Technical Analysis – Basic Candlestick Patterns
As the name of this article suggests, candlestick patterns form on a candlesticks chart – it is not possible to look for such patterns on a line or bar chart. The candlestick patterns belong to the Japanese approach to technical analysis. This approach is a relatively new one to the technical analysis field, and serves to complements the classical Western approach. Japanese candlestick techniques are mostly reversal patterns, but they can also be continuation ones. They involve at least one candle, and the outcome is a powerful one.
Basic Candlestick Patterns
The aim of this article is to list the basic candlestick patterns and to give some examples, as well as generalities, regarding their use in the technical analysis field. Some of them are quite powerful and, as a general rule, the longer the timeframe the patterns appear in, the better or the stronger the implications.
The Hammer and the Hanging Man
A hammer is a bullish pattern that forms at the end of a bearish trend. It is a reversal pattern, and long trades should be taken by the time the hammer appears. The hammer shows that the bearish trend is faltering, and bulls are starting to fight for survival. Not all hammers hold, and the longer the timeframe is, the better the chances that the hammer is going to survive and the trend reverse. A hammer is characterised by a candle that has a long shadow and a small body. The colour of the body doesn’t matter; either green or red, the implications are the same.
The chart above shows the EUR/USD pair forming a hammer on the daily timeframe; and by the time the pattern completes, the bullish trend starts. The battle between bulls and bears can be seen very clearly as bears are not willing to let go that easily. The moment the hammer is formed, the next candle starts, with bears pushing for new lows that would invalidate the hammer. This is why it is wise not to trade at the close of the hammer, but to wait for the market to make an attempt to take the lows before going long. Such an approach will result in a better entry, and the risk/reward ratio for the trade will be better. Again, the longer the timeframe, the better the chances that the hammer will survive. The opposite of a hammer is called a hanging man, and, despite the ugly name, is a powerful bearish formation. Everything discussed in the case of the hammer is valid for the hanging man, only the other way around.
Morning and Evening Stars
Stars are three-candle patterns that appear at the end of a bearish or a bullish trend. A morning star is a bullish formation (appears at the end of a bearish trend) and an evening star is a bearish one (appears at the end of a bullish trend). A morning star is formed out of a long red candle in the direction of the overall bearish trend, followed by a candle with a small body (this candle can be a hammer as well, and the colour of the body is not important), and the last candle is a strong reversal one. This formation is more powerful the longer the timeframe is.
For a morning star, a bearish trend needs to be in place, while for an evening star, a bullish one is required. Any other three candles that respect this arrangement, but are not following a bearish or a bullish trend, should simply be disregarded or ignored. As in the case of a hammer, the morning star also shows a battle between bulls and bears. Bears have a difficult time of letting go of the previous trend, and will try to take the lows of the pattern. This is why it is recommended to wait for a pullback to follow the morning star before going long. This would result in a better entry and better money management, as the resulting risk/reward ratio would be much better.
Bullish and Bearish Engulfing
A bullish or a bearish engulfing pattern is formed out of two candles: one in the direction of the general trend, and the other one as a reversal candle. Like the other two candlestick patterns mentioned in this article, the engulfing pattern is a powerful reversal one.
The bearish engulfing pattern above shows the second candle in the pattern totally engulfing the previous candle. It shows that bulls have been overcome by bears, and a new trend is starting.
Piercing and Dark-Cloud Cover
When the engulfing of the first candle is not complete, a piercing pattern (in the case of a bullish trend to start) or a dark-cloud cover pattern (in the case of a bearish trend to start) forms.
Above is a dark-cloud cover that forms at the end of a bullish trend; and by the time the second candle completes, the new trend starts. It is said that the second candle must travel more than half the distance of the first candle for the candlestick pattern to be valid as a reversal one. When compared with the engulfing patterns, the dark-cloud cover and the piercing ones are not that powerful. Nevertheless, the market will react, and the logger the timeframe, the bigger the reaction will be.
The Doji Pattern
Perhaps the most enigmatic pattern is the doji pattern. We’re talking about a single candle here, but it can be both a continuation and a powerful reversal pattern. The doji pattern is not possible to be seen on the Forex market anymore, because of the fact that now the currency pairs are quoted with five-digit data. The definition of a doji pattern calls for the opening and closing price to be the same. Such a thing is almost impossible with five-digit data, but one should be flexible enough to bend the rules without breaking the pattern. Depending on where the doji appears and where the opening and closing prices are, there are different types of doji candles: dragonfly, graveyard doji, etc.
Recommended Further Readings
- Trend Indicators
– Explains what trading indicators are; where to find them; and their benefits when trading Forex market based on technical analysis.
– Discusses what oscillators are; the differences between an oscillator and a trend indicator; and the most representative indicators that fit into this category.
- Central Banks
– The role of a central bank in Forex trading; why the market moves aggressively when monetary policy is set; and what information to look for when the central bank is deciding on its policy.
- Technical Analysis – Support and Resistance Areas
– Defines what support and resistance areas are; how to find them using technical analysis; and why traders look to buy into support and sell into resistance.
Other Educational Materials
- “Performance of candlestick analysis on intraday futures data.” Fock, J. Henning, Christian Klein, and Bernhard Zwergel. The Journal of Derivatives 13, no. 1 (2005): 28-40.
- Expert system for predicting stock market timing using a candlestick chart. Lee, K. H., & Jo, G. S. (1999). Expert systems with applications, 16(4), 357-364.