Candlestick Patterns, And Why Do They Work? (Candlestick Part 1)

Candlestick Patterns

One of the most significant goals of technical analysis is to identify changes in direction of price action. Because candlesticks give visual insight into what the market is market psychology, one of the most useful aspects of candlestick analysis is its ability to suggest changes in the sentiment of the market, and reversals in trend. We call these candle formations Reversal Patterns.

Important to note is that with candlesticks a reversal pattern does not necessarily suggest a complete reversal in trend, but merely a change or pause in direction. That could mean anything from a slowdown in trend, sideways trading after an established trend, or a full turnaround following a reversal candle pattern.

candlereading

 

Why do candlestick patterns work?

Traders often mistakenly believe that the patterns themselves drive the markets. Traders who treat candlestick patterns like templates and just look for an exact match to what the trading textbooks tells them will usually not be able to make this work.

Only when a trader knows how to “read” the path of candlesticks, he will be able to understand what the patterns tell him about the underlying market dynamics. Candlesticks are no magic trading tool, they are just a way of visualizing price movements. But the trader who can follow the path of price and knows how to interpret the thought-process other financial players are going through can take advantage of this knowledge.

”Price movements and trading is all about mass psychology and candlesticks are a manifestation of crowd behavior.”

Bullish Reversal (Bottom Reversal)

Engulfing Bullish
engulfing bullishIn a downtrend, there is a small black body, not a doji, followed and enclosed by a bigger white body.
Though not necessary, it is better when the white body also encloses the short shadows of the black candle.

An exceptional occurrence at the end of a downtrend is a white body followed by a bigger black body; this is called a last engulfing pattern.

engulfing bullish confirmation
Piercing Line
piercing lineIn a downtrend, a bigger black body is followed by a white body with a lower opening price than the low of the black body; however, the white candle closes above the midpoint of the black body.piercing line example
Bullish Counterattack
bullish counterattackA bullish counterattack is a bigger black candle in a downtrend, followed by a bigger white candle. Closing prices of both candles are at the same price level.
Confirmation is needed.
bullish counterattack example
Bullish Harami
bullish haramiIn a downtrend, a white (but preferably a black) body is followed by a small white or black candle that is completely covered by the first candle body.

A bottom reversal signal after confirmation. Black-white and black-black (called homing pigeon) combinations are the most common.

bullish harami example
Bullish Harami Cross
bullish harami crossIn a downtrend, a white (but preferably a black) body is followed by a doji that is completely covered by the first candle body.
A bullish harami cross pattern needs confirmation.

bullish harami cross example

Morning Star
morning starA bigger black body, followed by one or more small black or white bodies below the closing price of the first black body. The white candle that follows ideally lays 50% or more within the first black body and has a rising window with the previous candle body.morning star example

 

Morning Doji Star
morning doji starA bigger black body, followed by one or more doji’s with a falling window below the closing price of the first black body. The white candle that follows ideally lays 50% or more within the first black body and has a rising window with the previous doji body.

This is a stronger reversal signal than a morning star.

morning doji star example
Bullish Abandoned Baby
bullish abandoned babyAn abandoned baby pattern is a morning doji star with a window between the doji and the black and white candle, resulting in an island reversal. The island can have more candles and more than one doji.bullish abandoned baby example
Hammer
hammerA hammer is a small white or black body close to the high price. It has a long shadow below with a minimum size of twice the height of the body. There is a very small shadow or no shadow at the top. A dragonfly doji is a specific version of the hammer pattern.

Confirmation is required. A white body is more positive.

hammer example
Inverted Hammer
Inverted hammerAn inverted hammer is a small black ( but preferably a small white) body near the low price. It has a long shadow above that is, at minimum, twice the size of the body. It only has a very small shadow or no shadow below. A gravestone doji is a specific version of the inverted hammer.

A bottom reversal only after confirmation.

Inverted hammer example
Tweezer Bottoms
tweezer bottomsTwo or more candles making lows together. Preferably, the lows are made with low prices, but they also can be combinations of any of the other prices. Size and color are not important. This is a reversal pattern that, most of the time, is part of another pattern.tweezer bottoms example
Fry Pan Bottom
fry pan bottomThe fry pan bottom is formed with a number of smaller candles. After this bottoming pattern, the price usually makes an up-move with a rising window.

A fry pan bottom is a powerful reversal pattern.

fry pan bottom example
Three River Bottom
Three river bottomDuring a downtrend, there is a bigger black candle on the first day of this pattern. The second day starts with a higher opening price; then makes a new lower low and closes the day below the opening price. The third day opens lower and forms a small white body with a closing price below the closing price of the second day.
A rare bottom reversal pattern; confirmation is required.
Three river bottom example
Three White Soldiers
Three white soldiersThree white candlesticks with each bar having higher closing prices, close to the high of the bar. Opening prices of candles two and three are within the body of the previous candles.
Many times, there will be a small reaction before the new uptrend is resumed.
Three white soldiers example

Bearish Reversal (Top Reversal)

Engulfing Bearish
Engulfing bearishIn an uptrend, there is a small white body, not a doji, followed and enclosed by a bigger black body.
Though not necessary, it is better when the black body also encloses the short shadows of the white candle.
An exceptional occurrence at the end of an uptrend is a black body followed by a bigger white body; this is called a last engulfing pattern.
Engulfing bearish example
Dark Cloud Cover
Dark cloud coverIn an uptrend, a bigger white body is followed by a black body with a higher opening price than the high of the white body; however, the black candle closes below the midpoint of the white body.

Confirmation is required.

Dark cloud cover example
Bearish Counterattack
Bearish counterattackA bearish counterattack is a bigger white candle in an uptrend, followed by a bigger black candle. Closing prices of both candles are at the same price level.

Confirmation is a must.

Bearish counterattack example
Bearish Harami
Bearish haramiIn an uptrend, a black (but preferably a white) body is followed by a small white or black candle that is completely covered by the first candle body.

A top reversal signal after confirmation. White-black and white-white combinations are the most common.

Bearish harami example
Bearish Harami Cross
Bearish harami crossIn an uptrend, a black (but preferably a white) body is followed by a doji that is completely covered by the first candle body.

A bearish harami cross pattern needs confirmation.

Bearish harami cross example
Evening Star
Evening starA bigger white body, followed by one or more small black or white bodies with a rising window above the closing price of the first white body. The black candle that follows ideally lays 50% or more within the first white body and has a falling window with the previous candle body.  Evening star example
Evening Doji Star
Evening doji starA bigger white body, followed by one or more doji’s with a rising window above the closing price of the first white body. The black candle that follows ideally lays 50% or more within the first white body and has a falling window with the previous candle body.

This is a stronger reversal pattern than the evening star.

Evening doji star example
Bearish Abandoned Baby
Bearish abandoned babyAn abandoned baby pattern is an evening doji star with a window between the doji and the white and black candle, resulting in an island reversal. The island can have more candles and more than one doji.Bearish abandoned baby example
Hanging Man
hanging manA hanging man is a small white or black body close to the high price. It has a long shadow below, with a minimum size of twice the height of the body. There is a very small shadow or no shadow at the top. A dragonfly doji is a specific version of the hanging man pattern. Confirmation is required.hanging man example
Bearish Shooting Star
Bearish shooting starA bearish shooting star is a small white (but preferably a small black) body near the low price. It has a long shadow above that is, at minimum, twice the size of the body. It has a very small shadow or no shadow below. There is a gap between the bodies of the bearish shooting star and the previous candle.
A top reversal only after confirmation.
Bearish shooting star example
Bearish Gravestone Doji
Bearish gravestone dojiA bearish gravestone doji is a bearish shooting star where the opening, closing, and low prices are all about the same. It has a long shadow above and no shadow below. There is a gap between the bodies of the doji and the previous candle.
A top reversal only after confirmation.
Bearish gravestone doji example
Tweezer Tops
Tweezer topsTwo or more candles making highs together. Preferably, the highs are made with high prices, but they also can be combinations of any of the other prices. Size and color are not important. This is a reversal pattern that, most of the time, is part of another pattern.Tweezer tops example
Three Black Crows
Three black crowsThree black candlesticks with each subsequent bar having lower closing prices, close to the low of the bar. Opening prices of candles two and three are within the body of the previous candles.

Many times, there will be a small reaction before the new downtrend is resumed.

Three black crows example
Bearish Dumpling Top
Bearish dumpling topThe bearish dumpling top is formed with a number of smaller candles. After this top formation pattern, the price usually makes a down-move with a falling window.

A bearish dumpling top is a powerful reversal pattern.

Bearish dumpling top example
Upside Gap Two Crows
Upside gap two crowsA white candle in an uptrend is followed by a smaller black candle with a gap above the closing price of the white candle. The body of the next black bar completely covers the previous black bar. This bar also has a gap with the closing price of the white candle.

A very rare pattern.

Upside gap two crows example
Two Crows
Two crowsA white candle in an uptrend is followed by a smaller black candle with a gap above the closing price of the white candle. The body of the next black bar has an opening price within the body of the first black bar and a closing price within the body of the white candle.

Confirmation is needed.

Two crows example

Stop remembering candlestick patterns – start reading crowd behavior

Once you understand that it’s not about identifying exact patterns, but about knowing how to read price movements, you can analyze charts in a completely new way.

There are three main components of any candlestick pattern:

  1. The size – are candles getting larger or smaller? As seen in the example with the Three Inside Up pattern, the candles first become smaller (indicating a shift in sentiment and bears leaving the arena) and then become larger again when the bulls take over.
  2. The wicks – wicks can provide a variety of different information. A wick can show the rejection of a price level like on the Pinbar pattern and it can also show indecision in the markets like on the Doji pattern. A large candle without wicks often indicates greater strength and more conviction.
  3. The close – as mentioned, a candle that closes near the high or low and thus does not have wicks, often shows greater strength. Analyzing the close of a candle in combination with the size can provide meaningful insights about the current strength and the balance between bulls and bears.

Candlestick Part 2 – http://SingaporeStocksTrading.com/2015/04/30/technical-analysis-bullish-reversal-candlestick-formation/

Candlestick Part 3 – http://SingaporeStocksTrading.com/2015/03/30/technical-analysis-bearish-reversal-candlestick-formation/

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