In our past lessons, we’ve learned how to use Fibonacci retracement with Trendlines and Support and Resistance Levels. They are two simple but very powerful trading strategies.
Continuing this combination of technical analysis, this lesson will show you how to use various candlestick formations in combination with Fibonacci retracement levels.
This method can certainly increase the probability of your wins or serve as a very intellectual exercise!
Lesson Overview
- A trade signal is stronger when a reversal candlestick pattern collides with a Fibonacci retracement level
- Identifying exhaustive candlesticks with the Fibonacci retracement shows us indicators where price trends will go
- Using Fibonacci retracement analysis in combination with Japanese candlesticks make more effective forex strategies than just using one or the other
Fibonacci Retracement Tool and Japanese Candlesticks
To combine the Fibonacci retracement levels and Japanese candlesticks, the aim is to identify exhaustive candlesticks.
The Fibonacci retracement tool is often combined with the Japanese Candlestick when prices are experiencing a trend reversal.
Did you know? Munehisa Homma first used candlestick formations in the 18th century, and they were popular among Japanese rice traders. It was only in 1991, when Steve Nison published them in his book, that Western traders also started to notice.
Identifying Trend Reversal Japanese Candlestick Patterns
Trend reversal patterns represent the maximum buying or selling activity that results in trend reversals.
These patterns are called exhaustion because they form the end of a trend.
If the currency pair is experiencing a downtrend but has already exhausted the downward movement, it will reverse to an uptrend and vice versa.
But how does a currency “exhaust” a price movement?
This happens when buyers overpower sellers or vice versa. When traders run out of a currency to buy, they start selling; when they run out of a currency to sell, they start buying.
Japanese Candlesticks are a great way to identify if the movement is about to reverse.
One of the key indicators of a reversal trend is a Shooting Star Candlestick and a Hammer Candlestick. Remember them?
Here’s a quick refresher.
Shooting star candlestick
A shooting star represents a bearish reversal trend. They resemble the look of falling shooting stars. The market signals a bearish reversal when it forms this shooting star pattern.
The general rule is that the wick (or the thin line that extends out of the candlestick’s body) should be at least twice as long as the body. The longer the wick, the stronger the reversal signal is.
A long wick often represents the market's inability to continue its trend. This is the same for the hammer candlestick.
Hammer candlestick
Hammer indicates a potential bullish market reversal. This candle forms in a declining market when the market has found its bottom after a series of red candles. It looks like a hammer or a T, with a small lower body and a short, stout head.
Great! Now that we’ve recalled candlesticks that indicate reversal, let’s try to identify them in this price chart.
Take a look at this 4-hour price chart for the EURUSD.
We can see that it is experiencing a downtrend, with so many red candles! However, take a look at the price at 13:00 – a hammer candlestick!
Based on our previous discussion, we know that a hammer candlestick signals a bullish trend reversal.
Let’s look at what happens in the next 2 hours.
Our prediction was right! Because of the hammer candlestick after a downtrend, the price went up. That means that sellers were exhausted, and buyers are starting to drive up the price.
Using the Fibonacci Retracement Tool with Japanese Candlesticks
Now that we’ve recalled how to identify exhaustive candlesticks, we can learn about combining that strategy with Fibonacci retracement tools.
We can do this by identifying an exhaustive candlestick and aligning the Fib tool according to the Swing High and Swing Low points.
Let’s try the earlier example. Say you want to open a short position.
We’ve already established that the Hammer Candlestick at 13:00 can indicate an uptrend reversal. But when would be the best selling entry point?
This is when we can integrate the Fib tool.
Let's place the Fib levels according to the chart’s Swing High and Swing Low.
At this point, we’ll have to be patient and wait for where the trend will go. But if we look at the wicks of the candlesticks, we can see that the wicks are at the bottom, which indicates an uptrend.
By adding Fibonacci retracement levels, this gives us an idea about where the next support and resistance levels might be.
For example, we can see that the price is testing around the 0.236 levels as support. However, we also see that the the lower wick is longer than the upper wick, which signals that price will continue to go up.
Proceeding to the next hour, we can see that the price is continuing its uptrend. A majority of them also have longer lower wicks.
The price at 18:00 is almost at the 100% level of the Fibonacci levels.
Because the price is almost at the 100% level, and because of the continued presence of Hammer Candlesticks, you decide to place a SELL SIGNAL on the 100% Fib level.
Great! The price continued to go up to the 100% Fib Level and the upward trend was supported by the Hammer Candlesticks.
I’m sure you’d be pretty happy with that decision!
You can try this exercise with other currency pairs and see where it takes you. Mastering the combination of Fib retracement levels and Japanese candlesticks can reveal many significant cues for your predictions.
In the next lesson, we’ll learn about how to use the Fibonacci Retracement Levels to identify where to place stop levels.
