How to Trade Dark Cloud Cover Patterns – Forex Trading Strategy

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How to Trade Dark Cloud Cover Patterns?

Trading Dark cloud cover pattern… what is it and what is its significance? Is it a type of cloud formation signifying an impending doom? Nah… not really. It is a type of candlestick pattern which signifies a reversal in price action.

So, what is it really? How do we look for it? And how do we make use of it?

Dark cloud pattern is basically a bearish reversal pattern starting with a bullish candle followed by a bearish candle. The bullish candle is formed by a market that is dominated by buyers or bulls. During the start of the session, the price opens on a relatively low price and as the trading session continues, it goes higher and higher until it closes significantly higher than the open. In a daily stock chart, usually the next candle, opens above the close of the first candle. This is due to the pent-up buying pressure during the pause of the trading session. In the forex market and with intraday

This is due to the pent-up buying pressure during the pause of the trading session. In the forex market and with intraday charts however, this seldom happens since there are no breaks in the trading session. However, the same buying pressure still exists, pushing price higher. But the difference between this buying pressure and that of the prior candlestick is that in the current candle, the smart money is already selling their positions to cash in on the previous rally. The dumb money on the other hand continues buying from the smart money. This decreases the momentum of the rally. As the trading session continues, the dumb money starts to realize that the momentum is starting to dissipate, so they usually close their positions to avoid greater losses. This causes the price to significantly decrease until

This causes the price to significantly decrease until price closes far below the opening price. This forms a bearish candle with a body that penetrates through the body of the previous candle. Technically speaking, the bearish candle should close below 50% of the body of the previous bullish candle. This is a picture of what a dark cloud cover looks like on a forex chart.

Now that we’ve discussed what dark cloud cover pattern is, the next question is, how do we trade it?

Trading with the Trend Using 100 EMA

Although the dark cloud cover pattern is a highly reliable candlestick pattern, it doesn’t hurt to add the necessary filters when trading this pattern. One of the most important filters is trading with the trend. So, how should we know if we are trading with the trend? There are many techniques out there to identify the trend. But what we have is a simplistic filter that would allow us to decide whether we are trading with the trend or not.

The 100 exponential moving average (EMA) could act as a determinant of the intermediate trend. By determining where price is in relation to the 100 EMA, we could decide whether it is an uptrend or a downtrend. If price is above the 100 EMA, the chart is in an uptrend. If the price is below the 100 EMA, then it is in a downtrend.

Another thing to take note of with the 100 EMA is the direction of the slope on the right end of the chart. If the 100 EMA is sloping up, then it is an uptrend, while if the 100 EMA is sloping downward, then it is in a downtrend.

However, there are instances where in an uptrend, the right end of the 100 EMA is curling down, or in a downtrend, the right end of the 100 EMA is curling up. In these situations, price could start reversing. This usually happens when the price action has already pierced the 100 EMA. And this is a setup that we should not take.

The Dark Cloud Entry

Now that we’ve discussed the dark cloud cover pattern and the 100 EMA, we will be talking about the entry and its filters. Since, the dark cloud cover is a bearish reversal pattern, we will only be discussing about a short (sell) setup.

Also, we will be using an indicator that conveniently identifies dark cloud cover patterns for us, using our definition of what a dark cloud cover pattern is. The indicator will label a dark cloud cover pattern as DCC on the chart.

The rules for a short setup using the dark cloud cover are as follows:

  1. The dark cloud cover pattern is below the 100 EMA
  2. The 100 EMA is sloping down

In this chart, there are three valid bearish setups using the dark cloud cover pattern. We will examine all three if the setups did earn some pips.

The Stop Loss

The stop-loss should be just a few pips above the entry candle.

The Take-Profit

The take-profit will be a fixed ratio of 2:1. This means that for every 1 pip risked on the stop-loss, the take profit target should be 2 pips. So, if we are risking 15 pips on the stop-loss then our target take-profit should be 30 pips.

This allows us to have a positive risk-reward ratio, which in turn gives us an edge even if the win rate is above 50%. But don’t get me wrong. Dark cloud cover pattern is very reliable and usually indicates a reversal.

On the first opportunity, the stop-loss was 15 pips away from the entry, so the take profit was set at 30 pips. Price barely graced the take-profit, which may seem contentious, however, in the long run, the take profit would still have been hit.

The second and third opportunity was a clear win though. We risked 17.5 pips and 19 pips on the two setups and we gained 35 pips and 38 pips for each.

Conclusion

The dark cloud cover setup is an effective setup if used with the right filters. Whether, you are a scalper, a day trader, or a swing trader, this setup does work. Use it with a good risk-reward ratio and you would have a trading strategy that has an edge against the market.

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2 COMMENTS

  1. Dear Mr Tim Morris,
    I wish to express my heartfelt thanks for your generosity in sharing the “Candlestick Recognition Master” indicator.
    Thank you showing a way to trade the candlestick patterns, it is like a road map, allowing me to adapt it to longer time frame.

    I appreciate your willingness to share. Thanks again

  2. Dear Mr Tim Morris,

    i wish to amend my name to Stuart rather than my full name as per the fist comment. Your consideration is much appreciated. Have a pleasant weekend.

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