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April 19, 2018

Trading with Japanese Candlestick Charts – Introduction

Candlestick names and market emotion

Japanese candlestick charts use descriptive names

This makes it a lot easier to figure out if a pattern is either bullish or bearish. Actually, the candlestick names describe the emotional health of the market at the time these patterns are formed. Expressions like `hanging man` or `dark cloud cover` leave no doubt about the state of the market. These are both bearish patterns, their names clearly express an unhealthy state of the market.

Examples of Japanese candlestick names

Previously we mentioned one of the basics of trend analysis, that history repeats itself. But bear in mind that there is no chart that can predict for 100% how the market is about to move. That is why charting on HitBTC is referred to as rather an art than a science.

Price patterns on charts indicate signs of future price movements

Their predictive value is used by chartists to identify current trends and trigger buy and sell signals.

2 major categories of price chart patterns can be distinguished: reversal and continuation. A reversal pattern indicates that an important trend reversal will take place upon completion of the pattern. A continuation pattern, conversely, indicates a temporary pause in the market after which the existing trend will continue.

Reversal chart patterns

Technicians watch for price clues that can alert them to a shift in market psychology and trend. Reversal patterns form a first set of these technical clues. A trend reversal usually occurs in stages, as the underlying psychology shifts gears. A trend reversal signal implies that the prior trend is likely to change, but this does not necessarily need to be a reversal. It is wiser to think of reversal patterns as trend change patterns. In other words, reversal signs provide a warning sign, such as `Be cautious – Trend in process of change`.

Examples of top reversal signals

Some common and essential points that form the basis of reversal patterns

  1. Existence of a prior trend; if there is no preceding trend, there is nothing to reverse.
  2. Breaking of important trendlines; as already indicated, the violation of a major trendline does not always become a trend reversal, it often signals the beginning of a sideways price pattern, which then can be identified as either a reversal or a continuation type.
  3. Greater potential with larger patterns; patterns with greater sizes, meaning with high volatility and long duration of building, are more important and the potential for ensuring a price move becomes more likely.
  4. Difference between top and bottom patterns; top patterns usually take less time to build, as they are shorter in duration and are more volatile. The volatility of bottom patterns is lower and it takes a longer time to build. In top patterns, the prices tend to decline faster than they go up, so in this scenario, a trader can more quickly make money by trading the short side of a bear market, than by trading the long side of a bull market.
  5. Volume is more significant on the upside; volume usually increases in the direction of the trend. At market tops in the early stages of a trend reversal, volume is not so essential. On the other hand, at bottoms the volume increase is quite important.

Trade in the direction of the major trend

An important rule of thumb while trading is to place a new position (based on a reversal signal) only if that signal is in the direction of the major trend. So for example, that in a bull market, a top reversal pattern appears. This bearish signal would not justify a short sale, because the major trend is still up. However, it would indicate a liquidation of longs. In case there was a prevailing downtrend, this same top reversal formation could be used to place short sales.

In our next post we will clarify more about major reversal patterns.

Sources:
Technical Analysis Explained (by IFC Markets)
Japanese Candlestick Charting Techniques (by Steve Nison)