The Dark Cloud Cover pattern is a tool used by many traders to identify potential reversals in the market and achieve favorable risk-to-reward ratios. While it’s relatively easy to spot, it’s important for traders to consider other key factors alongside the formation of the Dark Cloud Cover candlestick and avoid entering a trade solely based on this pattern.
The Dark Cloud Cover is a type of forex candlestick pattern. Before diving in, it’s helpful to have a solid understanding of how to read a candlestick chart.
In this article, we will cover:
1. What is a Dark Cloud Cover Pattern?
2. How to Identify a Dark Cloud Cover on Forex Charts
3. How to Trade Using the Dark Cloud Cover
4. Advantages and Limitations
What is a Dark Cloud Cover Pattern?
The Dark Cloud Cover pattern is a candlestick formation that signals a potential reversal to the downside. It appears at the top of an uptrend and consists of two candles:
1. First Candle: A large green (bullish) candle, indicating the continuation of the uptrend.
2. Second Candle: A red (bearish) candle that initially creates a new high but then closes below the midpoint of the previous green candle.
While the Dark Cloud Cover pattern is similar to the Bearish Engulfing pattern, it’s important not to confuse the two. Both patterns suggest a potential trend reversal, but the Dark Cloud Cover typically offers more attractive entry levels because the bearish candle closes higher than it does in the Bearish Engulfing pattern.
How to Identify a Dark Cloud Cover on Forex Charts
Dark Cloud Cover Checklist:
1. Identify an Existing Uptrend: Begin by confirming that the market is in an uptrend.
2. Look for Signs of Slowing or Reversing Momentum: Use indicators like stochastic oscillators, bearish moving average crossovers, or the formation of subsequent bearish candles to detect a potential reversal.
3. Gap Considerations: In stock charts, the red candle typically gaps up, opening above the previous green candle. However, in forex charts, gaps are rare, and the red candle usually opens at or very close to the previous candle’s close.
4. Check the Closing Level: Ensure that the red candle closes below the midpoint of the previous green candle.
5. Seek Confirmation: Look for additional signals that confirm the new downward trend before entering a trade.
How to Trade Using the Dark Cloud Cover Pattern
Traders can apply the Dark Cloud Cover pattern in both trending markets, such as GBP/USD or EUR/USD, and in ranging markets. Below are strategies for trading in each market condition.
Trading in Trending Markets
Let’s look at an example of the Dark Cloud Cover pattern in the GBP/USD forex pair. The following checklist can help analyze a potential trade:
1. Identify the Uptrend: Look for higher highs and higher lows, indicating an uptrend.
2. Observe Market Behavior: Notice if the market starts to move sideways, showing that the upward momentum is weakening. In this example, the RSI indicator moves into overbought territory, adding more confidence to the trade.
3. Candle Formation: In forex, the red candle usually opens at the same level as the previous green candle’s close, though it may occasionally gap slightly above it.
4. Check the Bearish Candle: Ensure the red bearish candle moves lower and closes below the midpoint of the previous bullish candle, signaling that sellers are gaining control.
5. Confirm the Downtrend: Look for continued selling pressure in the next few candles. A series of lower highs and lower lows indicates that the market has successfully reversed into a downtrend.
Entry, Targets, and Stops:
• Entry Point: Enter the trade at the open of the next candle after the Dark Cloud Cover pattern has formed.
• Stop-Loss Placement: Place stops above the recent swing high to manage risk.
• Target Levels: Set the initial target at key support or resistance levels. Since this trade could be the start of an extended downward move, consider setting multiple target levels to capture potential profits as the trend develops.
Trading in Ranging Markets
The Dark Cloud Cover pattern can also be effective in ranging markets, where the price tends to ‘bounce’ between support and resistance levels. Here’s how to apply the strategy:
• Identify Consolidation: Look for periods where the market is not trending in any particular direction, with price moving within a defined range.
• Spot the Pattern Near Resistance: When the Dark Cloud Cover pattern appears near a resistance level, it provides a signal to go short.
• Potential Breakout: If there’s enough momentum, this setup could lead to a breakout trade, as shown in the example where the price breaks below the support level after the pattern forms.
By using these strategies, traders can effectively trade the Dark Cloud Cover pattern in different market conditions.
Advantages and limitations of the Dark Cloud
The validity of the Dark Cloud, like all other candlestick patterns, depends on the price action around it, indicators, where it appears in the trend, and key levels of resistance. Below are some of the advantages and limitations of this pattern.
| Advantages | Limitations |
|---|---|
| Attractive entry levels as the pattern appears at the start of a potential downtrend | Should not be traded based on its formation alone |
| The Dark Cloud Cover can offer a more attractive risk to reward ratio when compared to the Bearish Engulfing pattern | Where the pattern occurs within the trend is crucial. Must appear at the top of an uptrend |
| Easy to identify for novice traders | The Dark Cloud Cover candle requires an understanding of supporting technical analysis or indicators.Popular: Stochastics and RSI |
