A bullish candlestick forms when closing price is greater than the opening price which, indicates the existence of buying pressure.
A bearish candlestick forms when closing price is lower than the opening price which, indicates the existence of selling pressure.
Candlestick charts are a technical tool that fits data for multiple time-frames into single price bars. To create a Candlestick chart, one must have a data set that contains a close, open, high and low value for that specific time frame.
Using Candlesticks and understanding their patterns is crucial and helpful in technical trading for tracking the price movement in the forex market.
A bullish candlestick forms when the closing price is greater than the opening price, indicating buying pressure.
On the other hand, a bearish candlestick forms when the closing price is lower than the opening price, indicating selling pressure.
There are many candlestick patterns that can be useful in conjunction with other indicators to create an edge over the market to identify the movement in the market for trade opportunities or potentially filter some of the bad trades.
Thus, we will cover some of the important candlestick patterns here and in the following topics.
In this topic, we will cover two candlestick price patterns, the famous inside/outside bars.
Outside bar candlestick patterns
Outside Bars are those in which the trading range totally encompasses that of the previous bar. They develop both in up and downtrends and represent a strong signal of exhaustion.
To work as a higher probability signal of trend reversals, it is suggested to utilize them when they are formed at the sensitive psychological levels of support or resistance.
There are several guidelines for deciding on the potential significance of an outside bar. They are as follows:
1) The more significant the outside bar (First candle) relative to the proceeding ones, the stronger the signal.
2) The sharper the rally (reaction) proceeding the outside bar, the more significance the bar. For instance, the stronger the existing trend has been, the greater the likelihood that an outside bar pattern will lead to a reversal. This is due to the fact that in the case of an uptrend, buyers have temporarily pushed prices up too far and need a rest. On the other hand, there is little supply in the case of downtrends because sellers have completed their liquidation.
3) The more candles encompassed by the previous candle, the better the signal.
4) The greater the volume accompanying the outside bar relative to previous bars, the stronger the signal.
In the AUD/NZD chart below, notice that there is a strong rally and then price pauses and forms an outside bar pattern as a sign of exhaustion. At the same time, the Relative Strength Index (RSI) indicator signals an overbought condition. The alignment of the signals generated both by the candlestick pattern, and the RSI indicator shows a strong chance that the market has reached the exhaustion point and might reverse in the near future. Thus, as you can see, the market right after the formation of the outside bar starts falling.
The XAU/USD (Gold) chart below shows that after a sharp rally market reaches a sensitive resistance level, price forms an outside bar candlestick pattern. In addition, notice that the volume is building up while the market is approaching the reversal point.
This indicates that the market is potentially exhausted at this point, and it could bounce back in the near future. However, as can be seen, the market indeed started to fall right after the outside bar price pattern.
It is important to remember that we are dealing in probabilities, not certainties, in technical analysis. Therefore, the outside bar by itself would provide many false signals. It is suggested to be used in conjunction with other technical analysis tools and indicators, such as Support & Resistance, RSI, and different strategies.
The theory behind inside bars is that since the inside candle has a lower high and a higher low and is traded within the previous candle, it could indicate that the underlying currency pair is consolidating. The consolidation happens because the price cannot break higher or lower than the high/low of the previous candle to continue the prevailing direction. Once the inside bars are formed, it could be interpreted that there is not sufficient buying or selling pressure to break the previous candle's high/low, and there is a balance between buyers and sellers after a strong up or downtrend.
However, one must note that inside bars are not a strong indication of the reversal like outside bars. But, one could keep an eye for them when they are formed after an extended sharp uptrend/downtrend for a potential reversal in the near future, especially if they happen to form at the sensitive psychological levels in the market, for example, important support/resistance levels.
Also, the smaller is the inside candle relative to the previous candle, the stronger the probability of the signal generated.
Inside bar patterns can be utilized for short-term trading strategies. They are a good indication of balance between buyers and sellers within a trending market; it could create an opportunity for a short-term counter-trend after forming an inside bar.
In the GBP/USD chart above, notice that RSI is giving an overbought signal. Besides that, as you can see, the price also has formed an inside bar pattern at a very important resistance level. Before that price has surged to 1.715 and started consolidating for a short period of time; thus, this could be a great trade setup opportunity to sell. However, as you can see, the market has started falling rapidly right after the inside bar pattern.
In general, candlestick patterns are practical tools, and if utilized correctly in conjunction with other strategies, a high-quality trade setup can be generated. However, bear in mind that using a two-candlestick pattern solely as a trading strategy would generate many false signals. Therefore, trend indicators and other price action strategies could help to filter the false signals generated.