In previous articles, we took a look at simple and complex candlestick formations. Alert readers will have noticed that some of these formations are pretty similar, and some are an advancement of another formation. At first, this can seem confusing to traders.
To help you understand why these similar formations exist and how to interpret them, we will take a closer look at 3 of them:
- The Big Candle
- The Harami
- The 3 Method Formation
We will analyze the psychology behind them, and help you understand how to trade these similar formations.
From Big Candle to Harami and 3 Method Formation
First of all, let us remind ourselves what we are trying to do with technical analysis methods like candlesticks: We are not trying to come to some fundamental statement about the underlying asset. We are not saying: “The price of this stock should rise because the company is doing well”. And we do not claim: “This currency will rise because of what its central bank just did.”
Instead, we are sure that all this information has already affected the price, and is therefore included in it. In other words: If we can find out that the price is rising or falling, we do not need to know why to make a good investment. This logic applies to our candlestick formations, too.
Let us start with the Big Candle. Although all three formations we will analyze in this text work in both ways, we will focus on the formations starting with a bullish Big Candle. You can apply the same logic to their counterparts.
The Big Candle has a relatively large body compared to its neighboring candlesticks, signaling a large price movement. The closing and opening price are near the absolute high and low of the time period. This means, traders were buying this asset through the entire time period, and kept buying until the end. Therefore, it stands to reason that there is still some upwards momentum that will carry over into the next candlestick, and will ensure further rising prices.
This is a prediction you can invest in.
The entire prediction made by the bullish Big Candle can suddenly become worthless when a smaller black candlestick occurs that is contained within the Big Candle. Now this becomes a Bearish Harami formation and implies the exact opposite: Falling prices.
Obviously, there is some logic behind this. The Big Candle’s prediction, rising prices, did not come true. Therefore, the upwards momentum obviously has expired and bearish tendencies have taken over. Still, this entire switch in meaning makes some traders lose faith in Big Candles in general. As they assume, something that can lose its entire value so suddenly cannot be trusted.
Unfortunately, this is not where the confusion ends. If there is not only one single candlestick contained within the big candle, but two or more, and the entire formation is concluded by another big candle, the formation becomes a bullish three method formation indicating rising prices. This is already the second complete switch in prediction.
In this case, too, the logic is easy to understand. After the Big Candle had made prices rise significantly, all traders willing to buy had bought into the asset. Therefore, the price had to go through a brief period of consolidation. Now, it obviously created new demand, and prices are able to rise again.
Which formation should you trade?
As a trader, you have to understand that a signal becomes more valid the more candlesticks it contains. Just like you can judge a person’s character better the more you know about her, you can make better predictions about the price of an asset the more candlesticks are involved. Still, there are very good reasons why simple candlestick formations can be important for your trading. Remember, which signals you trust to create the basis for your trading should depend on your personality.
Trading Big Candles involves more risk than trading 3 Method Formations, and you have to be willing accept a higher percentage of lost trades. You will, however, find far more trading opportunities. If you trade well, you can therefore make a bigger profit in a shorter amount of time than with the 3 Method Formation.
In conclusion, always remember that complex candlestick formations are better suited for risk adverse traders, and simple candlestick formations are better for traders willing to take risks.