When does a candlestick signal fail?

Increasing numbers of forex traders are discovering the clarity of candlestick signals, particularly for currency pair reversals. However, as important as recognising their profit potential is recognising when a candlestick signal fails.

This allows forex traders to place an appropriate stop to exit their open positions as soon as the failure is registered, limiting their losses—or, for the more cautious traders, to avoid opening the position at all.

A candlestick signal is considered to have failed when:
•    the expected reversal does not materialise, and
•    the price instead moves beyond the point where the signal was initially generated.

For example, note the chart below. This is a detailed view of the hourly chart of the Euro versus the U.S. dollar, currency pair EUR/USD, for 7 June 2010:

In the centre of the chart, the price action rises for two long ascending candles, then forms a rather heavy shooting star, which is a short-bodied candle, either ascending or descending, with little or no lower wick but a long upper one. The shooting star forms when the price is attempting to rise higher, the bulls pushing for gains, but bears and selling pressure enter the market and force the price back down.

In this instance, the shooting star leads to a jittery short-term downtrend that reverses with another long ascending candlestick, which in turn is reversed by another, better formed shooting star.

These are good examples of the shooting star signal functioning as expected, and traders would have been rewarded with profits for following their lead.

However, look earlier on the chart, where a three-candle uptrend includes the very same shooting star pattern in its midst, as the expected reversal did not materialise but instead was overwhelmed by a second long ascending candle. This is an equally good example of the shooting star signal not functioning as expected, and it would have caused traders a loss rather than profits.

A reversal signal by definition is reversing a trend, and the shooting star by definition reverses an uptrend. Traders seeing this signal would have entered a short trade in anticipation of a downtrend.

The point at which the signal could be said to have failed, then, is when the price action rose higher than the shooting star’s high, at the top of its upper wick. When that level was breached, the uptrend was clearly continuing and the downtrend was off. That would be the appropriate price point to place the trade’s stop loss or, for more cautious traders who waited for the downtrend to prove itself prior to entering the trade, the place to abandon all hope of the reversal eventuating.

Candlesticks provide clear signals for forex traders, but not all of their signals play out as anticipated. Recognising when such a signal has failed helps the forex trader cut losses on the road to maximising profits.