The ChoosaBroker Trading Academy
11.4. An Introduction to Candlestick Patterns
It took more than two hundred years for candlestick charts to make the leap from feudal Japanese rice markets to traders in the West, and just under quarter of a century to become the preferred charting style of investors from Wall Street to Main Street. And the reasons behind their wide-spread popularity are not hard to find. Candlesticks provide brilliant visualization of market behaviour at key turning points, helping technical traders understand the underlying demand-supply dynamics better than the more traditional bar charts.
In order to plot a candlestick chart, all we need are the open, high, low and closing price for each time period under consideration. The filled portion of the candle bar is called the “real body,” and represents the area between the opening and closing prices. The thin lines extending above and below the “real body” depict the high and low for the session, and are called “wicks” or “shadows.” If an underlying asset’s price closes above its open, a green or white candlestick is drawn. If the close is below the open, the body is typically painted red or black.
Like classical chart patterns, candlestick formations can also be categorized as reversal and continuation. Let us now look at 9 of the most reliable candlestick patterns.
Doji
Doji are among the most important candlestick formations. They are formed when an underlying asset’s opening and closing price are virtually the same. The length of the upper and the lower shadows will depend on the trading range for the time period under consideration. Doji looks like a plus sign, a cross, or an inverted cross.
Doji are direction neutral patterns. Whatever bullish or bearish bias is formed is based on preceding and following price action. Ideally, the opening and closing prices should be exactly equal. However, what is more important is the demand-supply dynamics that’s playing out. Doji points to a tug of war between the buyers and the sellers. Price closing at or near the opening level indicates a standoff. Neither the bulls nor the bears were able to gain control of the market. Hence, textbook patterns are not mandatory. The underlying tension should be evident.
A doji formed within a range bound market is of not much use. A preceding trend adds relevance to the pattern. After a strong up move, or long green candle, a doji indicates that buying pressure is waning. After a strong decline, or long red candle, a doji signals that selling pressure is diminishing. However, a doji alone is not enough to mark a trend reversal. Further confirmation is necessary.
This confirmation may come in the form of subsequent price action. If a doji is printed after a strong up move, we can switch to a lower time frame chart, and wait for the break below the last major reaction low to confirm a short term trend change to down. Contrarily, if a doji is charted after a strong down move, we can switch to a lower time frame chart, and wait for the break above the last major reaction high to confirm a short term trend shift to up.
Long-Legged Doji
Long-legged dojis are composed of long upper shadows and long lower shadows that are approximately of equal length. Such patterns reflect even greater degree of indecision within the market. Price traded well above and below the open, but closed virtually next to the open. After a whole session of price see-sawing, the end result showed that little has changed in terms of sentiment.
Dragon Fly Doji
Dragon fly doji is formed when the opening price, high and close are almost equal and the low plots a long shadow underneath. The resulting candle looks like a “T.” Dragon fly doji suggests sellers dominated trading and managed to drive prices lower. However, towards the end of the session, bulls remerged and pushed prices back to the open, which was also the session high.
Dragon fly doji are especially relevant after prices have declined for some time and have come close to an important support zone. Bears tried to break through the support area, but failed, indicating a short term reversal is imminent. Subsequent price action should be followed to confirm that premise.
Gravestone Doji
Gravestone doji is formed when the opening price, low and close are the same and the high creates a long upper wick. The resulting candle looks like a “T” that’s upside down. Gravestone doji suggests that buyers dominated the session and succeeded in driving prices higher. However, bears resurfaced at some point and hammered prices back to the open, which also coincided with the session low.
Dragon fly doji that form at or near resistance after a strong move higher provides early warning signs of a trend reversal. Bulls tried to break through the resistance area, but failed. Subsequent bearish price action should confirm the shift in trend.
Harami and Engulfing
In old Japanese “harami” means pregnant. The pattern is made up of two candlesticks – the first has a large real body and totally encompasses the second, smaller candle. The body of the baby (second candlestick) must lie within the body of its mother (first candlestick). The bullish or bearish undertone of the Harami is dependent on the preceding trend. It is considered a potentially bullish reversal signal after a price decline and a likely bearish reversal zone following an advance.
The Engulfing is a mirror image of the Harami. The body of the second candle completely “engulfs” the body of the first. Engulfing is a major reversal pattern at market extremes. Generally, larger the second candlestick and greater the engulfing, the stronger is its bullish or bearish implication.
Hammer and Hanging Man
These two patterns look exactly alike. The real body is small in size and is situated near the top of the candlestick, with a shadow that is much longer than the body. The only difference between the Hammer and the Hanging Man is their location on a price chart. The Hammer appears during the last leg of a down move, and indicates exhaustion in selling pressure, while the Hanging Man can be found at the end of an up move, and points to bulls running out of steam.
During a down trend, traders look to buy above the Hammer pattern to profit from a reversal in sentiment. In case the ongoing trend is bullish, traders seek to short below the Hanging Man in anticipation of imminent market weakness.
Piercing Line and Dark Cloud Cover
The Piercing Line is a bullish candle formation. A white candlestick follows a red candlestick, with a significant gap between the close of the red candle and the open of the white candle. The body of the white candlestick should be large enough to cover at least half of the previous red candlestick. In addition, the second candle bar should have a close which is at or above the midpoint of the prior red candle.
The Dark Cloud Cover is a bearish reversal pattern consisting of two candlesticks, whereby a red candle opens above the close of the preceding white candle, but ends up closing below its midpoint. Traders should note that the real bodies of both the Piercing Line and the Dark Cloud Cover should be relatively long for the patterns to retain their validity.
Final Thoughts
As long as you have an open, high, low and close, you can use candlestick charts in any market and on any time frame. Candle charts provide you with early indications of market reversals. Learn to recognize the above patterns and you will likely stay one step ahead of the crowd. Many of the top Brokers often offer free webinars around candlestick patterns and overall trading.
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