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Trading Compound Candlestick Formations | Trading Forex

One of the easier ways to make progress with Forex trading is to “zoom out” from a chart, instead of “zooming in”. By zooming out you can see more and more information, which usually gives an increasingly reliable picture as to whether the price is more likely to up, down, or sideways in the near future. Determining this trend is what successful trading is all about.

By “zooming out” you can see that the previous ten candlesticks, for example, when taken together or “compounded”, provide much more reliable information that just the previous one, two or three candlesticks, which far too many traders are focusing on in an overly narrow way.

Let’s look at a few common and helpful compound candlestick patterns that can be found in charts all the time.

Compound Candlestick Patterns

First of all, you don’t have to worry about the shape of individual candlesticks when you are looking for these patterns. In fact, you can zoom out of a chart all the way until you can’t even see the individual candlesticks’ real bodies when you are searching for these patterns. Once you have located a pattern, you can then zoom in and watch the individual candlesticks forming on the right to determine a pin point entry.

So, what are we looking for?

Essentially, what we are looking for are double or triple tops or bottoms, and all variations on that, which will be explained later. These are formations where the price tries (and fails) to breach similar prices on at least two consecutive occasions. These are quite easy ways to identify what are often major turning points in prices.

When you identify a major turning point in the price in real time, it enables you to open a new trade in the direction of the turn, with a stop loss underneath the area of the price turn. If you can catch turns like these, you can enter new trades and exit with good reward to risk ratios.

There are a few variations so I will explain with some illustrated examples, using hourly charts. This time frame is nice to use because it is detailed enough to see the finer points of price movements, but large enough to filter out a lot of noise. Additionally, unlike H4 and Daily charts, everyone’s hourly charts look the same no matter what time zone their chart is based upon.

Double Top or Bottom

The basic formation you should look for is a double top or bottom. This is defined as the price reaching an obvious new high or low price and then retreating, only to come back later and retreat again at more or less the same price level. What we are looking for is not something immediate, i.e. the top or bottom price being made twice within a few minutes or hours, but rather something that happens over at least a day or so, usually longer, and that involves many hourly candlesticks taken together.

An example of a double bottom is shown in the chart below of the USD/CHF pair. Note how an extreme low price marked at 0.9635 was made (marked at 1), the price then rose quickly and significantly, before eventually falling back to touch the level at 0.9635 two days later (marked at 2). It took 4 or more hours for the price to “turn around”, but look at how significant the rise from there was! If you had “zoomed out” to watch the action at this level over several candles without being in a hurry to enter as soon as the price was touched, you could have entered long when the bullish turn really started to get going to make a very profitable long trade in terms of reward to risk. Here, a long entry at about 0.9755 would have been logical, with the stop placed under the low below 0.9635.

Separation in time between the tops or bottom is key. You ideally want to look for something like 24 to 72 hours.

Note how in the above chart, while the first bottom is made by 1 candle, the second bottom is really made by about 10 consecutive candles. This is what I mean by “compound candlestick formations”.

Here is an example of a double top that was made in Gold at an extreme high price of $1375 per ounce. There was a time period of about 60 hours between the peaks. A short entry close to 2 would have been logical at about $1368, with the stop above the high at about $1376.

Triple Top or Bottom

“True” triple tops or bottoms can be defined as where the three consecutive tops or bottoms are rejecting more or less the same price level. They are quite rare. It is important that the two gaps between the tops or bottoms are fairly equal in terms of the time interval. Again, the best examples seem to take something like 48 to 72 hours to form, or maybe a little longer. An example is shown below from the AUD/USD currency pair. Note how at the high price made by the first top, there is nothing but candlestick wicks at the second and third highs, which is usually a positive sign:

A short entry would have been logical somewhere between 0.7800 and 0.7760, with tht stop loss placed above the high at about 0.7840.

2b Breakout

A “2b Breakout” is really just a double top or bottom, but one where the second top or bottom quickly exceeds the high or low of the first top or bottom before reversing very quickly and strongly. It is a failed breakout, and the faster and more dramatic its failure, the better.

Now of course technically, every double top or bottom is a 2b breakout if the second top or bottom exceeds the first one by any measure at all. However, we can usually distinguish “true” 2b breakouts by the fact that there is a candlestick wick making the breakout, followed immediately by a strong candle in the opposite direction. The example of a triple top shown above is a fairly good example of a 2b failed breakout on the third top: note the strongly bearish candlestick immediately following the break.

This pattern is the most common of all the patterns covered in this article. For that reason, be careful in picking which ones you will trade. They ideally will fall at price extremes which are rarely touched.

Quasimodo (Over & Under)

This pattern is a triple top or bottom, but one where the middle top or bottom is lower than the other two bottoms (if it is a bottom) or higher (if it is a top). This can be a very powerful pattern and is often nested within other similar, longer term compounded candlestick formations.

An example is shown in the Gold chart below:

Referencing the numbers marked in the chart above, at 1, we can see the price made a bottom, which had greater validity as it made another low after the spike before rising again. At 2, the price made a low just barely below that slower low within the structure at 1: a double bottom. However, within the second, longer-term bottoming, we can see almost equal but higher lows (compared to the low at 2) which are shown at 3 and 4. If the price were now to rise suddenly, it would be based off both a double bottom and a Quasimodo, as well as a very short-term double bottom at 4.

Here, a long entry would have made sense when the price broke up quickly to ast least $1335, with the stop loss placed just below either the lowest low at $1331 or alternatively the most recent low at about $1331.40.

Often, the best and most effective compounded candlestick formations include several elements all within the same structure, giving them greater power to push the price in the same direction.

Square Root

A square root is a low followed by two higher but equal lows: equal to each other. In the other direction, it would be a high followed by two lower but equal highs. It is called a “square root” as its shape mimics the mathematical symbol for square root.

An example of a bearish square root formation is shown in the below chart of the GBP/USD currency pair:

At the high marked as (1) in the chart above, we have a high, then at (2) and (3) we have nearly equal lower highs that presage a strong downwards move.

Note that it is also more or less a Quasimodo / over and under pattern too.

Here, a logical short entry would have been at around 1.3275, with the stop loss placed just above the double top at 1.3345.

Conclusion

Following longer-term compounded candlestick patterns on higher timeframes such as the hourly chart, using a zoomed-out chart, can lead to much greater accuracy and an ability to cherry-pick a higher percentage of truly profitable trades. It can be difficult to find many trades that line up precisely at predetermined support or resistance levels, which is why using compounded candlestick formations to determine where support and resistance has been found can be a more fruitful trading methodology.

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