There are several different types of forex analysis available to investors. Two of the most popular kinds are oscillators and candlestick patterns. Both have advantages and disadvantages, and good retail investors should understand each of them.
Actually, Candlestick patterns refer to regular patterns on candlestick charts. Andcandlestick charts are an originally Japanese method of recording price changes over a session. The candlestick (so named for its appearance) includes the open, close, high, and low prices of the session. Certain patterns are claimed to indicate selling or buying pressure in a particular direction.
First, a bit more about the candle. The ‘wick’ refers to the difference between the absolute high and low intraday, and the ‘body’ the shaded difference between the open and close price. Some common patterns are as follows:
A wick extending downwards from a short body. This is where a currency (or stock) has come under intense selling pressure during the day but rallied upwards. Sometimes the close price is higher, sometimes lower, but so long as there is a short body and long downwards wick a hammer has formed. These are considered a bullish signal.
A Doji star is a distinctive candlestick pattern that looks like a small cross. Normally coming at the end of a trend, this pattern indicates a reversal. The cross shape with no body means that the opening and closing prices were very close. Depending on the length of the wick, there may have been more or less intraday variation. Either way, this is a sign of hesitation and possible reversion in a trend.
Combination candlestick patterns
Some candlestick patterns require multiple sessions to form. One of the most reliable of these is the ‘three line strike’, a pattern analysts claim has 83% efficacy. The three line strike appears when there are three successive downward trading sessions, where the close is lower than the open. Finally, on the fourth day, the price opens even lower before rallying to a level above the first day open price.
This is an example of an ‘engulfing’ candlestick – one which placed next to the previous day is larger from top to bottom. These are some of the strongest reversal indicators available. Traders seeing a three line strike would enter a long trade on the asset, using the second day close as a stop loss. The ensuing rally would be expected to continue well past the level of the first three days, but it is important to practice proper risk management.
Another combination pattern is the evening star. A long bodied positive trading day is followed by a day with a narrow range, similar to the Doji star (although the body may be slightly thicker). Finally there is a gap before the opening price of the third session. This pattern indicates the end of a rally. Traders seeing an evening star pattern are likely to enter a short trade or close long positions.
Not all candlestick patterns ‘come true’, but many of them have high degrees of predictive power. On very short timescales they are less useful as algorithmic strategies execute faster than retail traders can. The candlestick system was devised to look at behaviour across an entire session, and so the one day candle timeframe is the most appropriate. The rationale about trading psychology does not make sense on shorter or longer timescales. Despite this, many traders use candlesticks across all time periods, some successfully.
The best known oscillators are the RSI and Stochastic oscillator. The RSI stands for ‘relative strength index’. Oscillators aim to predict changes in trend by flashing when the market is overbought or oversold. They do this by calculating the momentum of price changes, including the volume.
When an indicator flashes oversold, it is a sign that the market is about to reverse direction and a rise in price is anticipated. Likewise the opposite is true in an overbought condition. Sometimes markets can remain in overbought territory for long periods, so it pays to be careful.
In fact, traders use candlestick patterns and oscillators to predict future market direction. Not everyone accepts this is possible, and some claim the results of these strategies are no better than chance. Nevertheless, they are extremely popular with both professional and retail investors.
How can I use these indicators?
If you are a retail forex trader you probably have already heard of some of these patterns. You can use chart patterns and oscillators to enter and exit positions, time purchases, and gain an overall feel for market sentiment. Be careful to validate your analysis with multiple indicators.
It takes time and practice to gain a good understanding of these tools. By learning more about the many different patterns and oscillators available you can improve your chances of executing profitable trades, consistently.