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Walker England of DailyFX.com explains why candlestick patterns provide traders with the best means of predicting market turns.

One of the toughest tasks given to traders is spotting price reversals. There are a variety of tools at the disposal of technical forex traders for the job, but more often than not, it is a candlestick pattern that provides the first clues to a market turn. Candlestick patterns are a great way to begin your trading analysis as they are a direct interpretation of price action. With this in mind, today we will focus on spotting and trading one of the market’s most clear-cut reversal signals using the bullish morning star pattern.

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What is a bullish morning star pattern?
A bullish morning star pattern is a candle pattern established at the end of an extended downtrend. The pattern itself is pictured above, and it should be noted that the bullish morning star is comprised of three different candles. The first candle should depict a continuation of the established down trend. The second candle will show the slowing of bearish momentum. Price will make one final attempt at lower lows here, with the candle closing near its open price. Dojis and hammer candles are often found in this position.

The third candle in the bullish morning star pattern is the actual reversal signal. An extended blue candle should be seen in this position beginning a new swing in bullish momentum. Ideally this should be a bullish engulfing candle with its high extend well above the high of the previous candle. This strong surge in price depicts fresh buying pressure on the pair with bearish traders exiting the market. The greater the advance of this secondary candle declines, the stronger the reversal signal is considered.

(Created using FXCM’s Marketscope 2.0 charts)
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Uses in Trading
The great thing about the bullish morning star pattern is the fact that once you can identify it, you can immediately apply it to your trading. In the graph above we can see the pattern in action on a GBPNZD daily chart. From April 13 through May 24 of this year the GBPNZD rallied as much as 1883 pips. This rally was preceded with a bullish morning star giving us our first opportunity to consider trading a reversal and establishing buying opportunities.

Traders often select to trade a breakout strategy in reversing markets. In a breakout scenario, the high of the first candle of the pattern can be used as an area of resistance. Entry orders to buy can be set at this point as the pair begins to trade to higher highs. Also it is not uncommon to see traders use this analysis in conjunction with an oscillator. Market orders can be placed in the direction of the new trend when indicators such as RSI show momentum returning from oversold levels. Regardless of the method chosen, traders should consider placing a stop order under the second candle low. In the event that a reversal fails and a lower low is made traders will want to exit their buy positions.

Walker England is a trading instructor at DailyFX.com.