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Morning and evening stars represent powerful reversal patterns. Japanese candlestick techniques are mainly about reversal patterns, with only a few patterns dealing with continuation ones.
Like the name suggests, a reversal pattern deals with trying to pick a bottom in a falling trend or a top in a rising one. While this goes against the conventional wisdom (that one should wait for a trend reversal confirmation), many traders prefer to take a calculated risk rather than wait for the reversal’s confirmation.
The reason for that comes from the fact that a confirmation may be too late. Trading in general, and Forex trading is all about managing risk. Or, to be more exact, managing expectations.
In their running for the best risk/reward ratio, traders take a calculated risk. If they wait for a reversal’s confirmation, the risk/reward ratio wouldn’t be so good anymore.
The classical reversal patterns as known in the Western world do not help. Think of the head and shoulders pattern, for example.
To enter a trade with this pattern, one needs to wait for the neckline’s break. By the time this happens, traders go for the measured move (the distance between the highest point in the head formation until the neckline, projected from the neckline).
When the measured move comes, the general approach is to move the stop loss at break-even and then let the market go for a nice risk-reward ratio.
A typical risk-reward ratio for the Forex market is 1:2 or 1:2.5. This means that for every pip risked, the expected reward is two or two and a half pips.
This way, for every, take profit hit or trade won, there’s room for two or two and a half losing trades. Not bad for an industry known for being full of fake moves.
But if traders wait for confirmation, like in the case of the head and shoulders pattern, such risk-reward ratios are difficult to achieve. Think of other reversal patterns, like rising or falling wedges. The same problem exists, in the sense that one needs to wait for the 2-4 trend line’s break before entering a trade.
Among the Japanese candlestick techniques, morning and evening stars represent powerful reversal patterns. To trade them, one needs a candlestick chart.
A candlestick chart has candles for every interval, like the five-minute chart, hourly, daily, and so on. Each candle represents one period.
Having that in mind, the morning or evening star pattern is a group of three candles. No more, no less.
If the pattern appears on the monthly chart, it considers three months. If it is on the daily, three days, and so on.
Their name tells much about the market interpretation: morning stars shows bullish conditions and evening stars bearish ones. Traders look to sell when an evening star pattern forms and to buy when a morning star pattern appears.
One big mistake traders make is to look at this group of candles as part of the wrong trend. Remember, a morning or evening star has only three candles.
However, if these candles do not appear at the end of a bullish trend (in the case of an evening star) or a bearish one (in the case of a morning star), they should be ignored.
The morning star pattern appears after a bearish trend. , bears control the market and will look to sell any meaningful bounce.
The first candle is always a strong, red one. As a reminder, a candle has a body (the distance the price travels from the candle’s opening price until the closing one) and a shadow (the spike higher or dip lower outside the opening and closing price).
Typically, candlesticks have a red color for a bearish candle and a green one for a bullish candle. However, colors can be easily edited.
Coming back to the morning star pattern, the first candle is a strong, bearish one. Nothing surprising for the moment as the trend, remember, is a bearish one.
However, the second candle must be one that shows hesitation. Ideally, it would be either a doji candle (a candle with a very small body, almost equal opening and closing levels) or a hammer (a bullish candle that has a small body but a very long shadow).
If one of these candles appear as the second candle in the morning star formation, bulls will have an interest. All they need to do know is to wait for the third candle.
The third candle in the pattern must be bullish. Most of the times it is as aggressive, if not more aggressive, than the first bearish one.
This shows that bulls step in and the bulls/bears fight can start. At this moment, the pattern is completed.
Identifying these patterns is easy. Even more complicated is to trade them.
One should remember before going in a trade that risk must be managed at all costs. In a morning star, for example, keep in mind that the pattern forms at the end of a bearish trend.
Bears will not concede that easily. In a way, it is like you’re trying to catch a falling knife.
Almost always, after the third candle in the morning star formation, bears will try to take the lows. Or, in the case of an evening star, bulls will have a run for the highs.
Therefore, the way to trade these patterns is to measure the length of the morning/evening star with a Fibonacci Retracement tool and find out the 50% and 61.8% retracement. Wait for a retracement in this area before going long/short, with a stop loss at the lows/highs and a 1:2 or 1:2.5 risk/reward ratio.
The bigger the time frame, the more chances the pattern will survive as the “noise” given by the economic releases will not influence the market. With a 1:2.5 ratio, traders can fail for two and a half times for every trade that is a winner.