Decoding reversal Japanese candlesticks: A guide for forex traders

The power of reversal candlestick patterns

In the fast-paced and intricate world of forex trading, one of the most effective tools used by experienced traders is the study of Japanese candlestick patterns. Among these, reversal candlestick patterns hold significant importance as they signal potential trend changes in the market.

Reversal candlestick patterns are formations that indicate an imminent reversal in price direction after a prevailing trend. These patterns are formed by the open, high, low, and close prices over a specific period. By interpreting these patterns correctly, traders can identify potential turning points in the market, offering valuable opportunities for profit-making or risk management.

In this comprehensive guide, we will explore the essential reversal candlestick patterns, provide insightful explanations, and offer practical tips to help both seasoned traders and beginners enhance their trading prowess.

Common reversal candlestick patterns

Hammer and Hanging Man:

Hammer is a bullish reversal pattern that forms after a downtrend. It has a small body near the top of the candlestick and a long lower shadow (wick) that is at least twice the size of the body. The presence of a small upper shadow (or none at all) further strengthens the pattern. The hammer signals that despite selling pressure, buyers managed to push the price higher, indicating a potential trend reversal to the upside.

Hanging Man is the bearish counterpart of the hammer and forms after an uptrend. It also has a small body near the bottom of the candlestick and a long lower shadow. The difference is that the hanging man appears at the top of an uptrend and suggests that despite buying interest, sellers pushed the price lower, indicating a potential trend reversal to the downside.

Bullish and Bearish Engulfing:

Bullish Engulfing pattern appears at the end of a downtrend. It consists of a small bearish candle followed by a larger bullish candle that engulfs the entire body of the previous candle. This pattern demonstrates a strong shift in sentiment, with the buyers overwhelming the sellers, potentially signalling a bullish reversal.

Bearish engulfing pattern occurs at the end of an uptrend. It comprises a small bullish candle followed by a larger bearish candle that completely engulfs the previous candle's body. This indicates a significant shift in sentiment, with the sellers overpowering the buyers, potentially leading to a bearish reversal.

Morning Star and Evening Star:

Morning Star is a bullish reversal pattern that appears after a downtrend. It consists of three candles - a long bearish candle followed by a small-bodied candle (can be bullish or bearish) and then a long bullish candle. The middle candle (the star) shows indecision, and the bullish candle signals a possible trend reversal to the upside.

Evening Star is a bearish reversal pattern that emerges after an uptrend. It also comprises three candles - a long bullish candle followed by a small-bodied candle and then a long bearish candle. The middle candle represents uncertainty, and the bearish candle suggests a potential trend reversal to the downside.

Doji:

The Doji is a candlestick pattern with a very small body where the open and close prices are almost the same or exactly the same. It looks like a horizontal line with little or no body. Doji patterns indicate uncertainty and indecision in the market. They suggest that the forces of supply and demand are relatively balanced, and a potential trend reversal may be on the horizon.

How to trade reversal candle patterns

Upon identifying a reversal candle formation, traders should assess the strength of the signal. In cases of a robust signal, there are typically three available courses of action.

1. If a trader has been aligning with the prevailing trend, they may opt to liquidate their entire position.
2. If the trader perceives the reversal signal to be somewhat weaker, they might consider tightening their trade's stop loss or partially closing their position to secure gains.
3. If the trader currently holds no position in the market, they can utilise the signal as an opportunity to initiate a fresh position in alignment with the reversal. For instance, if a bullish reversal pattern emerges, they could consider opening a new bullish position.

Are reversal candle patterns reliable?

A solitary reversal candlestick pattern does not guarantee a change in the prevailing trend. The positioning of the candlestick pattern also holds significant importance.

For example, a bullish pattern at the top of an extended rally does not guarantee the continuation of the rally. Conversely, a bullish pattern that appears at the end of a prolonged downtrend has a higher likelihood of success.

It's important to recognise that not all patterns are infallible, underscoring the necessity of implementing a stop loss on every trade to manage risk effectively.