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.
This is a daily chart of the USD/JPY. The trendline identifies the trend as being down. To draw a trendline 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 is what points 3 and 4 represent since the trendline 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.
This closer look at points 3 and 4 show 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 trendline. 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 to be used. Many traders are now looking for the next test on this move up towards the trendline. Instead of just selling at the trendline, using a candle formation can offer confirmation of a reversal which can increase our chance of success on the trade.