Candlestick shadows are an interesting phenomenon in formations of price movements for a financial instrument, and they are, almost, an essential part of every price movement, or “candlestick”. Candlestick shadows can be formed at the bottom, top or both sides of the candlestick, and they represent the high and low prices of this candlestick in that specific time period. We can use candlestick shadows to determine take profit and cut loss points but what we need to remember after reading this article is that shadows mentioned here are the ones formed when the candlestick is closed, which is the final and permanent form of this candlestick. Candlestick shadows’ analysis is a main method used in both Managed Forex Accounts, Forex Trading Signals, and it is among subjects discussed in the Training Course.
When a long shadow is formed, it proves that market participants reject the pressure of the price movement at that level and in that time period, so, consequently, prices are not accepted. Whereas, if prices are accepted, the candlestick will remain stable at that price for a specific time period, and it will close at that price or close to it to form a candlestick with short or no shadows. Since the relationship between “when” and “where” is generally essential in trading, it has a very strong connection with the principle of the candlestick shadows, which is rejecting the price movement in that time period at that level.
If we are looking at a five-minute price chart, then the shadow related to this specific five-minute candle will be practically with no use since most of it is just noise. But, if we are analyzing daily price charts or four-hour price charts, we will find that they usually have a significant impact, thus, the power of rejection to that price movement during that time period should be very strong and important in order to form a long shadow on the four-hour price chart. Since the daily trader rarely notices this movement as it needs a long period of time to be complete, which usually leads him to trade against the price movement, which supports the theory of conflict of interests between individual traders and trading firms. We propose considering the four-hour price chart when working with this theory or when prices move rapidly on the one-hour price chart.
For example, in the following price chart, notice how the price reverses its direction at the level where long shadows are formed. Actually, this is the way the market uses to tell us that prices are not accepted at these levels, because the price level is not relatively proportional to its time period which meant lack of market participants at that price level and, consequently, a shadow is formed proving the pressure of the counterpart side which took place during the subsequent time period.
If a long shadow is formed on the daily price chart, traders who are present in the following trading sessions should take note of it and mostly trade confidently against the shadow’s direction especially when confirmation is available using trading patterns or fundamental and technical analysis, and the reason is that the market already rejected this price throughout the day, so most likely the price will change its direction.
Since candlestick shadows are the high and low of the candlestick, and they also represent rejection zones, then trading on a daily basis is usually outside the shadow area and within the candlestick’s body. Thus, the possibility of the prices to go further away than the price level at the end of the shadow is quite low, and so finding the appropriate stop loss point. Note the following price chart:
Notice in the chart above how the price re-tests the price level at the end of the shadow, and also notice how these levels serve as support and resistance levels. Thus, when trading in the opposite direction of the shadow, the attempt to re-breach the support or resistance level formed at price level at the end of the shadow should be taken into consideration. This helps in executing the trade at a better price.
If we can find the stop loss point, it is also possible to use the shadow to determine the take profit point using the principle of the risk and reward. It is possible also to apply this theory to deduce the price movement when trading within ranges or break outs. In both cases, shadows serve risk management principles if applied correctly on long time frames; four hours or daily.