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Recognizing the dark cloud cover pattern in forex allows traders to spot potential trading opportunities near the end of an uptrend. It allows traders to potentially exit long positions or even enter short positions in anticipation of a price decline.
Let’s discuss how to use dark cloud cover.
What is a dark cloud cover?
Dark cloud cover in forex is a two-candlestick pattern that signals a potential bearish reversal, indicating a shift in momentum from an uptrend to a downtrend.
It consists of two candles:
- First candle: A large bullish candle (often green or white), signifying strong long pressure and a price increase
- Second candle: A large bearish candle (often red or black) that opens above the close of the first candlestick, initially continuing the uptrend, and closes significantly below the midpoint of the first candlestick’s body, indicating a strong reversal in entry pressure
It suggests that the bulls might lose control after an initial price rise. The large bearish candle engulfing the bullish dark cloud cover candle signifies exit pressure taking over.
How to trade the dark cloud cover pattern
Here are the steps to trade when the dark cloud cover occurs:
- Identify the uptrend and dark cloud cover
Look for a clear uptrend on the chosen currency pair chart. This is characterized by a series of higher highs and higher lows. Within the uptrend, identify the dark cloud cover pattern itself. This consists of two candlesticks discussed above.
- Look for confirmation signals
Do not jump right into a trade just because the dark cloud cover has formed. Consider:
- Volume: Check if a significant increase in exit volume accompanies the second candlestick’s dark cloud cover bearish reversal move. This suggests stronger exit pressure
- Technical indicators: Analyze other technical indicators like moving averages or oscillators. Look for signals that support a potential trend reversal, like a shorter-term moving average crossing below a longer-term one or an RSI/Stochastic Oscillator moving into overbought territory
- Consider trend strength
While the dark cloud cover suggests a reversal, consider the overall uptrend’s strength. A dark cloud cover during a strong uptrend might be less reliable than one at the end of a weaker trend.
- Enter the trade
Only after confirmation from volume and potentially other indicators consider entering a short position in the forex pair. Traders can place an exit order slightly below a recent swing low or a break of support level.
- Manage risk
Place a stop-loss order above the high of the dark cloud cover pattern. This limits potential losses if the reversal fails. Traders can also place a trailing stop-loss order to lock in gains as the price moves in their favor.
- Plan an exit strategy
Have a predetermined take-profit level based on technical analysis or price targets. If the price breaks above the high of the dark cloud cover pattern with a strong long volume, exit the trade to minimize losses.
How does the dark cloud cover help in trading?
Identifying potential exit opportunities
By recognizing the dark cloud cover, traders can spot possible exit opportunities near the uptrend’s peak. This allows them to:
- Exit long positions: If traders were previously entering in anticipation of continued price increases, traders might exit the trade to lock in gains or avoid potential losses
- Enter short positions: This is a more aggressive strategy in which traders borrow the forex pair to sell it now, hoping to purchase it back later at a lower price, return it, and pocket the difference
Psychological shift
The dark cloud cover suggests a potential shift in market sentiment. The large bullish candle signifies strong entry pressure initially. However, the following large bearish candle closing is significantly lower, indicating exit pressure overcoming the entry pressure. This can help traders adjust their strategies accordingly.
Confirmation and risk management
While the dark cloud cover suggests a reversal, it is not a confirmed signal. Traders can use the pattern as an initial indicator and then look for confirmation from other factors like:
- Increased exit volume during the second candle’s decline
- Technical indicators like moving averages crossing over or oscillators entering overbought territory, supporting a potential downtrend
This confirmation helps traders make more informed decisions and manage risk effectively by allowing them to use stop-loss orders to limit potential losses if the reversal fails.
Potential support levels
Sometimes, the low of the second bearish candle in the dark cloud cover candlestick chart can act as a temporary support level. If the price tries to fall below this level but bounces back up, it can be a sign that the downtrend might be losing momentum. This can help traders refine their exit or entry strategies.
Example of dark cloud cover candlestick pattern
Imagine trading EUR/USD forex pair charts and a trader identifies a dark cloud cover pattern. The chart will show a clear uptrend for EUR/USD with several higher highs and higher lows over the past few days.
While the candlestick pattern suggests a potential reversal, traders decide to look for confirmation by checking the volume during the second red candle’s decline. They see a significant increase in exit volume, which reinforces the bearish candle engulfing action.
Then, based on the dark cloud cover pattern and the confirmation signals, traders decide to:
- Exit any long positions traders might have to lock in gains or avoid potential losses as the uptrend might be ending
- Consider entering a short position, waiting for a break below a recent swing low or a confirmed support level break for a better entry price
**This is an example only to enhance a consumer’s understanding of the above note and is not to be taken as Blueberry Markets providing personal advice.
What trading signals can we identify with the dark cloud cover?
Bearish reversals
This is the primary signal of the dark cloud cover pattern. It suggests a potential shift from an uptrend to a downtrend. The large bullish candle followed by the large bearish engulfing it signifies a potential weakening of entry pressure and a rise in exit pressure.
Volume
A significant increase in exit volume during the second bearish candle’s decline reinforces the dark cloud cover candlestick pattern’s bearish engulfing action. It suggests stronger exit pressure supporting the potential downtrend.
Overbought conditions
Similar to divergences, some traders might analyze if the price action leading up to the dark cloud cover formed near overbought territories on technical indicators like RSI or Stochastic Oscillator. This overbought condition and the dark cloud cover candlestick pattern can strengthen the case for a potential reversal.
Combining the dark cloud cover with other technical indicators
While spotting a dark cloud cover pattern in forex can be tempting for shorting during an uptrend’s end, traders should remember it is a probabilistic tool, not a confirmed signal. False signals are a risk. However, a dark cloud cover candlestick pattern can offer clues of a potential reversal. When including it in a trading strategy, use it with confirmation and proper risk management for informed trading decisions.
Disclaimer: All material published on our website is intended for informational purposes only and should not be considered personal advice or recommendation. As margin FX/CFDs are highly leveraged products, your gains and losses are magnified, and you could lose substantially more than your initial deposit. Investing in margin FX/CFDs does not give you any entitlements or rights to the underlying assets (e.g. the right to receive dividend payments). CFDs carry a high risk of investment loss.
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