If you’re been following so far, this next question should be easy for you to answer.
What does this situation tell you about where the market price is more likely to be headed? Up or down?
Take a moment to think about your answer based on the concepts we’ve covered.
Ready for the answer?
Did you guess that prices are more likely to move up?
Let’s examine why:
Candles 1 and 2 indicate that the market is on a downtrend. But although candle 1 shows strong downward momentum, we can see a slowing down of this momentum in candle 2 (candle 2 has a smaller real body).
Next, we see candle 3 showing strong upward momentum, as it (more than) covers the body of candle 2. This is an indication of weakness of the sellers in the market, as the buyers completely overwhelm them.
You may realise that Candles 2 and 3 form a candlestick pattern called the ‘engulfing’ pattern… but now that you understand the basics of price action, you won’t have to memorise any patterns at all.
All you have to do is apply the concept of momentum, and you’ll be able read candle patterns right away. Everything you need to know is already in your head!
Occasionally, prices will reverse without any prior indication. In those situations, how do we know whether a counter-trend move is going to be a temporary pullback, or a full-blown reversal?
Here’s the trick…
You’ll first have to identify what I call an ‘Anchor’ candlestick. An Anchor candle is basically a candlestick with a significantly longer body than the surrounding candlesticks.
There’s no scientific rule to determine an Anchor candlestick. Simply use your judgement — they’re pretty easy to find. If you’re having trouble looking for one, it probably isn’t there.
Now here’s the rule about Anchor candles:
When a candlestick closes past the opening price of the Anchor candle,a reversal is likely to happen.
If not, it’s market price is likely to just be making a temporary pullback.
Here’s what I mean…
Here, we see prices moving up and forming an Anchor candlestick. Two candles later, the market closed past the opening price of the Anchor, and the prices subsequently reversed.
Here’s another example
The market moved up with a strong anchor, and then dropped back down. This looks like a reversal… but is it really?
What do you think?
Let’s see what happened next…
Ah… it turned out to be a strong pullback!
Could we have known it was probably a pullback beforehand?
The answer is yes! If you look closely, the market price did not close past the opening price of the Anchor candlestick.
This one is pretty straight forward. Prices dropped significantly, forming an obvious Anchor candle.
Then two candlestick later, the market closed past the opening price of the
Anchor, confirming the reversal. Subsequently, prices continued in the direction of the reversal.
Take a moment now to open up your trading charts and see if you can identify any Anchor candles. Notice how the market price “threatens” to reverse, but only truly does so after there is a close past the opening price of the Anchor.
Do this exercise a few times and you’ll see how this is a reliable way to tell a reversal apart from a mere pullback.