Trading strategy using the Morning Star Pattern

The Morning Star pattern is popular among traders because it can relatively reliably indicate a change in sentiment from bearish to bullish. The Morning Star symbolizes that the night (price decline) is ending and the day (price rise) is coming.

What does the Morning Star look like?

The Morning Star is a formation of three candles that can be identified by the following rules:

1. The first candle is usually a long bearish (red) candle, indicating strong selling pressure.
2. The second candle is a small-bodied candle, or a doji candle, which often closes near the low of the first candle. This small candle signals weakening selling power and uncertainty in the market.
3. The third candle is a long bullish (green) candle that usually closes above the midpoint of the body of the first (red) candle. Here we see that the buyers have taken control and the price is starting to rise.

Together, this creates a reversal pattern, which is often found at the end of a downtrend, where the market threatens to not take another big fall and starts to rise.

How to trade the strategy?

1. Identifying a downtrend
   • Moving averages (e.g. SMA50 and SMA100) can be used to identify the trend or just by looking at the chart at series of lower lows and lower highs.
   • We usually look for the Morning Star at the end of such a downtrend.
2. Finding a Morning Star pattern at a strong support level
   • A pattern can form at an important price level:
     • - the previous swing low,
     • - an important psychological level (e.g. a round number),
     • - Fibonacci retracement or long-term trend support.
   • The formation of a Morning Star Pattern on such support is a strong signal of a potential reversal.
3. Trade entry
   • Entry ("buy") usually takes place after the close of the third candle.
   • A more conservative approach: wait until the price gets above the high of the third (bullish) candle.
   • A more aggressive approach: open the trade immediately after the close of the third candle.
4. Stop Loss (SL)
   • A stop loss can be placed below the low of the second or third candle, i.e. the candle with the lowest low of the whole formation).
   • It is a good idea to enter the SL with a small margin (e.g. a few pips in forex, ideally according to the backtest results), so that market noise does not cause unnecessary exit from the position if the SL is too tight.
5. Take Profit (TP)
   • We can set a target price according to different rules, for example:
     • - at the most important resistance level (for example, the previous high),
     • - based on the RRR ratio (e.g. RRR 2:1, where we risk $100 to make $200).
   • As the price approaches the target, we can move the Stop Loss into profit (Trailing Stop) and thus protect the profit already made.

Example of a trade

In our example, we observed a multi-day downtrend on the USDJPY pair. The price gradually reached the level that formed a fairly strong resistance level a few weeks before and turned into support after breaking it.

At the same time, a Morning Star pattern formed here, which points to a possible trend reversal. If we were thinking of a trade, we could enter the trade at a price around 138.50 (Entry) and we could place the Stop Loss somewhere around the red line as indicated in the picture, which would amount to around 140 pips.

The price eventually bounced off the support and headed upwards. Although the trade took a loss for a time, it would eventually end in profit at an RRR of 2:1. Had we been extremely aggressive and patient, we could have reached the TP at the nearest resistance, which would have taken us to an RRR of over 4.5.

Common mistakes of beginners

• Entering too early: traders immediately enter the position after the formation of the second small candle without confirming the recovery of growth.
• Ignoring the trend: sometimes traders try to trade Morning Star in a sideways market without a clear downtrend, where the pattern may not have such strength.
• Inappropriately set Stop Loss: traders set the SL too "tight" and market noise then easily throws them out of the position at a loss.
• Lack of money management: traders trade with too much capital in one trade and the loss is then psychologically unbearable.

Summary

• Morning Star is a reliable turnaround pattern after a declining market.
• Ideally, it should form at important support levels to increase the probability of success.
• It is important to have a predetermined exit strategy, i.e. Stop Loss and Take Profit.
• It is good to remember that even the best pattern is not a guarantee of 100% success. Part of any strategy is money management and a willingness to accept losses.

This strategy is simple and suitable for beginners who want to learn to recognize specific candlestick patterns and enter the market with a reasonably defined risk.