Candlestick patterns are in use in some way shape or form by the majority of retail traders trading the forex market. The two most well know patterns are the engulfing candle and the pin bar ( often referred to as a hammer candle in price action books) While these are the patters traders know best anyone who has read books on candlestick patterns will understand there are far more which don’t tend to get mentioned very often.
Today’s article is going to show you why the vast majority of candlestick patterns are pretty much useless and why the definitions given as to how some fairly popular candlestick patterns form are incorrect with the reason why they actually form in the market. Towards the end of the article I’ll explain why the only candlestick patterns you really need to have any knowledge on are pin bars and engulfing candles as these are the two pattern which allow us to clearly see what is taking place behind the scenes.
How Are Candlestick Patterns Created ?
All candlestick patterns are simply a visual representation of something happening which we cannot see.
If we had access to a true forex order-book ( not the 0ne provided by Oanda ) we would be able to see how the candlesticks on our charts are actually created in terms of which orders come into the market and when. With this information we would be able tell with 100% certainty if a pin bar has formed due to a bank placing trades or because of some other trading related decision such as profit taking.
Typical price action traders never think about why candlestick patterns form in the market, for them a candle pattern signifies that something is about to take place. For example, when a price action trader see’s a bearish pin bar form on his charts, he believes it means the price about to reverse, the trader doesn’t realize the price has already reversed and the formation of the pin bar is a result of the price actually reversing.
It’s All About The Names……
I’ve read many books and online articles about candlestick patterns during my time trading, one of the things you tend to see is the person who wrote the book or article giving explanations as to what candlestick patterns mean when they appear in the market.
There’s no problem with this apart from the fact that many of these people do not understand how the forex market works, which means the explanations they give as to why these patterns have formed and what they mean for the near term market direction are too simple and don’t take into account a lot of additional things which have an effect on the candlestick pattern itself being created.
For the most part, online websites and books simply state pin bars are created by traders placing buy or sell trades.
That’s fine, but which type of buying/selling is it ?
Is it from traders taking profits ?
Or from traders placing trades ?
Both of the actions above can cause a pin bar to form in the market but nobody ever seems to realize this because they get told “pin bars are created by buying or selling” therefore they assume all pin bars are basically the same and the only thing which defines one pin from another it the characteristics of the pin itself.
Take a look at the bearish pin bar above.
By going off the articles definition of how a bearish pin bar is created in the market we would know this pin has formed because of traders placing sell trades.
To a trader who has read and believed the articles definition of what causes a bearish pin bar to form, the pin above means he should place a sell trade, as bearish pin bars are supposedly created by traders selling. If he then went and placed a sell trade based on the pin its likely to have lost him money because the market only dropped a small distance and before long the price was trading back above the high of the pin.
If the trader had thought a little deeper into what causes a pin bar to form he would have seen the pin was likely to have been created by bank traders taking profits rather than traders placing sell trades. It’s unlikely for the trader to have thought this as he believed what the books/websites told him was everything there is to know about why pin bars form in the market.
I knew when the bearish pin above formed that it was far more likely to be caused by profit taking than it was from traders placing sell trades. The first clue I had was the big move up which took place after the consolidation. When the market makes a large move like this its always caused by bank traders, retail traders cannot cause such a large up-move in the market, therefore it has to have been created by bank traders placing buy trades.
Since the big move up was created by bank traders, the first thing they would want to do when they have made a large profit is take some profits off their trades, they can only take profits when there is a large amount of buy orders coming into the market.
The majority of these buy orders will come from the retail traders placing buy trades on the candle which ended up being a bearish pin bar, when the pin was forming it was bullish, which meant lots of retail traders were going long giving the bank traders the orders they need to take profits off their buy trades.
When they take profits the buy orders are consumed and the price falls, creating the wick on the bearish pin bar and thus telling us the pin has been created by profit taking.
Although I nor you would have been able to determine with 100% accuracy why the bearish pin formed, by understanding what has taken place beforehand we can establish the most likely reason behind its creation. If we just looked at the pin using the definition the article gave i.e ( bearish pin bars are created by selling ) then we would have just assumed this bearish pin was identical to any other bearish pin which has formed in the market before.
If we had understood there were differences between why pin bars form then we probably wouldn’t have taken the trade as we know the likelihood of large down-move taking place after the formation of the pin is low because it was created by banks taking profits rather than banks placing sell trades.
What you must know about the explanations these so-called candlestick pattern experts give, is they do this for all the other candle patterns which can form in the market. In one book I have on candlestick patterns there are at least 20 different patterns the author gives explanations for, none of these explanations detail why the pattern has formed, they just say what the market is supposed to do after a pattern has appeared.
Essentially the author is giving the traders who buy his books half-baked reasons as to why 20 different patterns form in the market. If you take his word for it and trade with the understanding he gives to these patterns then you are probably going to wind up losing money. There will be occasions where you make money, but overall you’ll never be able to generate a good return from trading candlestick patterns because you wont be able to distinguish between a pattern which has a high probability of working out and a pattern which has a low probability of working out, because you wont understand the cause behind why the candlestick pattern has formed in the first place.
Why You Only Need Pin Bars And Engulfing Candles
Like I said at the beginning of the article pin bars and engulfing candles are the only two candlestick patterns you really need to have knowledge on when trading the markets.
Both pin bars and engulfing candles clearly show a process which is happening behind the scenes and can be understood easily with a little bit of study. With the other candlestick patterns its much harder to determine the reason they have formed and why they should cause something to happen, such as a reversal or continuation.
The main reason why engulfing candles and pin bars are the only two candles you need is because they both achieve the same action when they form. When a pin bar forms the traders who brought or sold ( depending on the pin ) during the time the pin was forming have their trades turn from profit to loss, as the market moves in the direction of which the pin bar suggested, these traders close their losing trades and the price is pushed in the direction of the reversal.
Engulfing candles do the same thing. When an engulfing candle forms the traders who had placed trades on the previous candle watch as their trades go from being at a profit to being at a loss, as the engulfing candle engulfs more and more of the previous candle these traders start closing their losing positions which causes the engulfing candle to get bigger and the price to move further in the direction of the reversal.
With all of the other candlestick patterns I can’t work out why the pattern should cause a reversal.
Take the bearish harami for instance….
The bearish harami is a candlestick pattern which apparently has the potential to cause a price reversal upon its creation.
What I can’t understand is how the pattern has the capability to cause the price to reverse ?
The only way for a trend to change direction is if lots of traders start closing their trades at a loss, the engulfing candle and pin bar accomplish this by the market making a big move in the opposite direction. On pin bars the big move creates the wick we see on the pin, with engulfing candlesticks it’s the candle itself which is big. With the harami pattern there is no big move, the candle is small which means hardly any traders will feel the need to close their losing trades, if only a small amount of traders are closing losing trades then a reversal cannot take place as there will not be enough orders coming into the market to push the price in the opposite direction.
All candlestick reversal patterns are like this in terms of, ( they don’t actually do what their suggested to do in trading books ), apart from the pin bar and engulfing candle. None of the other patterns actually have a decent reason as to why they should cause a reversal in the market, trading books will state a pattern can cause a reversal but do not give any info as to why a reversal should take place.
If they cannot give a reason as to why a reversal should take place then why should we believe they have potential to cause a reversal ?
Candlestick patterns are not really something which I put much attention on, pin bar and engulfing candles I’ll frequently use because I can understand the reasons why they form in the market and what effect they’ll have upon the market price. I can’t put any faith into the other patterns because I know the definitions given to them are wrong which makes using them useless as I can’t distinguish why their supposed to do what they are claimed to do such as cause a reversal.
If I were you I would just focus on understanding pin bars and engulfing candles for the time being, the other patterns aren’t great and wont help much in making money from the market, if you stick to using things you understand I believe you’ll have more success than using things which are ambiguous such as other candlestick patterns.