There are several different ways to analyze the FX market in anticipation of trading. Although categories of analysis may be plentiful, traders should keep the analysis simple enough to identify good trading opportunities.
This article explores the three most common forex analysis techniques: Fundamental, technical and sentiment analysis, and how they help to shape a trading strategy. Thereafter, it is up to the individual trader to try find out what type of analysis suits there trading style.
The 3 Most Common Types of Forex Market Analysis:
Forex fundamentals center mostly around the currency’s interest rate. This is due to the fact that interest rates have a sizeable effect on the forex market. Other fundamental factors are included such as gross domestic product, inflation, manufacturing, economic growth activity. However, whether those other fundamental releases are good or bad is of less importance than how those releases affect that country’s interest rate.
Traders reviewing the fundamental releases should keep in mind how they might affect the future movement of interest rates. When investors are in a risk-seeking mode, money follows yield (currencies that offer a higher interest rate), and higher rates could mean more investment. When investors are in a risk adverse mentality, then money leaves yield for safe-haven currencies.
Forex technical analysis involves looking at patterns in price history to determine the higher probability time and place to enter a trade and exit a trade. As a result, technical analysis in forex is one of the most widely used types of analysis.
Since FX is one of the largest and most liquid markets, the movements on a chart from the price action generally gives clues about hidden levels of supply and demand. Other patterned behavior such as which currencies are trending the strongest can be obtained by reviewing the price chart. An example of this can be seen below in the GBP/USD chart where the US dollar is strengthening against the Pound Sterling.
Other technical studies can be conducted through the use of indicators. Many traders prefer using indicators because the signals are easy to read, and it makes forex trading simpler.
Technical versus fundamental analysis in forex is a widely debated topic. There is no right answer to the question of which type of analysis is better and traders tend to adopt one, or a combination of the two, in their analysis.
Forex sentiment is another widely popular form of analysis. When you see sentiment overwhelmingly positioned to one direction, this means the vast majority of traders are already committed to that position.
Perhaps this can be better explained with an example. Let’s assume that an overwhelming number of traders and investors are bullish the Euro. They think the Euro is going higher. Since people vote with their trades, we can assess through DailyFX (which uses IG Client Sentiment) that the EUR/USD sentiment shows a majority of traders are buyers in the currency pair.
Since we know there is a large pool of traders who have already BOUGHT, then these buyers become a future supply of sellers. We know that because eventually, they are going to want to close out the trade. That makes the EUR to USD vulnerable to a sharp pull back if these buyers turn around and sell to close out there trades.
More astute traders will analyze retail sentiment alongside sentiment at the institutional level. Senior Analyst at DailyFX, Tyler Yell explains how traders can analyze the Commitment of Traders (CoT) report for clues on how the institutional market is positioned and how to implement this analysis into their trading analysis.
How to apply forex techniques to your trades
Traders can utilize a mix of all three types of forex market analysis. This can be done by:
• Identifying long term trends with the use of fundamental analysis
• Pin-pointing ideal entry points using technical analysis and accompanying indicators
• Making use of client sentiment as the last check box before entering the trade.
Keep reading for in-depth examples of how to analyse forex market trends with the three analysis techniques:
1) Use fundamentals to assist in identifying a long-term trend:
Analyzing a country’s GDP, interest rate and inflation rate provides insight on the strength of that country’s economy and by extension, their currency. For example, if the US begins an interest rate hiking cycle, the US dollar will look attractive. If enough investors/traders buy US dollars this will prop up the value of the USD.
2) Apply sound technical analysis to spot entries into the market:
Using multiple time frame analysis and an indicator like the MACD or Relative Strength Index, traders can spot ideal entries into the market.
3) Consider client sentiment:
Traders can analyze client sentiment either by observing the net number of traders long or short, or by trading the difference in net short/long movements. The main takeaway however, is that retail clients tend to trade against prevailing trends therefore, making client sentiment a contrarian indicator.
Technical v/s Fundamental
Understanding the differences between fundamental and technical analysis in forex trading
There is a great debate about which type of analysis is better for a trader. Is it better to be a fundamental trader or a technical trader? In this article we will explore what the difference is between these two types of traders and which pieces of information forex traders in particular tend to look at.
Technical vs fundamental analysis comparison
|TECHNICAL ANALYSIS||FUNDAMENTAL ANALYSIS|
|Definition||Forecast price movements using chart patterns||Various economic data used to establish value/target price|
|Data considered||Price action(charts)||Inflation,GDP,interest rates etc|
|Time horizon||Short,medium and long term||Medium and long term|
|Skillset required||Chart analysis||Economics & statistical analysis|
Fundamental analysis involves assessing the economic well-being of a country, and by extension, the currency. It does not take into account currency price movements. Rather, fundamental forex traders will use data points to determine the strength of a particular currency.
A fundamental forex trader will analyze the country’s inflation, trade balance, gross domestic product, growth in jobs and even their central bank's benchmark interest rate.
Below is an example of an economic calendar where fundamental traders will be able to keep up to date with the latest data releases. There are many data releases on any given day which is why traders should know how to filter the calendar to show relevant information only.
By assessing the relative trend of this and other data points, a trader is analyzing the relative health of the country’s economy and whether to trade the future movement of that country’s currency.
The table below summarizes the general effects that different economic data tends to have on the strength of a currency. However, this is not guaranteed as there are many factors that influence currency movements.
How economic data affects currencies
|EXPECTATIONS||EFFECT ON CURRENCY|
|Gross Domestic Product(GDP)||Better than expected||Positive|
|Consumer Price Inflation(CPI)||Better than expected||*Positive|
|Trade Balance||Trade deficit(imports > exports)||Negative|
|Central Bank Benchmark Rate||Increase in interest rate||Positive|
|Manufacturing Index(ISM)||Better than expected||Positive|
|Producer Price Index(PPI)||Better than expected||Positive|
*Developed nations welcome moderate inflation as it is a sign of a growing economy. Developing nations view decreasing, or maintained, inflation as a positive statistic as this keeps price levels in check.
Technical analysis involves pattern recognition on a price chart. Technical traders look for price patterns such as triangles, flags, and double bottoms. Based on the pattern, a trader will determine the entry and exit points. Unlike fundamental traders, a technical trader is not as concerned about why something is moving because the trends and patterns on the charts are their signals.
Below is an example of a chart pattern - the double bottom pattern. The market makes the first low, rebounds slightly before creating a new low and subsequently gains upward momentum as the trend reverses. Technical traders will look to set a stop loss at the recent (lowest) low and wait for the market to produce higher highs and higher lows before placing the long trade.
In practice, technical traders will need to identify the pattern as shown below on the USD/JPY daily chart where the “W” shape can be seen.
A technical forex trader will assess the price action, trend, support and resistance levels observed on a chart. Many of the patterns used in technical analysis of forex markets can be applied to other markets as well.
Additionally, traders make use of indicators and oscillators which are added to a price chart when analyzing foreign exchange markets. Moving averages, Bollinger Bands, MACD, Relative Strength Index (RSI), and stochastic tend to be some of the more common tools in a technical traders tool box. Indicators are preferred by technical traders because they are easy to use and provide clear signals.
The benefits of technical analysis
Technical analysis does not include ‘black magic’ that many fundamentalists claim. Getting started in technical analysis can be done quickly by assessing the direction and strength of trends. Traders will use the trend analysis to help them determine which pair to trade and the direction to trade it.
Below, is an example of how a technical trader would notice this 6,000 pip trend where the AUD is very strong relative to a very weak EUR (which is why the currency pair is moving down). Furthermore, it is clear to see that the currency pair is trading in a strong downward direction. This is referred to as a tend and traders make use of key levels, levels of support and resistance, and indicators to identify trends as soon as possible and with accuracy.
Finding out how to identify strong and weak currencies will provide traders with an indication of which currency pairs are most likely to trend and therefore lead to higher probability trades. A trader would trade in the direction of this particular trend by selling the EUR/AUD pair.
Fundamental and technical analysis involve very different strategies and approaches to trading; offering unique value and insights to support trading decisions, and when to enter or exit a trade. While some traders prefer to use these types of analysis separately based on their preferred trading style and goals, many use a combination of the two. The benefits of combining fundamental and technical analysis are wide ranging.
Introduction to Charting
Technical analysis charts: Talking Points
Technical analysis of charts aims to identify patterns and market trends by utilising differing forms of technical chart types and other chart functions. Interpreting charts can be intimidating for novice traders, so understanding basic technical analysis is essential. This article reveals popular types of technical analysis charts used in forex trading, outlining the foundations and uses of these chart types.
How many types of charts are there
There are three main types of technical analysis charts: candlestick, bar, and line charts. They are all created using the same price data but display the data in different ways. As a result, they involve different types of technical analysis to help traders make informed decisions across forex, stocks, indices and commodities markets. While there are several different types of charts, this article is covering only the top three because these three are the most widely followed.
The three charts presented below have been selected as they are universal across most trading platforms.
Top 3 types of technical analysis charts for trading
• Best for trading: Stocks
• Trading experience: Beginner
• Technical analysis technique: Holistic market overview which eliminates shifting data
• Advantages: Supports trading without the influence of emotions
A line chart typically displays closing prices and nothing else. Each closing price is linked to the previous closing price to make a continuous line that is easy to follow.
This type of chart is often used for television, newspapers and many web articles because it is simple and easy to digest. It provides less information than candlestick or bar charts but it is better for viewing at a glance for a simplistic market view.
Another advantage of the line chart is that it can assist in managing the emotions of trading by selecting a neutral colour, like the blue chart depicted above. This is because the line chart eliminates ‘choppy’ movements in different colours as seen in the bar and candlestick charts.
Expert tip: Due to the line chart illustrating only closed prices, more experienced traders will consider a line chart to map out the daily closing prices or for situations when the analyst wants to inspect the sub-waves without the noise.
Bar (HLOC) Charts
• Best for trading: Forex, stocks, indices and commodities
• Trading experience: Intermediate
• Technical analysis technique: Use price data (HLOC) to identify trends, support/resistance and entry points
• Advantages: Provides the trader with more detail which helps to identify key levels and in-depth data
A bar chart displays the high, low, open and closing (HLOC) prices for each period designated for the bar. The vertical line is created by the high and low price for the bar. The dash to the left of the bar was the opening price and the dash to the right signals the closing price.
Being able to identify whether a bar closes up (green) or down (red), indicates to the trader the market sentiment (bullish/bearish) for that period.
The similarities between this chart type and a candlestick chart are visible when they are viewed side by side, but a bar chart is better for a cleaner market view. By removing the bolded colour from the chart, traders can view market trends with an uncomplicated outlook.
• Best for trading: Forex, stocks, indices and commodities
• Trading experience: Intermediate
• Technical analysis technique: Equivalent to the bar chart technique (dependant on trader preference)
• Advantages: Candlesticks are easier on the eye for traders as opposed to bar charts, due to the fuller nature of the candlestick
A candlestick chart displays the high, low, open and closing (HLOC) prices for each period designated for the candle. The “body” of each candlestick represents the opening and closing prices while the candle “wicks” display the high and low prices for each period.
The colour of each candle depends on the applied settings, but most charting packages will use green and red as the default colours. The green candles reflect that price closed higher than where it opened (often called a bullish candle), and every candle that is red means the price closed lower than where it opened (often called a bearish candle).
The candlestick chart is by far the most popular type of chart used in forex technical analysis as it provides the trader with more information while remaining easy to view at a glance.
How to analyse technical charts
Charting techniques in technical analysis will vary depending on the strategy and market being traded. It is important to be familiar and comfortable with a strategy to then implement that strategy accurately. Analysing charts based on the strategy will allow for consistency in trading.
Questions to ask before selecting a technical analysis chart type:
1. What is the trading strategy being adopted?
2. Is the trading strategy targeting short, medium or long-term trades?
Once the above questions can be answered, the chart type may then be selected using the respective information provided.
The Trend is Your Friend: Forex Trendlines
A popular trading expression is "the trend is your friend." This expression has stood the test of time because trends are critically important to any trading plan. Forex trendlines can be seen in almost any charting analysis due to its usefulness and simplicity. This article provides traders with an in-depth guide on what trendlines are, how to draw them and how to apply this when trading.
Why is the trend your friend in forex trading
Top traders will admit that there isn’t a single trading strategy that has a one hundred percent win ratio. This statement may seem obvious, but this is exactly why traders need to be on the lookout for anything that can improve their chances of making winning trades. One such candidate is the trend.
Learning how to trade in an imperfect world is very important. Trend trading is a simple way to cover up strategy imperfections by identifying the strongest trends in the market. As can be seen below, a short trade could still work out even if a trader entered as the market rose temporarily.
The dominant trend (downwards) was strong enough to possibly turn a loser into a winner depending on where the stop loss was placed.
The chart below shows that there are more pips available in the direction of the trend, as opposed to against the trend.
How to determine the trend
To determine the trend, pull a price chart on a currency pair of your choice with between 100-200 candles. Then answer the question of which direction prices are generally moving?
If the trend is up, then confirm the direction by looking for a series of higher highs and higher lows on the chart. A valid up trend would look similar to the below chart.
Notice how each successive high is higher than the last and each low is higher than the one that precedes it.
However, in reality, all trends will end. Therefore, this uptrend will change to a downtrend when a series of lower highs and lower lows are established. The chart below depicts the point when traders should be on the lookout for a trend reversal as the market breaks lower than the previous low.
If the trend is down, confirm the downtrend by looking for a series of lower highs and lower lows on the chart. Below is a chart of a valid downtrend.
This downtrend changes to an uptrend when a series of higher highs and higher lows begin to form. The image below depicts the trend reversal.
It is important to note that there are no specific rules for identifying high and lows to use for trend analysis. The idea is to pick the most obvious examples of an uptrend or a downtrend to trade.
Insist on finding an forex pair in such an obvious trend that a ten-year-old child can identify the trend direction from across the room. If you are not sure of the trend direction, then move to the next pair where the identification is obvious.
Using Forex Trendlines
It is often easiest to identify a trend by drawing forex trendlines. Trendlines make it easier to spot areas where the market is likely to bounce off of trendline support/resistance, or, break through trendline support/resistance and move in the opposite direction.
The chart below depicts a strong uptrend confirmed by higher highs and higher lows. Drawing a trend line that connects multiple lows in an uptrend and multiple highs in a downtrend is often an easy way to identify the trend from a visual perspective.
The chart reveals levels that price has respected in the past while moving upwards in the direction of the trend. Bearing this in mind, traders are able to look for long entries into the market until such time as the uptrend comes to an end.
Introduction to Indicators
Technical indicators are chart analysis tools that can help forex traders better understand and act on price movement. There is a huge range of technical analysis tools available that analyze trends, provide price averages, measure volatility and more.
In this piece, we explore the types of technical indicators available, from RSI to Bollinger Bands®, explain how to respond to technical signals, and reveal the top tips to making the tools an effective part of your trading journey.
Types of Technical Indicators
There are four main types of technical indicators: Trend Following, Oscillators, Volatility and Support/Resistance. They are grouped based on their function, which ranges from revealing the average price of a currency pair over time, to providing a clearer picture of support and resistance levels.
List of Technical Indicators
1. Trend Indicators
Trend following indicators were created to help traders trade currency pairs that are trending up or trending down. We have all heard the phrase ‘the trend is your friend’ – these indicators can help point out the direction of the trend and can tell us if a trend actually exists.
Moving Average Indicator
A Moving Average (MA) is a technical tool that averages a currency pair’s price over a period of time. The smoothing effect this has on the chart helps give a clearer indication on what direction the pair is moving – either up, down, or sideways. There are a variety of moving averages to choose from, with Simple Moving Averages and Exponential Moving Averages being the most popular.
Ichimoku is a complicated looking trend assistant that is simpler than it appears. This Japanese indicator was created to be a standalone indicator that shows current trends, displays support/resistance levels, and indicates when a trend has likely reversed.
The Average Direction Index won’t tell you whether price is trending up or down, but it will tell you if price is trending or is ranging. This makes it the perfect filter for either a range or trend strategy by making sure you are trading based on current market conditions.
2. Oscillator Indicators
Oscillators give traders an idea of how momentum is developing on a specific currency pair. When price treks higher, oscillators will move higher. When price drops lower, oscillators will move lower. Whenever oscillators reach an extreme level, it might be time to look for price to turn back around to the mean.
However, just because an oscillator reaches ‘Overbought’ or ‘Oversold’ levels doesn’t mean we should try to call a top or a bottom. Oscillators can stay at extreme levels for a long time, so we need to wait for a valid sign before trading.
The Relative Strength Index is arguably the most popular oscillator to use. A big component of its formula is the ratio between the average gain and average loss over the last 14 periods. The RSI is bound between 0 – 100 and is considered overbought above 70 and oversold when below 30. Traders generally look to sell when 70 is crossed from above and look to buy when 30 is crossed from below.
Stochastics offer traders a different approach to calculate price oscillations by tracking how far the current price is from the lowest low of the last X number of periods. This distance is then divided by the difference between the high and low price during the same number of periods. The line created, %K, is then used to create a moving average, %D, that is placed directly on top of the %K.
The Commodity Channel Index is different than many oscillators in that there is no limit to how high or how low it can go. It uses 0 as a centerline with overbought and oversold levels starting at +100 and -100. Traders look to sell breaks below +100 and buy breaks above -100.
The Moving Average Convergence/Divergence tracks the difference between two EMA lines, the 12 EMA and 26 EMA. The difference between the two EMAs is then drawn on a sub-chart (called the MACD line) with a 9 EMA drawn directly on top of it (called the Signal line). Traders then look to buy when the MACD line crosses above the signal line and look to sell when the MACD line crosses below the signal line as seen here. There are also opportunities to trade divergence between the MACD and price.
3. Volatility Indicators
Volatility measures how large the upswings and downswings are for a particular currency pair. When a currency’s price fluctuates wildly up and down it is said to have high volatility. Whereas a currency pair that does not fluctuate as much is said to have low volatility. It’s important to note how volatile a currency pair is before opening a trade, so we can take that into consideration with picking our trade size and stop and limit levels.
Bollinger Bands® Indicator
Bollinger Bands® print three lines directly on top of the price chart. The middle ‘band’ is a 20-period simple moving average with an upper and low ‘band’ that are drawn two standard deviations above and below the 20 MA. This means the more volatile the pair is, the wider the outer bands will become, giving the Bollinger Bands® the ability to be used universally across currency pairs no matter how they behave.
The Average True Range tells us the average distance between the high and low price over the last set number of bars (typically 14). This indicator is presented in pips where the higher the ATR gets, the more volatile the pair, and vice versa. This makes it a perfect tool to measure volatility.
4. Support/Resistance Indicators
Support and resistance is key to technical analysis. The concept refers to the price levels on charts that form barriers to an asset price being pushed in a given direction. For more, see our article on Identifying Support and Resistance and make sure you consider the indicators below.
Pivot Points are one of the most widely used in all markets including equities, commodities, and Forex. They are created using a formula composed of high, low and close prices for the previous period. Traders use these lines as potential support and resistance levels, levels that price might have a difficult time breaking through.
Price channels or Donchian Channels are lines above and below recent price action that show the high and low prices over an extended period of time. These lines can then act as support or resistance if price comes into contact with them again.
When your forex trading adventure begins, you’ll likely be met with a swarm of different methods for trading. However, most trading opportunities can be easily identified with just one of four chart indicators. Once you know how to use the Moving Average, RSI, Stochastic, & MACD indicator, you’ll be well on your way to executing your trading plan like a pro. You’ll also be provided with a free reinforcement tool so that you’ll know how to identify trades using these forex indicators every day.
The Benefits of a Simple Strategy
Traders tend to overcomplicate things when they’re starting out in the forex market. This fact is unfortunate but undeniably true. Traders often feel that a complex trading strategy with many moving parts must be better when they should focus on keeping things as simple as possible. This is because a simple strategy allows for quick reactions and less stress.
If you’re just getting started, you should seek the most effective and simple strategies for identifying trades and stick with that approach.
"Simplicity is the ultimate sophistication"
- Leonardo da Vinci
Discover the Best Forex Indicators for a Simple Strategy
One way to simplify your trading is through a trading plan that includes chart indicators and a few rules as to how you should use those indicators. In keeping with the idea that simple is best, there are four easy indicators you should become familiar with using one or two at a time to identify trading entry and exit points:
• Moving Average
• RSI (Relative Strength Index)
• Slow Stochastic
Using Forex Indicators to Read Charts for Different Market Environments
There are many fundamental factors when determining the value of a currency relative to another currency. Many traders opt to look at the charts as a simplified way to identify trading opportunities – using forex indicators to do so.
When looking at the charts, you’ll notice two common market environments. The two environments are either ranging markets with a strong level of support and resistance, or floor and ceiling that price isn’t breaking through or a trending marketwhere price is steadily moving higher or lower.
Using technical analysis allows you as a trader to identify range bound or trending environments and then find higher probability entries or exits based on their readings. Reading the indicators is as simple as putting them on the chart.
Trading with Moving Averages
One of the best forex indicators for any strategy is moving average. Moving averages make it easier for traders to locate trading opportunities in the direction of the overall trend. When the market is trending up, you can use the moving average or multiple moving averages to identify the trend and the right time to buy or sell.
The moving average is a plotted line that simply measures the average price of a currency pair over a specific period of time, like the last 200 days or year of price action to understand the overall direction.
GBPUSD Daily Chart - Moving Average
You’ll notice a trade idea was generated above only with adding a few moving averages to the chart. Identifying trade opportunities with moving averages allows you see and trade off of momentum by entering when the currency pair moves in the direction of the moving average, and exiting when it begins to move opposite.
Trading with RSI
The Relative Strength Index or RSI is an oscillator that is simple and helpful in its application. Oscillators like the RSI help you determine when a currency is overbought or oversold, so a reversal is likely. For those who like to ‘buy low and sell high’, the RSI may be the right indicator for you.
The RSI can be used equally well in trending or ranging markets to locate better entry and exit prices. When markets have no clear direction and are ranging, you can take either buy or sell signals like you see above. When markets are trending, it becomes more obvious which direction to trade (one benefit of trend trading) and you only want to enter in the direction of the trend when the indicator is recovering from extremes.
Because the RSI is an oscillator, it is plotted with values between 0 and 100. The value of 100 is considered overbought and a reversal to the downside is likely whereas the value of 0 is considered oversold and a reversal to the upside is commonplace. If an uptrend has been discovered, you would want to identify the RSI reversing from readings below 30 or oversold before entering back in the direction of the trend.
Trading with Stochastics
Slow stochastics are an oscillator like the RSI that can help you locate overbought or oversold environments, likely making a reversal in price. The unique aspect of trading with the stochastic indicator is the two lines, %K and %D line to signal our entry.
Because the oscillator has the same overbought or oversold readings, you simply look for the %K line to cross above the %D line through the 20 level to identify a solid buy signal in the direction of the trend.
Trading with the Moving Average Convergence & Divergence (MACD)
Sometimes known as the king of oscillators, the MACD can be used well in trending or ranging markets due to its use of moving averages provide a visual display of changes in momentum.
After you’ve identified the market environment as either ranging or trading, there are two things you want to look for to derive signals from this indictor. First, you want to recognize the lines in relation to the zero line which identify an upward or downward bias of the currency pair. Second, you want to identify a crossover or cross under of the MACD line (Red) to the Signal line (Blue) for a buy or sell trade, respectively.
Like all indicators, the MACD is best coupled with an identified trend or range-bound market. Once you’ve identified the trend, it is best to take crossovers of the MACD line in the direction of the trend. When you’ve entered the trade, you can set stops below the recent price extreme before the crossover, and set a trade limit at twice the amount you're risking.
Types of Charts
How to Read a Candlestick Chart
What is a candlestick chart?
A candlestick chart is simply a chart composed of individual candles, which traders use to understand price action. Candlestick price action involves pinpointing where the price opened for a period, where the price closed for a period, as well as the price highs and lows for a specific period.
Price action can give traders of all financial markets clues to trend and reversals. For example, groups of candlesticks can form patterns which occur throughout forex charts that could indicate reversals or continuation of trends. Candlesticks can also form individual formations which could indicate buy or sell entries in the market.
The period that each candle depicts depends on the time-frame chosen by the trader. A popular time-frame is the daily time-frame, so the candle will depict the open, close, and high and low for the day. The different components of a candle can help you forecast where the price might go, for instance if a candle closes far below its open it may indicate further price declines.
Interpreting a candle on a candlestick chart
The image below represents the design of a typical candlestick. There are three specific points (open, close, wicks) used in the creation of a price candle. The first points to consider are the candles’ open and close prices. These points identify where the price of an asset begins and concludes for a selected period and will construct the body of a candle. Each candle depicts the price movement for a certain period that you choose when you look at the chart. If you are looking at a daily chart each individual candle will display the open, close, upper and lower wick of that day.
The open price depicts the first price traded during the formation of the new candle. If the price starts to trend upwards the candle will turn green/blue (colors vary depending on chart settings). If the price declines the candle will turn red.
The top of the upper wick/shadow indicates the highest price traded during the period. If there is no upper wick/shadow it means that the open price or the close price was the highest price traded.
The lowest price traded is the either the price at the bottom of the lower wick/shadow and if there is no lower wick/shadow then the lowest price traded is the same as the close price or open price in a bullish candle.
The close price is the last price traded during the period of the candle formation. If the close price is below the open price the candle will turn red as a default in most charting packages. If the close price is above the open price the candle will be green/blue (also depends on the chart settings).
The next important element of a candlestick is the wick, which is also referred to as a ‘shadow’. These points are vital as they show the extremes in price for a specific charting period. The wicks are quickly identifiable as they are visually thinner than the body of the candlestick. This is where the strength of candlesticks becomes apparent. Candlesticks can help traders keep our eye on market momentum and away from the static of price extremes.
The direction of the price is indicated by the color of the candlestick. If the price of the candle is closing above the opening price of the candle, then the price is moving upwards and the candle would be green (the color of the candle depends on the chart settings). If the candle is red, then the price closed below the open.
The difference between the highest and lowest price of a candle is its range. You can calculate this by taking the price at the top of the upper wick and subtracting it from the price at the bottom of the lower wick. (Range = highest point – lowest point).
Having this knowledge of a candle, and what the points indicate, means traders using a candlestick chart have a clear advantage when it comes to distinguishing trendlines, price patterns and Elliot waves.
Bar Chart vs Candlestick Chart
As you can see from the image below, candlestick charts offer a distinct advantage over bar charts. Bar charts are not as visual as candle charts and nor are the candle formations or price patterns. Also, the bars on the bar chart make it difficult to visualize which direction the price moved.
How to read a candlestick chart
There are various ways to use and read a candlestick chart. Candlestick chart analysis depends on your preferred trading strategy and time-frame. Some strategies attempt to take advantage of candle formations while others attempt to recognize price patterns.
Interpreting single candle formations
Individual candlesticks can offer a lot of insight into current market sentiment. Candlesticks like the Hammer, shooting star, andhanging man, offer clues as to changing momentum and potentially where the market prices maytrend.
As you can see from the image below the Hammer candlestick formation sometimes indicates a reversal in trend. The hammer candle formation has a long lower wick with a small body. Its closing pricing is above its opening price. The intuition behind the hammer formation is simple, price tried to decline but buyers entered the market pushing the price up. It is a bullish signal to enter the market, tighten stop-losses or close out a short position.
Traders can take advantage of hammer formations by executing a long trade once the hammer candle has closed. Hammer candles are advantageous because traders can implement ‘tight’ stop-losses (stop-losses that risk a small amount of pips). Take-profits should be placed in such a way as to ensure a positive risk-reward ratio. So, the take-profit is larger than the stop-loss.
Recognizing price patterns in multiple candles
Candlestick charts help traders recognize price patterns that occur in the charts. By recognizing these price patterns, like the bullish engulfing pattern or triangle patterns you can take advantage of them by using them as entries into or exit signals out the market.
For example, in the image below we have the bullish engulfing price pattern. The bullish engulfing is a combination of a red candle and a blue candle that ‘engulfs’ the entire red candle. It is an indication that it could be the end of a currency pairs established weakness. A trader would take advantage of this by entering a long position after the blue candle closes. Remember, the price pattern only forms once the second candle closes.
As with the hammer formation, a trader would place a stop loss below the bullish engulfing pattern, ensuring a tight stop loss. The trader would then set a take-profit. For more forex candlestick charts check our forex candlesticks guide where we go in depth into the advantages of candlestick charts as well as the strategies that can be implemented using them.
Further tips for reading candlestick charts
When reading candlestick charts, be mindful of:
•The time frames of trading.
•Classic price patterns.
Higher Probability Candlestick Entries
Trading by Candlelight
Candlestick charting is a method of displaying price action so that you can readily see the battle and winner of buyers to sellers to obtain distinctive trading signals. Candlestick trading has been around for centuries and has been introduced to the Western world within the last few decades.
There are many individual candlesticks and candlestick patterns that can tip you off to a new move. Common formations are the doji, the shooting star, and the hammer. To get a better handle on different patterns.
Combining Market Type with Candlestick Signals
First, it’s important to note that a market is either in one of two common environments. Either a range bound market with price bouncing between support and resistance. This is the most common market environment. The other market that trader’s find themselves in is a trend with price showing higher highs and higher lows in an uptrend or the opposite in a downtrend.
Here is the first rule for candlestick entries that we want to focus on once the market type has been identified.
-When in a range bound environment, we want to focus on candlestick formations or patterns near support or resistance for entries. Support and resistance can be identified by eyeing price action ceiling and floors or by adding Pivot Points to the charts.
-When in a trending environment, we want to focus on candlestick formations or patterns near pull backs in the direction of the trend for entries.
In addition to Pivot Points, we can also look to common indicators like the 200 period moving averages to help us pinpoint candlestick patterns around key prices in the market.
Pivot points are a famous indicator to help you forecast future points of resistance and support to limit risk and find profit targets.
The Pivot number is the high, low, and close added up and then divided by three.
P= (H+L+C)/3= pivot point
This is easier than it sounds because it will be a default indicator you can add.
Once the Pivot Levels are added along with a major moving average, we will look for price action to move to one of these levels. That is when we’ll heighten our attention to patterns that develop to see if a reversal is upcoming or a continuation is shown.
On the AUDUSD, 2 hour chart we see price respect and move off of the monthly pivot price. We also see additional action around the 200 day moving average that confirms the bounce of the Resistance line (green) back down to the monthly pivot line. There is nothing predictive about the Pivot Lines except the fact that many traders look to them in placing profit targets, stop exits or deciding when to stop buying or selling into a move. This gives Pivot Lines a bit of a self-fulfilling power. As you add these lines onto the charts, you see that price often respects these lines in either reversing from them or showing a strong continuation off of them.
Here is the USDJPY, 2 hour chart which shows price bouncing off the pivot and rushing up to the Resistance 1 line.
The take home message is that you can look to Pivot Points and a large period moving average for reversal or continuation signals and then set your stop below the signal and your profit target near the resistance or support line. This will ensure you keep good risk management while hunting for higher probability entries.