Improve trading probability with candlestick action.
4 important candlestick patterns that every trader should know
Candlesticks can be quite useful in offering guidance to the direction of the next price move. Though it’s only indicative and can’t be used in isolation, candlestick patterns are a powerful tool to 'prepare' the trader for the next move.
Trading candlesticks is a skill that gets developed over time. You can learn to identify signals from the candlesticks, and start trading small sizes to test the signals in real time. When you have traded enough of those signals, you will have a good idea of which signals to trust and which to let go of.
Thomas Bulkowski is a highly regarded expert on candlesticks and the video below summarises his best ideas coupled with probability.
Candlestick chart Basics
A candlestick chart represents the price action of an asset plotted using a series of candle-like price bars. The bar has a body and wicks on both ends of the body. The two ends of the body depict the open and close price, while the upper wick extends to the high price of the selected time frame, and the lower wick to the low price. As shown in the picture below, a red candle is formed when the close price is lower than the open price, and a green candle is formed when the opposite happens.
Here we discuss four such candlestick patterns and how they can be included in a trader’s tool book to further improve probability.
Bullish Candlestick Patterns
Bullish candlestick patterns indicate a reversal of a downtrend or continuation of an uptrend and help in taking trades on the long side.
Bullish Engulfing Candlestick Pattern
A bullish engulfing pattern is formed towards the end of a downtrend signalling the reversal of the trend. As shown in the picture below, the pattern can be formed with two or more candles, with the body of the candle at the right completely engulfing the body of immediately preceding candle.
As stated earlier, a candlestick may not be the best solo indicator of change in trend and can be used if the signal is confirmed by other technical signals. For example, in the chart below, the price was in a declining trend forming lower lows and lower highs. It makes a higher low at the bottom and forms an engulfing candle right after that, confirming the bullish signal. The price moved upwards for a decent swing trade afterward.
The psychology of an engulfing candle goes like this. Sellers control the candle's opening, and as time progresses, buyers jump in to absorb the selling and take the price higher. By the time the candle ends, buyers are in full control and are ready to take the price higher. A decent entry point would have been when the price crossed the high of the engulfing candle with a stop loss at the low of the candle.
Hammer Candlestick Pattern
A hammer pattern gets formed at the end of the downtrend. The candle looks like a hammer with a small body and a long lower wick. As can be seen in the picture below, the body can be red or green in a hammer candle, both signalling a bullish reversal.
The psychology behind the hammer is that the sellers were in control when the candle opened and they continued to push the prices lower. However, the last of the sellers got out in the mid and buyers took control afterward to close near the open point of the candle. The long wick in the above example is therefore classed as support, whereas a long wick above the candle would be classed as resistance.
In the chart below, the price declined quickly to lower levels and formed a perfect hammer, signalling an end of secondary downtrend. As the low of the hammer candle was higher than previous swing low, the primary trend was still up and a trade could have been taken at the high of the hammer candle with a stop loss at the low of the candle.
Bearish Candlestick Patterns
Bearish candlestick patterns signal a reversal of an uptrend or continuation of a downtrend. These patterns can be used to take trades on the short side or simple to exit a position you already hold.
Bearish Engulfing Candlestick Pattern
As the name suggests, this candlestick pattern is the exact opposite of the bullish candlestick pattern and forms near the top of the trend. As shown in the picture below, the red candle is formed after a green candle and the body of the red candle completely engulfs the body of the green candle. Buyers control the start of the candle but sellers weigh in and take the price lower signalling a change in trend.
In the chart below a bearish engulfing candle is formed right at the point when the price tested its previous high. Another one was formed later when the price rebounded a little to hit a lower high. A series of lower highs and two bearish engulfing candles was a good enough signal to go short (or sell) for a decent quick profit.
Shooting Star Candlestick
A shooting star candle is an inverted version of a hammer and depicts the exact opposite of a hammer signal. As shown in the picture below, the shooting star candle has a long wick at the upper end and a small body at the lower end. The candle signals a bearish reversal, irrespective of the colour of the candle. The low close of long candle shows that the sellers dominated at the end of the period.
In the chart below, a shooting star was formed when the price failed to reach a new high and rolled back quickly after the shooting star candle was formed. A lower high along with a shooting star was a good enough signal to prepare for a short swing trade, or to sell your position.
Those who follow my personal approach will know that I look for breakouts from consolidation, however the breakout will ideally be with a full bodied candle.
A breakout candle showing an excessive upside wick (below) would be a sign of resistance and would not be a breakout with conviction.
The Final Word
Candlesticks can be a very useful tool in a trader’s arsenal to confirm trading signals at important turning points. However, like any other trading setup, they aren’t right 100% of the time and have to be followed with stop-loss discipline.
The best results of candlesticks come when they are mixed with other tools like Dow theory, trendlines, support and resistance, volume and moving averages etc. For example, when a stock is trading near its resistance and you can’t decide to when to sell it, a bearish engulfing or a shooting star at that point will help confirm the resistance and make it easy to go into a short trade or sell your position. This makes candlesticks quite useful and effective tool for all traders.
Like all other things in trading, the belief and confidence in the execution of candlestick setup will develop over time when you would have traded enough setups with small positions. Therefore, practice is key to trade candlestick patterns.
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