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Chapter 2 Candlestick Patterns

Candlestick

Candlesticks are the most popular chart choice among traders as compared to line chart, bar chart and the point & figure chart. It has gained popularity among the traders as it conveys wide range of trading information in one go in a highly visual way. Candlestick charts are also simple to read and interpret. It consists of a body (rectangle part of the candle) and shadow or wicks (lines above or below the body).Each candlestick also consists of an open, high, low and close price. The trader based on his trading horizon sets the time frame of the candlestick chart.

Interpreting Candlestick Chart

Open - The open is the first price traded and is indicated by either the top or bottom of the body of the candlestick.

High - The high is the highest price traded during the time period set for the candlestick, and is indicated by the top of the shadow that occurs above the body (called the upper shadow). The high price could be the open, close or a high hit within the time frame of the candle. If the open was the highest price then there will be no upper shadow.

Low - The low is the lowest price traded during the candlestick, and is indicated by the bottom of the shadow that occurs below the body (called the lower shadow). The low could also be one of the three prices open, close or a low price hit within the time frame of the candle. If the open was the lowest price then there will be no lower shadow.

Close - The close is the last price traded during the candlestick, and is indicated by either the top or bottom of the body.

The color of a candlestick is based on whether the closing price (or the last traded price, if the candlestick is incomplete) is above (green) or below (red) the opening price. While the candlestick is the process of formation, the candlestick could constantly alter as the price fluctuates. The open remains fixed, but the rest of the parameter i.e. high, low and close could constantly change. When the time period of the candle comes to an end the last traded price is taken as the closing price, after which a new candlestick is formed which continues to convey the price movement over the next time segment.

Range - The price difference between the upper and lower shadow indicates the range the price moved during the time frame set for the candlestick. It is calculated by subtracting the high from the low of the candlestick. Range indicates the volatility associated with the candlestick .Higher the range higher the volatility and vice versa. (Range = High - Low).

Interpreting candlesticks charts is one of the very first steps in learning how to trade. Once a trader has gained knowledge to interpret a chart he can then move on to the other aspects of technical analysis and develop trading strategies as per his needs.

Use of Candlesticks

Candlesticks tend to form patterns which are interpreted by traders to indentify a continuation or reversal of the existing trend .It is also made use of to spot short term trading opportunities. Different traders make use of candlestick charts differently. Candlestick patterns should be used in conjunction with the prevailing trend.

Candlestick also tends to act as a unique leading indicator providing the trader an edge while entering and exiting a trade. It also gives an early signal of a reversal in trend compared to the rest of the technical indicators hence it is widely used in short term trading and in volatile markets.

Candlestick compliments most of the other technical analysis indicators and works well with the western technical tools.

Candlestick patters also tend to act as support or resistance levels and indicate the start of a pullback or bounce.

Time frame

Most candlestick patterns form over a period of 1-3 days, which makes them short-term patterns that are valid for 10- 15 trading sessions. For example hammers and hanging man require just one day. Engulfing patterns, bullish belt hold and dark cloud cover patterns require two days. Three white soldier and evening stars require three days for the pattern to complete.

Preceding Trend

Candlestick patterns gain significance based on their location within the trend, a reversal candlestick pattern has validity only if it is formed at the end of the current trend. I.e. there should be a prior trend to reverse. Bullish reversals require a preceding downtrend while a bearish reversal requires a prior uptrend. The direction of the trend can be determined using trend lines, moving averages, peak/trough analysis or other aspects of technical analysis.

Tussle between bulls and bears

Candlestick depicts the fight between the bulls and bears over the set time period.

1) Long green candlestick indicates that the trading session was controlled by the buyer’s i.e. bulls.

2) Long red candlestick indicated that the trading session was controlled by the seller’s i.e. bears.

3) A long lower shadow indicates the bears controlled the price until the bulls took control and made a strong comeback.

4) A long upper shadow indicates that the bulls controlled prices until the bears made an impressive comeback and took control.

5) Small candlestick indicates that neither the bulls nor bears could gain control over prices during the session.

6) A long upper and lower shadow indicates a volatile trading session with both the bulls and bears having gained control but unable to sustain the advantage.

Color of Candlesticks

The color of the candlestick depends on the preference of the trader. The commonly used combinations are

+ ve Day (Open Higher than close) -ve Day (Close lower than open)
Green Red
Blue Red
Hollow Filled

In the examples below we have made use of the blue and red color combination.

Candlestick Patterns

Bullish Patterns

1) Bullish Hammer

Definition

This pattern occurs at the bottom of a trend or during a downtrend. It is a single candlestick pattern that has a long lower shadow and a small body at the top of its trading range.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • A small body at the upper end of the trading range is observed. The color of the body is not important.

  • The lower shadow of this candlestick is at least twice as long as the body.

  • There is (almost) no upper shadow.

Candlestick Pattern Interpretation

The Bullish Hammer appears in a downtrend, a sharp selloff is witnessed during trade. After the decline comes to an end, price almost returns to the high of the day. Market fails to continue on the selling side. This price movement reduces the previous bearish sentiment causing short traders to feel increasingly uneasy with their bearish positions. If the body of the Hammer is blue, then the situation looks even better for the bulls.

Buy/Stop Loss Levels

The confirmation level is defined as the top of the Hammer’s body. Prices should cross above this level for a buy signal to be initiated. The stop loss level is defined as the low of the candlestick pattern.

2) Bullish Belt Hold

Definition

Bullish Belt Hold is a single candlestick pattern, basically, a blue Opening Marubozu (long candlestick with no lower shadow) occurs in a downtrend. It opens at the low of the day, and then rallies against the current trend in the market to close near the high.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • The market gaps down and opens at its low, and closes near the high of the day.

  • A long blue body that has no lower shadow is observed.

Candlestick Pattern Interpretation

The market opens lower with a significant gap in the direction of the existing downtrend. However, soon after the market opening, sentiment changes rapidly and the market moves in the opposite direction from there on. This causes fear among traders who have short positions, leading to the covering of short positions, which further aids the rally in the market.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for buy signal to be generated. The stop loss level is defined as the low of the candlestick pattern.

3) Bullish Engulfing

Definition

This pattern is characterized by a large blue body engulfing a prior smaller red body, which appears during a downtrend. The blue body does not have to engulf the shadows of the prior candle but it totally engulfs the body.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • A red body is observed on the first day.

  • The blue body is formed on the second day completely engulfing the red body of the prior day.

Candlestick Pattern Interpretation

While the market is characterized by a downtrend, selling is observed with the occurrence of a red body on the first day but with light volumes. The next day, the market opens lower. It looks as if there’s going to be a continuation of the bearish trend, however the selling pressure loses momentum and the bulls gain control during the day. The buying force overcomes the selling force and in the end markets manages to close above the open of the prior day.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. A buy signal is generated when prices move above the second candles close. The stop loss is defined as the low of the candlestick pattern.

4) Bullish Harami

Definition

This pattern consists of a large red body on the first day followed by a small blue body the next day that is completely inside the range of the red body. It tends to act as a reversal pattern.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • A red candlestick is observed on the first day.

  • The blue body that is formed on the second day is completely engulfed by the body of the first day.

Candlestick Pattern Interpretation

The market is characterized by a downtrend and a bearish mood, and there is heavy selling reflected by a red body. The next day prices open higher or at the close of the preceding day and steadily rises bringing a sense of fear among the short sellers. This leads to the covering of short positions, causing the price to rise further. Some short sellers however still expect the market to correct and continue shorting thus limiting the rise. Hence, a small blue body is formed. This may signal a trend reversal since the second day’s small real body shows that the bearish power is diminishing.

Buy/Stop Loss Levels

The confirmation level is defined as the last close or the midpoint of the first red body, whichever is higher. Prices should cross above this level for a buy signal to be generated. The stop loss level is defined as the lowest point among the two candles.

5) Bullish Doji Star

Definition

It consists of a red candlestick followed by a Doji with a downward gap at the opening the next day. This pattern appears in a downtrend and indicates that the trend will reverse.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • On the first day a red candlestick is observed.

  • Then we observe a Doji on the second day that gaps down.

Candlestick Pattern Interpretation

The market is in a downtrend and a large red candlestick further confirms it. The next day markets opens lower with a gap down, and trades in a small range. The closing price and opening price are similar, causing the formation of a Doji. Bearish sentiment was prevalent during the downtrend but now a change is implied by the formation of a Doji Star, which shows that the bulls and the bears are in equal control. The bearish sentiment has reduced. It is not favorable to further short at current levels.

Buy/Stop Loss Levels

The confirmation level is defined as the midpoint of the gap between the Doji and the prior day’s candlestick. Prices should cross above this level for a buy signal to be generated. The stop loss level is defined as the lowest point among the two candles.

6) Bullish Morning Star

Definition

This is a three-candlestick pattern indicating a bottom reversal. It is composed of a red candlestick followed by a short candlestick, which opens lower to form a star. The following day we have a blue candlestick whose closing price is well into the first session’s red body.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • We observe a red candlestick on the first day.

  • Then, we see a short candlestick on the second day that gaps in the direction of the prevailing downtrend.

  • A blue candlestick is witnessed on the third day.

Candlestick Pattern Interpretation

A downtrend is in progress and the formation of a red candlestick on the first day confirms the continuation of the downward trend. The appearance of the short candlestick with a gap the following day indicates that bears are still pushing down the price. However, the narrow price movement on the second day indicates indecision. The third day is a blue body candlestick where price closes well into the first day’s red body. Indicating a reversal in trend.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for a buy signal to be generated. The stop loss level is defined as the lowest point in the candlestick pattern formation.

7) Bullish Morning Doji Star

Definition

This is a three candlestick pattern signaling bottom reversal. It is composed of a red candlestick followed by a Doji, which usually gaps down to form a Doji Star. On the third day, we have a blue candlestick whose closing price is well into the first session’s real body.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • We observe a red candlestick on the first day.

  • Then, we see a Doji with a gap down on the second day.

  • A blue candlestick is observed on the third day.

Candlestick Pattern Interpretation

A downtrend is in progress, and the red candlestick on the first day confirms this. The appearance of the Doji with a gap indicates that bears are still in control. However, the narrow price action between the open and the close shows indecision. On the third day, the body of the blue candlestick is above the previous day, and closes well into the body of the red day.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for a buy signal to be generated. The stop loss level is defined as the lowest point of the candlestick pattern formation.

8) Bullish Piercing Line

Definition

This is a bottom reversal pattern with two candlesticks. A red candlestick appears on the first day while a downtrend is in progress. The second day opens gap down at a new low but manages to closes more than halfway into the prior candlestick’s red body, leading to the formation of a strong blue candlestick.

Identification Criteria

  • The market is characterized by an existing downtrend.

  • A red candlestick appears on the first day.

  • On the second day we witnesses a gap down opening but the candlestick manages to close more than halfway into the body of the first red candle.

Candlestick Pattern Interpretation

The market is currently in a downtrend. The first red body reinforces this view. The next day the market opens gap down, showing that the bearishness still persists. After this very bearish open, bulls take charge. The market surges toward the end of the session, resulting in a close way above the previous day’s close. A sense of fear develops among the short sellers who consider covering their position resulting in a further surge in prices.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for a buy signal to be generated. The stop loss level is defined as the lowest point of the candlestick pattern formation

9) Bullish Three White Soldiers

Definition

This pattern indicates a bottom reversal in the market. It is characterized by three blue body candlesticks moving upwards. The opening of each day is slightly lower than previous close and prices progressively close at higher levels.

Recognition Criteria

  • The market is characterized by an existing downtrend.

  • Three consecutive slightly long blue candlesticks are observed.

  • Each candlestick opens within the body of the previous day.

  • Candlesticks progressively close at new highs, above the previous day.

Candlestick Pattern Interpretation

The pattern appears in a prevailing downtrend where price are testing new lows or is already at the bottom. Then we see the first blue candlestick which makes an attempt to move upwards. The trend persists for the next two days progressively making new highs at the close. This brings about a sense of fear among the bears who now consider closing their short positions leading prices to head further.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for confirmation. The stop loss level is defined as the lowest point of the candlestick pattern formation

Bearish Candlestick Patterns

1) Bearish Hanging Man

Definition

This pattern occurs at the top of a trend or during an uptrend. It is a single candlestick pattern which has a long lower shadow and a small body at or very close to the top of its daily trading range. The name Hanging Man comes from the fact that the candlestick looks somewhat like a hanging man.

Identification Criteria

  • The market is characterized by an existing uptrend.

  • A small real body at the upper end of the trading range is observed. The color of the body is not important. The length of the lower shadow is at least twice as long as the body.

  • There is (almost) no upper shadow.

Candlestick Pattern Interpretation

The Hanging Man is a bearish reversal pattern. It signals a top for the market or a resistance level. Since the pattern is observed after an advance, it signals that selling pressure is starting to increase. The long lower shadow indicates that the bear’s pushed prices lower during the session. Even though the bulls regained control and drove prices higher towards the close, the appearance of this selling pressure after a rally is hint of a correction. If the body is red, it indicates that the close was not able to get back to the opening price level, which has potentially more bearish implications.

Sell/Stop Loss Levels

The confirmation level is defined as the midpoint of Hanging Man’s lower shadow. Prices should cross below this level for a sell signal to be generated. The stop loss level is defined as the high point of the candlestick pattern formation.

2) Bearish Belt Hold

Definition

Bearish Belt Hold is a single candlestick pattern, basically, a red Marubozu that occurs in an uptrend. It opens at the high of the day, and then prices begin to fall during the day against the overall trend of the market, eventually closing near the low.

Recognition Criteria

  • The market is characterized by an existing uptrend.

  • The market gaps up and opens at its high, only to closes near to the low of the day.

  • A long red body that has no upper shadow.

Candlestick Pattern Interpretation

The market opens higher, with a gap in the direction of the prevailing uptrend. However, after the market opening, things change rapidly and the market moves in the opposite direction from there on. This brings about a sense of fear among the bulls, leading them to close their position which tends to accentuate the selloff.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross below this level for a sell signal to be generated. The stop loss level is defined as the high point of the candlestick pattern formation.

3) Bearish Engulfing

Definition

This pattern is characterized by a large red body engulfing the prior day’s smaller blue body, which appears during an uptrend. The red body does not necessarily engulf the shadows of the blue candle but totally engulfs its body.

Recognition Criteria

  • The market is characterized by an existing uptrend.

  • A blue body is observed on the first day.

  • The red body that is formed on the second day completely engulfs the white body of the preceding day.

Candlestick Pattern Interpretation

While the market is characterized by a preexisting uptrend, buying on low volumes is observed on the occurrence of a blue candlestick on the first day. The next day, the market opens gap up at new highs. It looks as if the bullish uptrend would continue, however the uptrend soon loses momentum and the bears take charge during the day. The selling pressure overcomes buying and finally the market closes below the open of the previous day. Indicating a reversal in trend.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should move below this level for a sell signal to be generated. The stop loss level is defined as the high point of the candlestick pattern formation.

4) Bearish Harami

Definition

This pattern consists of a blue body followed by a small red body candlestick that is completely inside the range of the blue body.

Recognition Criteria

  • The market is characterized by an existing uptrend.

  • A blue body is observed on the first day.

  • The red body that is formed on the second day that is completely engulfed inside body of the first day candlestick.

Candlestick Pattern Interpretation

The market is characterized by an uptrend and there is heavy buying interest indicated by a blue body, which further supports the bullishness. However, the next day prices open lower or at the close of the preceding day and trades in a small range throughout the day, closing even lower, but still within the prior day’s body. The bulls now begin to doubt the strength of the market, due to this suddenly deteriorating trend.

Sell/Stop Loss Levels

The confirmation level is defined as the last close or the midpoint of the first blue body, whichever is lower. Prices should cross below this level for a sell signal to be generated. The high point of the candlestick pattern formation is considered as the stop loss level.

5) Bearish Harami Cross

Definition

This is a major bearish reversal pattern; the pattern is characterized by a blue body followed by a Doji that is completely inside the range of the prior white body.

Recognition Criteria

  • The market is characterized by a prevailing uptrend.

  • A white body is observed on the first day.

  • The Doji that is formed on the second day is completely engulfed by the body of the first day.

Candlestick Pattern Interpretation

A bullish trend prevails in the market, and the bulls are firmly in control. The first day’s candlestick is a blue body, which further supports the uptrend. But the next day, prices open lower than the close or at the close of the prior day and manage to close at the price it opened. This implies a complete lack of decision, and brings about a sense of fear among the bulls.

Sell/Stop Loss Levels

The confirmation level is defined as the last close or the midpoint of the first blue body, whichever is lower. Prices should cross below this level for a sell signal to be generated. The high point of the candlestick pattern formation is considered as the stop loss level.

6) Bearish Shooting Star

Definition

This pattern consists of a blue body followed by an Inverted Hammer that is characterized by a long upper shadow and a small body. It is similar in shape to the Bullish Inverted Hammer pattern but unlike it, the Shooting Star appears in an uptrend and signals a bearish reversal.

Recognition Criteria

  • The market is characterized by an existing uptrend.

  • The first day of the pattern is a blue candlestick.

  • On the second day, a small body is observed at the lower end of the trading range. Color of this body is not important.

  • The upper shadow of the candlestick on the second day should be at least twice as long as the body.

  • There is (almost) no lower shadow.

Candlestick Pattern Interpretation

The pattern occurs in a bullish uptrend and the blue candlestick that appears on the first day further supports the bullishness. On the second day, in which an Inverted Hammer is formed, market opens at or near the day’s low. Then buying interest is witnessed leading to a rally. However, the bulls are not able to succeed in sustaining the rally during the rest of the day and prices ultimately close either at or near the low of the day. The price action generates a sense of discomfort among the bulls.

Sell/Stop Loss Levels

The confirmation level is defined as the low of the Inverted Hammer’s body. Prices should cross below this level for a sell signal to be generated. The high point of the candlestick pattern formation is considered as the stop loss level.

7) Bearish Dark Cloud Cover

Definition

This is a top reversal pattern with two candlesticks. A blue candlestick appears on the first day while an uptrend is in progress. The second day opens at a new high, with a gap up and closes more than halfway into the prior blue body, leading to the formation of a strong red candlestick.

Recognition Criteria

  • The market is characterized by an existing uptrend.

  • A blue candlestick is observed on the first day.

  • A red candlestick opens on the second day with a gap up and closes more than halfway into the body of the first day.

  • The second day fails to close below the body of the first day.

Candlestick Pattern Interpretation

The market is currently in an uptrend. The blue body on the first day reinforces this view. The next day the market opens higher via a gap, after this bullish gap up the bears decide to take charge. The market witness a correction and prices start to go down resulting in a close way below the previous day’s close. At this stage the bulls decide to close their position as a sense of fear sets in. Looking at the correction in price short sellers consider to take fresh positions resulting in a reversal in trend.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross below this level for a sell signal to be generated. The high point of the candlestick pattern formation is considered as the stop loss level.

8) Bearish Three Black Crows

Definition

Three black crows indicate a topping out pattern in the market. It is characterized by three red candlesticks moving downwards. The opening of each day is slightly higher than previous close and prices progressively close at lower levels.

Recognition Criteria

  • The market is characterized by an existing uptrend.

  • Three consecutive slightly long red candlesticks are observed.

  • Each candlestick opens within the body of the previous day.

  • Candlesticks progressively close at new lows, below the preceding day.

Candlestick Pattern Interpretation

The pattern appears in a prevailing uptrend where the market is testing new highs or is already at the top. Then we observe the first red candlestick which makes an attempt to move downwards. The downward correction persists for the next two days progressively making new lows at the close. This brings a sense of fear among the bulls who now consider closing their long positions leading causing prices to head lower.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross below this level for a sell signal to be generated. The high point of the candlestick pattern formation is considered as the stop loss level.

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