Candlestick Charts: Indicators of Market Extremes

02/16/2016 9:00 am EST

Focus: FOREX

Citing a real-time currency pair trade example for support, Richard Cox at DailyForex.com illustrates how candlestick structures can serve to mark a critical point of indecision in the forex markets.

As technical analysis becomes more and more popular in forex markets, it has become undeniable that Japanese candlestick charts dominate the landscape in terms of utility.  This is because candlestick charts give us much more information in a single glance when compared to common alternatives like the line chart, the bar chart, or the point-and-figure chart.

Candlestick charts give us the ability to differentiate between prior trend outcomes in clearer ways as different color bars are associated with different types of price movements.  For example, if your bearish candlestick bars are shown in red then it will be easier to identify whether or not there is sufficient momentum in the market to initiate short positions if you see large groupings of red candles. The opposite would be true for your candle analysis if the bullish color scheme was showing something similar. This can be highly valuable information, especially if you are trading on small or medium time frames.

Bullish/Bearish Spike Candles:  Indicators of Market Extremes

In addition to this, candlestick charts can be excellent in terms of the ways they can help technical analysis traders to identify market extremes.  These extremes will often show themselves as price spikes that can occur in either direction and ultimately suggest that a reversal scenario is unfolding.  Consider the visual examples below:

chart
Source:  FiboGroup
Click to Enlarge

With these examples, we can see that spiking candles can come in a few different reforms, so perhaps it is more useful to think of these price occurrences as belonging to a family of candle shapes rather than any single cookie-cutter format.  Some of the names that are commonly used when these structures occur would include names like morning/evening stars, dojis, hammers, dragonflies, and pin bars (among others).  The main point here is not in the name classification but in the fact that all of these candlestick structures mark a critical point of indecision in the marketOn a real-time chart, examples of these types of events (both bullish and bearish) can be seen in the graphic below:

chart
Click to Enlarge

This information can be highly valuable when assessing the true strength of the underlying trends that are visible in the forex markets.  If an underlying trend is not able to sustain the market extremes that create these spikes, it starts to make much more sense to play things from the other direction. Price spike examples are shown in the red circles above and these situations represent instances where traders would start to enter positions that oppose the directional momentum that had been seen during the preceding move.

Real-Time Trade Example:  GBP/USD

As a hypothetical example, let’s assume that we are dealing with an uptrend in the GBP/USD.  Higher highs and higher lows make up most of what is visible on the price chart and we are considering taking a long position in the GBP/USD.  We see the uptrend culminate in a 50-pip surge to hit resistance just below 1.59.  But as this happens, the GBP/USD posts a bearish pin bar, which shows the price spike reversal in question:

chart
Click to Enlarge

An occurrence like this would be an early indication that traders should start to consider short positions in the GBP/USD, as long as prices hold below the 1.59 resistance. Any violations here would mean that the spike high is not valid and that there is no real bearish reversal in place and this would mean that the trade should be closed.

NEXT PAGE: Price Spikes and Tweezer Tops and Bottoms

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For price targets, an excellent early level to watch is the price level that marks the original surge in prices. This would suggest that the price level is a significant area of support and there is potential for more bounces later. In our example above, this area comes in at 1.5849 and traders would start to take partial profits once we see a downside move into this price region. This does not mean that the trade should be closed out completely if this occurs but it would generally be a good idea to take part of your gains and to bring your stop loss to breakeven for the remainder of the position.

Logical Basis for Trades:  The Paradigm Shifts

All technical analysis positioning is based on some sort of logic that is used to suggest one directional outcome is more likely than another.  In this case, the appearance of price spikes suggests that a significant price move has reached its exhaustion point and there is not enough agreement in the market to create the number of active buy or sell positions that would be required to propel the trend further. This means that the paradigm has shifted and that it is time to start betting in the other direction.

Confirmation of these events occurs once we can identify the break of a major support or resistance level. This can be seen in the chart example shown above. Bearish scenarios are confirmed by major support breaks, while bullish scenarios are confirmed by major resistance breaks. In both cases, the central point to remember is that the environment that was previously in place is now changing.  So if you already have open positions in the direction of that trend, it is probably a good idea to close-out and take profits.  If you are not already in a position that is aligned with the direction of that trend, it is probably a good idea to start planning out a contrarian trade.

Tweezer Tops and Bottoms

Last, we should take a look at the Tweezer formation, which is another incarnation of the spike highs discussed previously. The Tweezer formation is basically a double spike high or low that occurs at the end of a bullish or bearish trend.  Trading probabilities for eventual reversal confirmation are slightly higher in these cases because the market has essentially made two attempts to continue with the prior trend…only to fail later.  In the chart graphic below, we can see examples of the bullish and bearish Tweezer structure.

chart
Click to Enlarge

The underlying logic when trading a Tweezer Top or a Tweezer Bottom is the same as what would be seen with a standard price spike, so we will not go into further examples here. Instead, it should be kept in mind that the double-spike Tweezer candle structure has a slightly higher success rate in predicting the validity of true reversals in the underlying trend.

Conclusion:  Price Spikes Should Be Faded, Not Chased

With all of this in mind, it should be understood that price spikes should be viewed with caution rather than enthusiasm. These are structures that indicate trends are ending and this can be confusing in some cases because spikes are characterized by significant surges in momentum. This creates problems for some traders that might be unsure whether or not this is a continuation factor that should be chased rather than faded.  But when we look at the ways these structures typically play themselves out, the opposing rationale makes much more sense.  

Price spikes and Tweezer formations are relatively easy to spot and they can be a powerful addition to any trading strategy. In most cases, experienced traders will not use these instances as a complete basis for a trade. Instead, they can be used to confirm a bias that has already been generated by other technical indicators or price structures.  Price spikes can give us critical information about the underlying sentiment levels that are currently seen in the market for a given asset and this can help you to improve trading probabilities when you are looking to enter into contrarian positioning.

By Richard Cox, Contributor, DailyForex.com

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