Trading candlestick patterns on a trending market can be a very effective way to trade the forex market. It allows for high-probability trades and is very simple to implement.
Although using candlestick patterns can be a very effective way to identify trade entry points, many new traders may find it difficult to properly identify these patterns. It takes familiarity of what the patterns look like and where it should form. This is because candlestick reversal patterns should signify price reversals. If the pattern forms out of nowhere with no clear support or resistance level to reject, then it would still be a low-probability signal.
This strategy uses an indicator that helps traders objectively identify candlestick patterns that signify price rejection. It also uses the RSI and a moving average line to confirm the trend bias.
Relative Strength Index
Relative Strength Index (RSI) is a widely used technical indicator that can be used for a variety of trading strategies. It can be used to identify mean reversal setups coming from overbought and oversold markets, as well as trending markets where prices may continue moving in the same direction.
The RSI plots a line that oscillates within the range of zero to 100 based on prior price movements and momentum.
The range of the RSI has markers levels 30 and 70. An RSI line dropping below 30 indicates an oversold market, while an RSI line breaching above 70 indicates an overbought market. Both scenarios are prime conditions for a potential mean reversal, which is probably the main use of the RSI.
Some traders though would modify the markers on the RSI to make it suitable for indicating trending markets. These added levels are 45, 50, and 55. In an uptrend market, the RSI line would usually be above 50 while level 45 would usually act as a support level for the RSI. On the other hand, the RSI line would usually be below 50 in a downtrend with 55 acting as a resistance level for the RSI. Traders can also confirm the resumption of an uptrend based on the RSI line breaking back above 55 and the resumption of a downtrend based on the RSI dropping below 45. However, in a market with a very strong uptrend, the RSI line would usually be above 55, and in a market with a very strong downtrend, the RSI line would usually be below 45.
20 Simple Moving Average
The 20-period Simple Moving Average (SMA) line is a widely used moving average line for determining a short-term trend.
Price action would usually be above the 20 SMA line in a strong uptrend market while the 20 SMA line slopes up. Inversely, price action would also generally be below the 20 SMA line in a strong downtrend with the 20 SMA line sloping down.
The 20 SMA line could also act as a dynamic support level during a strong uptrend and as a dynamic resistance level during a strong downtrend where the price may bounce from.
Patterns on Chart Indicator
The Patterns on Chart Indicator is a custom technical indicator that automatically detects Japanese candlestick patterns that are available on the price chart. It does this by using a set of algorithms that compares the high, low, open, and close of each candle with the prior candles. It then has a set of rules which objectively defines a candlestick pattern based on the above-mentioned price points. For example, a bullish engulfing pattern should have a close price that is greater than the whole body of the previous candle. Different candlestick patterns have different sets of rules to detect the pattern.
The Patterns on Chart Indicator then plots labels on the price chart which would indicate if a pattern were available. The different labels are also displayed on the upper left corner of the price chart for the user’s reference.
Trading Strategy Concept
This trading strategy is a short-term trend continuation strategy that trades on the pullbacks touching the 20 SMA line.
The RSI is mainly used as a trending market confirmation. This is based on whether the RSI line is generally above or below 50. This should also be confirmed based on the characteristics of price action.
The trend could also be observed based on the 20 SMA line as price action would typically err to the side of the direction of the trend.
Trades are considered whenever the price pulls back towards the 20 SMA line and then shows signs of price rejection by forming a Japanese candlestick pattern on the line.
For this strategy, we will only use the Shooting Star, Hammer, and Engulfing Patterns.
Buy Trade Setup
Entry
- The RSI line should consistently stay above 55 indicating a very strong uptrend.
- Price action should be above the 20 SMA line while the 20 SMA line slopes up.
- Enter a buy order as the Patterns on the Chart indicator indicate a bullish reversal pattern as the price touches the 20 SMA line.
Stop Loss
- Set the stop loss below the bullish reversal pattern.
Exit
- Set the take profit target at 2x the risk on the stop loss.
Sell Trade Setup
Entry
- The RSI line should consistently stay below 45 indicating a very strong downtrend.
- Price action should be above the 20 SMA line while the 20 SMA line slopes down.
- Enter a sell order as the Patterns on the Chart indicator indicate a bearish reversal pattern as the price touches the 20 SMA line.
Stop Loss
- Set the stop loss above the bearish reversal pattern.
Exit
- Set the take profit target at 2x the risk on the stop loss.
Conclusion
Price rejections of the 20 SMA line is a very common scenario in a market with very strong trends. Price would often retrace near the 20 SMA line and then reverse as it touches the line. This often causes reversal patterns to form at the 20 SMA line. This strategy objectively identifies these scenarios and allows traders to trade based on a very strong trending market bounce.
This strategy can provide consistent results when used in the right market conditions. These are trending markets which are trending with very strong momentum. This does not occur too often, but these conditions typically provide high-probability trade setups when they develop.
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