chart, this means that the increase is likely to continue. Opposite to that, if the price is increasing and we see a Bearish Harami on the chart, we are likely to see a continuation of the bearish trend.
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