How to Trade Reversals with the Hanging Man Pattern

What is the Hanging Man？

A hanging man candle (aptly named) is a candlestick formation that reveals a sharp increase in selling pressure at the height of an existing uptrend. This is generally brought about by many market participants believing the market has reached its highest level resulting in the ‘bears’ outweighing the ‘bulls’. This can be observed in the GBPUSD chart below where it is clear to see the red candle appearing at the top of the upward trend as a result of mass selling pressure.

GBP/USD HANGING MAN CANDLESTICK

Characteristics of the Hanging Man candle

The hanging man candle is characterized by having a small real body, little or no upper shadow (wick) and a lower shadow at least twice the length of the body.

Upward trend: The hanging man can only be identified as such once it has formed at the top of an uptrend.

Opening level: The hanging man candle can either be a green candle (bullish), or a red candle (bearish) although, the bearish candle provides a better indication of a weakening market.

Upper shadow: A small upper shadow indicates that there was an attempt to maintain the current uptrend before the significant drop in the price of the Pound Sterling.

Long lower shadow: This is probably one of the most insightful observations on the candle, depicting a significant sell-off before the bulls tried to regain some ground forcing the closing price to end up somewhat closer to opening levels but still down for the period.

Closing level: In this case the closing level was below the opening level and therefore, confirms that this is a bearish hanging man candle.

Identifying hanging man candlestick trading signals

The hanging man candlestick can be used to identify a short trade (bearish view of the market) as the long shadow indicates massive selling. The true test of the legitimacy of the hanging man candlestick is often revealed in subsequent activity on the chart. If the following candle moves further down and breaks below the short-term upward trend line, this can be seen as a continuation of the downward long-term trend. Another possible entry-level could be to enter the trade once the market has moved past the low of the hanging man candle.

Trading the Hanging Man？

It is important to view the hanging man candle formation in relation to the long-term trend. The best way to do this is to make use of multiple time frame analyses. Start off by viewing the market using a longer time frame chart like the daily or weekly timeframe to observe the direction the market is tending to in the long term. Then, zoom in using a smaller time frame chart (4 hours or 2 hours) to analyze the ideal entry point for your trade.

Step 1: Identify the long-term trend

View the chart on a longer time frame (perhaps a daily chart) to get an idea of the direction the market is heading. You do not want to place a trade in the opposite direction of the long-term trend.

Step 2: Spotting your ideal entry point

having use of a shorter time frame chart (4-hour chart), identify the ideal entry point. The hanging man candle formation provides us with a signal for a short trade.

Step 3: Make use of supporting indicators

Does the RSI confirm that the market has turned and is now in a downward trend？ Has the 20 SMA line crossed over the 50 SMA line？ Does the hanging man candlestick appear near the top of the short-term uptrend？ Is a relevant Fibonacci retracement level nearby？

Step 4: Place your trade

Look for an entry point at the low of the hanging man candlestick. If your bearish view of the market is correct, you will see subsequent price action moving down – providing you with an indication to place your short trade.

Step 5: Risk management

Be sure to place your trade in accordance with your position sizing strategy. Consider how much of your total account value you are prepared to risk at any point in time and do not deviate from this. At DailyFX, we talk about risking less than 5% on all open trades. In addition, ensure that you place your stop at the high of the hanging man candle formation.

Step 6: When to close out of trade？

Whenever entering a trade it is always best to have at least a 1:2 Risk-to-Reward ratio. You are risking half of what you intend to gain. This means that the distance from your entry level to your take profit level should be twice the distance from your entry-level to your stop loss level. Applying this technique will mean that even if you only get half of your trades correct, you will still have a positive trading account. We talk about these trading insights in our Traits of Successful Traders research.

GBP/USD DAILY PRICE CHART (DOWNTREND)

Zooming a little further, having use of the shorter, 4-hour chart (below), you will be better equipped to spot the ideal opportunity to enter the trade.

GBP/USD (4 HOUR)HANGING MAN CANDLE

On the 4-hour chart, you will see that the previous level of support 1.40000, now acting as a level of resistance. The hanging man candle appears near the peak of the short-term uptrend, below the new level of resistance. At this point, we are on the lookout for a reversing market to the downside. Eventually, price breaks below the low of the hanging man delivering an entry signal to short. Stops can be placed at the level of resistance (1.40000) for risk management purposes should the market move against you.

Confirmation of the sell signal:

Long-term downward trending market

Hanging man candle appearing near the peak of the short-term uptrend

The hanging man appearing near a significant level of support/resistance

Subsequent candles moving lower (lower highs & lower lows)

What is a Doji Candlestick and How Does it Work？

The Doji candlestick, or Doji star, is characterised by its ‘cross’ shape. This happens when a forex pair opens and closes at the same level leaving a small or non-existent body, while exhibiting upper and lower wicks of equal length. Generally, the Doji represents indecision in the market but can also be an indication of slowing momentum of an existing trend.

Advantages of Using the Doji Candlestick in Technical Analysis

The Doji star can prove invaluable as it provides forex traders with a “pause and reflect” moment. If the market is trending upwards when the Doji pattern appears this could be viewed as an indication that buying momentum is slowing down or selling momentum is starting to pick up. Traders may view this as a sign to exit an existing long trade.

However, it is important to consider this candle formation in conjunction with a technical indicator or your particular exit strategy. Traders should only exit such trades if they are confident that the indicator or exit strategy confirms what the Doji is suggesting.

Remember, it is possible that the market was undecided for a brief period and then continued to advance in the direction of the trend. Therefore, it is crucial to conduct a thorough analysis before exiting a position.

Understanding Doji Candlestick Variations

Apart from the Doji candlestick highlighted earlier, there are another four variations of the Doji pattern. While the traditional Doji star represents indecisiveness, the other variations can tell a different story and therefore will impact the strategy and decisions traders make.

Furthermore, it is very unlikely to see the perfect Doji in the forex market. In reality, traders look for candles that resemble the below patterns as closely as possible and more often than not, the candles will have a tiny body. Below is a summary of the Doji candlestick variations. For an in-depth explanation read our guide to the different Types of Doji Candlesticks.

How to Trade the Doji Candlestick

There are many ways to trade the various Doji candlestick patterns. However, traders should always look for signals that complement what the Doji candlestick is suggesting in order to execute higher probability trades. Additionally, it is essential to implement sound risk management when trading the Doji to minimize losses if the trade does not work out.

Below we explore various Doji Candlestick strategies that can be applied to trading.

Trading with the Doji star pattern

The GBP/USD chart below shows the Doji star appearing at the bottom of an existing downtrend. The Doji pattern suggests that neither buyers or sellers are in control and that the trend could possibly reverse. At this point, it is crucial to note that traders should look for supporting signals that the trend may reverse before executing a trade. The chart below makes use of the stochastic indicator, which shows that the market is currently in overbought territory – adding to the bullish bias.

Using the Dragonfly Doji in Trend Trading

A popular Doji candlestick trading strategy involves looking for Dojis to appear near levels of support or resistance. The below chart highlights the Dragonfly Doji appearing near trendline support. In this scenario, the Doji doesnt appear at the top of the uptrend as alluded to previously but traders can still trade based on what the candlestick reveals about the market.

The Dragonfly Doji shows the rejection of lower prices and thereafter, the market moved upwards and closed near the opening price. This potential bullish bias is further supported by the fact that the candle appears near trendline support and prices had previously bounced off this significant trendline.

Double Doji Strategy

A single Doji is usually a good indication of indecision. However, two Dojis (one after the other), present an even greater indication that often results in a strong breakout. The Double Doji strategy looks to take advantage of the strong directional move that unfolds after the period of indecision.

Traders can wait until the market moves higher or lower, immediately after the Double Doji. In the GBP/ZAR chart below, the entry point can be below the low of the two Dojis with a stop placed above the highs of the two Dojis.

Targets can be placed at a recent level of support however, breakouts with increased momentum have the potential to run for an extended period of time hence, a trailing stop should be considered.