Using Candle Charts to Time Entries

03/15/2010 10:48 am EST

Focus: STRATEGIES

Candle formations can be a valuable addition to a trader’s approach to trading, but only if used correctly.

Like technical indicators, these formations were only designed to help a trader better time their entry. So by definition, the trader first has to identify the trade setup. This means that the candle formation is the last thing that a trader should look for in a trading opportunity. Candle formations on their own have little value and can be found just about anywhere on a chart. However, when used correctly, they can identify an entry into a trade and a good place for the placement of our protective stop. Let’s look at a couple of examples. 

chart
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This is a daily chart of the USD/JPY. The trend line identifies the trend as being down. To draw a trend line, we need two points to connect. So we just connected point 1 and point 2 and continued that drawing that trendline out so we can look for any future tests. Points 3 and 4 are the tests and represent selling opportunities. Since this is a downtrend, we only want to look for sells, and some of the best sells are rallies up to resistance, which are what points 3 and 4 represent since the trend line should offer resistance. It is important to note that we have not yet used a candle formation or a technical indicator, but we have identified two selling opportunities. Let’s move down to take a closer look at points 3 and 4.

chart
Click to Enlarge

This closer look at points 3 and 4 shows just how candle formations can be used to help time our entry and offer a good place for our initial protective stop. Point 3 is a dark cloud cover formation at resistance with a long wick up through the trend line. This is a strong indication of a reversal. A trader would sell at the open of the next candle after the formation has been completed and place their protective buy stop above the long wick. 

The next sell at point 4 shows an evening star formation at resistance. The entry would be at the open of the next candle after the formation has been completed with the protective buy stop placed above the high of the evening star. Candle formations can be quite valuable when used like this, as this is really what they were designed to do. They really have no predictive value at all on their own, but like any tool, can be quite valuable when used in the way they were intended.  Many traders are now looking for the next test on this move up towards the trend line. Instead of just selling at the trend line, using a candle formation can offer confirmation of a reversal, which can increase our chances of success on the trade.

By Thomas Long of DailyFX.com

DailyFX provides forex news on the economic reports and political events that influence the currency market.

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