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Understanding Japanese Candlesticks: The Dark-Cloud Cover and Piercing

Candlesticks analyses exist for generations in Japan, but only around 1990, were they introduced to the Western world.

The Japanese used candlesticks charts way before the bar, and point and figure charts appeared in the Western world. Nowadays, traders around the globe favor candlesticks charts because:

  • They are easy to use and understand, as most of the patterns use only a few candles (in some cases, a one-candle pattern is enough to reverse a significant trend).
  • They provide an early trading signal when the market reverses, way earlier than classic technical analysis patterns.
  • They offer a trading setup hard to match: explicit entry, stop loss and take profit that respect the strict money management setups needed to profit from Forex trading.

So far, we have covered three reversal patterns part of the Japanese candlesticks techniques:

All of them are reversal patterns, with one, two or three candles in their componence. Yet another two-candle pattern belongs to the same reversal patterns category: the dark-cloud cover and the piercing pattern.

Dark-Cloud Cover in Forex Trading

As with the patterns mentioned above, there is one bullish and one bearish version here too. The bullish pattern is the piercing, and the dark-cloud cover shows bearish conditions.

For any reversal pattern, a trend must exist first. With no trend, any similar two-candle group should be discounted.

The first thing to remember about the piercing and dark-cloud cover patterns is that they resemble a fake engulfing. Here’s a list of what makes the engulfing pattern:

  • Two opposite candles
  • The second candle engulfs the previous one

In the case of the piercing and the dark-cloud cover, the second candle fails to engulf the previous one. But, it needs to close at least 50% into its territory.

For this reason, many patterns fail to fit into this category, and traders ignore them as fake signals. The chart below shows a bullish trend present, a strong, green candle, but the second candle fails to close below the 50% distance of the previous one. Hence, showing a fake pattern. It is no wonder that the market eventually made a new high.

Here are the conditions for the dark-cloud cover:

  • Being a bearish reversal pattern, the market rises with a bullish trend
  • The first candle is a normal bullish candle, having a green real body and little or no upper shadow

· The second candle and the most important one is the one that reverses the bullish trend. It is bearish and closes beyond the 50% distance of the previous candle, without engulfing it. When this happens, the market formed a dark-cloud cover; a pattern often met in Forex trading.

Above, the EURGBP four-hour chart rises in a bullish trend. Nothing seems to warn traders of a potential reversal, mainly because the last move up looks so aggressive.

However, at one point, one red candle comes and spoils the bulls party. It closes beyond the 50% distance of the previous candle, forming a dark-cloud cover. It spells troubles for bulls and the bears jump in.

Savvy traders will know that the quicker the reversing signal, the better. For this reason, they love the Japanese patterns as they give an early entry with great risk-reward ratios.

How to Trade the Dark-Cloud Cover Pattern

Because it reverses a bullish trend, traders go short. Here’s a trading plan for the pattern:

  • Wait for the second candle to close and make sure the rules of the dark-cloud cover are in place
  • Measure the distance between the highest and the lowest point in the pattern
  • Use the Fibonacci retracement tool to find out the 50% and 61.8% retracement levels
  • Place a pending sell limit order in that area or enter short at the market on that retracement
  • Set a stop loss at the maximum point in the dark-cloud cover
  • Use a take profit that respects an appropriate risk-reward ratio in Forex trading (1:2 or 1:3)

Look what the previous EURGBP chart did after the dark-cloud cover formed. The bulls totally lost control of the situation, even though it took some time until the trend reversed.

The Piercing Pattern in Forex Trading

The piercing pattern is the opposite of the dark-cloud cover. Here are the conditions for it:

  • Being a bullish reversal pattern, the market falls with a bearish trend
  • The first candle is a normal bearish candle, having a red real body and little or no upper shadow
  • The second candle and the most important one is the one that reverses the bearish trend. It is bullish and closes beyond the 50% distance of the previous candle, without engulfing it.

When this happens, the market formed a piercing, a pattern often met in Forex trading.

The same EURGBP pair offers a piercing pattern at the end of a bearish trend. Nothing signals the potential reversal, until a green candle closes beyond 50% of the previous red candle, without engulfing it.

When it happens, it means bulls try to get in control and reverse the bearish trend. However, the battle between bears and bulls continues, with the invalidation level being at the bottom of the piercing pattern.

How to Trade the Piercing Pattern

After the piercing pattern appears, the natural trade is on the long side. Traders go long and use the following trading plan:

  • Wait for the second candle to close and make sure the rules of the piercing pattern are in place
  • Measure the distance between the highest and the lowest point in the pattern
  • Use the Fibonacci retracement tool to find out the 50% and 61.8% retracement levels
  • Place a pending buy limit order in that area or enter long at the market on that retracement
  • Set a stop loss at the minimum point in the piercing pattern
  • Use a take profit that respects an appropriate risk-reward ratio in Forex trading (1:2 or 1:3)

Here’s what followed the piercing pattern. The bears tried to overcome the lows as for the next twelve hours they pushed for the invalidation.

However, the stop loss area holds and eventually the market breaks higher. Conservative traders will set the take profit and just wait for the market to reach it.

The “set and forget” approach works best because no emotions interfere with the trading setup and no follow up is needed. But aggressive traders want to make the most of a trend, so they’ll use trailing stops to ride the recent trend.

Conclusion

With the dark-cloud cover and the piercing pattern, we’ve covered the most important reversal patterns within the Japanese candlesticks techniques. Some other ones exist, but, one way or another, they represent deviations from the ones presented so far.

A dark-cloud cover or piercing pattern often appears in Forex trading. When compared with the engulfing patterns, for example, they are more frequent.

Using the patterns covered in this section will give traders enough opportunities to take advantage of the market swings. Moreover, the resulting risk-reward ratios represent an excellent incentive to start trading with the Japanese candlesticks patterns, as few other patterns prove so efficient.