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Candlestick charts were first introduced by a Japanese rice trader, Honma Munehisa, in the early eighteenth century. Still sometimes referred to as Japanese candlestick patterns, this versatile charting method has long outgrown its original use in rice futures markets, with candlestick charts now used worldwide to give a clear visual signal of trading session performance in multiple asset classes.
CFD traders use candlestick charts to get a visual idea of past trading sessions, which according to technical analysts can provide a guide to future price moves. Not everyone accepts this, and traders need to be aware markets can move against them, and not always in the way candlestick patterns would imply. Even so, identifying well known candlestick patterns such as the doji star, hammer and pennants is essential for successful technical trading.
Candlestick charts are visual representations of price movements in financial markets over a single session. Composed of one or more usually several candlesticks, a pattern shows the user information about market psychology and its effect on price action. There are two key types of candlestick pattern – continuation and reversal. Reversal patterns indicate potential trend changes, signalling shifts from bullish to bearish or vice versa. Examples include the head and shoulders, a well-known pattern that can mark the end of an uptrend, and the hammer, seen as a sign of a potential bullish reversal.
Continuation patterns, on the other hand, imply that the prevailing trend still has momentum and can be expected to continue. The flag and pennant patterns are seen during a brief consolidation before the main trend resumes. Bullish continuation patterns indicate an upward trajectory, while bearish patterns forecast ongoing downward movement. Many chart patterns are reversible, for example the hammer is matched to the inverted hammer, that is simply an upside-down version of the same candlestick. Inverted patterns have the same significance in terms of continuation or reversal, but are bearish instead of bullish or vice versa.
To generate a useful trading signal, we need to understand whether a pattern is bullish or bearish. Bullish patterns indicate positive sentiment, with buying pressure predominating in the session, while bearish patterns indicate sellers playing the larger role. Traders use these insights to make informed decisions, predicting potential price movements as they happen. Candlestick charting is a broad topic that takes years to fully master, but knowing a few of the most important patterns will help.
Candlesticks often give a warning sign about changes in market direction, but their interpretation is not an exact science. The most sensible strategy is to use candlesticks to confirm your existing suspicions about the market. Say for example you have a short view on USD/JPY and have seen the RSI trading above 80 for several sessions. At that point, a hammer pattern would offer a strong signal the expected reversal is about to happen. Mean reversion traders may then open a short position in USD/JPY or wait until they see decisive downwards price action before joining the market.
CFDs are highly flexible, with forex CFD traders often using candlesticks to identify ideal entry and exit points. You can use candlesticks to identify entry and exit points for trades: often a reversal candlestick will form around a key support or resistance level. Chart patterns also help when deciding when to close an open trade, with a continuation pattern normally seen as a positive side for a (profitable) open position, whereas the appearance of a doji star or reversal pattern like a hammer may be a sign its time to take profit.
Candlestick patterns form the oldest rational basis for technical analysis, and have been successfully applied to all markets worldwide. ADSS traders, whether they deal in CFDs on equities, indices, or forex, can benefit from understanding candlestick patterns and using them to guide their trading strategies. The appearance of a bullish pennant or inverted hammer is a clear signal that will be picked up by traders checking charts. Even if you are sceptical about the predictive power of some of these patterns, the mere fact that many traders do use them can result in a self-fulfilling prophecy, where the expected market result is encouraged by traders responding to the pattern. Candlestick charts aren’t without critics – some traders view them as outdated or a relic of the days of single-day, in person trading sessions, and others point to the well-known tendency for humans to see patterns in random noise – but there is no denying they can and do work in some circumstances. The best strategy, as always, is to combine signals from candlesticks with other technical and fundamental methods, following prudent risk-management strategies, and sizing positions appropriately. If you remember these key points, understanding candlesticks is a powerful tool for technical CFD traders in all markets. But you must also appreciate that sometimes markets don’t follow trends, and that could lead to losses.
Understanding candlestick charts is an important part of successful technical trading, but it does not guarantee success. Traders are split on the effectiveness of candlesticks, and not all technical analysts accept them. The most common criticism is that multi-candle patterns like the head and shoulders are vague and resist neat identification. This means two traders looking at the same chart may draw completely different conclusions about the presence of a chart pattern. The criticism is valid, but in principle at least candlesticks are a useful way of visualising market psychology.
Originally, candlestick charts were used across daily sessions. This made sense when market sessions involved traders in a single location, constrained by time limits. Today, FX markets operate around the clock, and even time-limited equity trading sessions no longer involve face to face dealing. Nowadays, traders use candlesticks to view price action across any time period, from minutes to months. Be careful to remain consistent in the time periods you use – different trends will exist across different time periods, so a pattern may only be valid in the chart you found it on.
No method, technical or fundamental, should be used in isolation. If you have an investment case based on candlestick patterns alone, you will struggle to understand the markets and tread consistently. Instead, use multiple technical strategies combined with a solid grasp of market fundamentals to know when to go long or short using CFDs.