Identifying and Evaluating Chart Patterns

A chart pattern aims to explain the repeating behavior of human nature when trading the global financial markets.

What is a Chart Pattern? (our definition)

A chart pattern is a set of identifiable price formations that occur during the analysis of a data series. After filtering and eliminating the random market noise, a recognizable chart pattern can be used for evaluating the potential continuation or reversal of the master price trend.

 

General Insights about Patterns in a Time Series

In a time-series, a pattern is a formation of data which is based on a trend, on seasonality, or on both. There are three general categories of recognizable patterns:

(i) Trend Patterns (following a certain trend)

(ii) Seasonality Patterns (repeated over time)

(iii) Multiplicative Seasonality Patterns {(i) and (ii) combined}

Note that the chart pattern described below are based on a price trend (i), and not on seasonality (ii). Nevertheless, there are some types of financial patterns that are based on seasonality, and these patterns are called financial circles.

 

Chart Patterns

The ability to recognize chart patterns is very important, no matter the timeframe you trade. Chart patterns can reveal the real dynamics of the market, and at the same time, they can forecast the direction of the upcoming price action.

A chart pattern can emerge anywhere, from the 15-Minutes to the 1-Month timeframe, and it is able to spot both the continuation or the exhaustion of the trend.

Key Benefits from Identifying Chart Patterns

  • Can be very helpful in analyzing the market dynamics

  • Can spot trend reversal and trend continuation

  • Can often explain the real price action when indicators can’t

  • Can generate reliable trade signals

  • Can be combined with any other technical analysis method

  • Can be instantly visualized (in any timeframe)

The Japanese Candlesticks and Fibonacci Retracement

 

The candlestick formations have been identified in the 18th century by the Japanese rice trader, Munehisa Homma. In the Western world, they were introduced in 1991 by Steve Nison {book:“Japanese Candlestick Charting Techniques”}. Candlestick formations create an advanced communicational bridge between global traders. They can be seen as a complex trading language.

Candlestick formations can be combined with another technical analysis tool in order to signal the perfect time for entering / exit a trade. For example, they can be combined with the Fibonacci Retracement. The great advantage when using the Japanese candlestick formations is that you get the first sign of a market direction change. The most common reversal you can trade is the U-turn.

Charting

A Japanese candlestick as any other candlestick can be used for analyzing price movements against time. The Candlestick chart is a sophisticated tool that can be used alternatively to an ordinary line chart or a bar chart. There are many candlestick formations, more than a hundred, but the key formations are less than 10. The Japanese candlesticks can be identified in any timeframe (M5, M15, M30, H1, H4, D1, or even longer charts).

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Information Incorporated in Candlestick Formations

Candlestick formations are made up of bodies and wicks and incorporate four types of information:

  • Opening price
  • Closing price
  • High price
  • Low price

The filled section of the candlestick is called the body and the thin lines above and below the body are called the shadows.

Chart: The Basic Candlestick Formation

The filled section of the candlestick is called the body and the thin lines above and below the body are called the shadows.

Notes:

  • If the closing price is above the open price, then a hollow candlestick appears (usually colored white)
  • If the closing price is below the open price, then a filled candlestick appears (usually colored black)

 

Basic Candlestick Patterns

 

There are tens of recognizable candlestick patterns, here are the most important patterns:

  1. Doji Formation
  2. Hammer Formation / Hanging Man
  1. Shooting Star Formation / Inverted Hammer Formation
  1. Morning Star Formation / Evening Star
  1. Harami Formation
  1. Marubozu Formation
  1. Three White Soldiers Formation / Three Black Crows Formation
  1. Spinning Top Formation
  1. Railway Tracks Formation

Check all nine Candlestick Formations with examples and charts at Forex-Investors.com:

» http://Forex-Investors.com/index.php/trading/candlesticks

 

Combining Fibonacci Retracement with Japanese Candlesticks

 

The Fibonacci retracement can be combined with several technical analysis indicators but it can also be combined with candlestick patterns.

When combining the Fibonacci retracement with Japanese patterns, the aim is to identify trend exhaustion (exhaustive candlesticks). This exhaustion can occur either after a strong bullish / bearish trend.

How to Combine Fibonacci Retracement with Japanese Candlesticks

  • The Fibonacci Retracement tool is applied after the completion of a strong trend and as the trend is correcting
  • The possible retracement zones are identified by the Fibonacci levels (23.6%, 38.2%, 61.8%, and 78.6%)
  • When the price reaches a Fibonacci Level, we don't trade the reversal, unless a reversal candlestick pattern appears
  • Once it appears we open a position placing a stop-loss above or below the recent local high / low
  • Most common reversal formations include: the Hammer, Shooting Star, Spinning Top, and Railway Tracks 

 

The Japanese Candlesticks and Fibonacci Retracement

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