Candlestick Patterns
The Japanese have used candlestick charts to analyze rice prices since the 17th century. In his book Japanese Candlestick Charting Techniques, Steve Nison introduced candlestick patterns to modern technical analysis.
Candlestick charts, despite their historical origins, are straightforward and clear. They contain the same data as a standard bar chart but highlight the relationship between opening and closing prices. The narrow stick shows the price range (high to low), while the broad mid-section shows the opening and closing prices.
- If the close is higher than the open - the candle mid-section is hollow or shaded blue/green.
- If the open is higher than the close - the candle mid-section is filled in or shaded red.
The candle's body is filled on black-and-white charts if the open is higher than the close.
The advantage of candlestick charts is the ability to highlight trend weakness and reversal signals that may not be apparent on a normal bar chart.
Shadow and Tail
The shadow is the portion of the trading range outside of the body. We often refer to a candle as having a tall shadow or a long tail.
- A tall shadow indicates resistance;
- A long tail signals support.
Candlestick Patterns
Long Lines
The long white line is a sign that buyers are firmly in control - a bullish candle.
A long black line shows that sellers are in control - definitely bearish.
Marubozu
Marubozu are even stronger bull or bear signals than long lines. Buyers or sellers have remained in control from the open to the close -- there are no intra-day retracements.
Doji
The doji candle occurs when the open and closing price are equal.
An open and close in the middle of the candle signal indecision. Long-legged dojis, occurring after small candles indicate a surge in volatility and warn of a potential trend change. 4 Price dojis where the high and low are equal, usually are only seen on thinly traded stocks.
Dragonfly
The dragonfly candlestick occurs when the open and close are near the top of the candle. This signals reversal after a downtrend: control has shifted from sellers to buyers.
Hammer and Gravestone
A hammer candle also signals reversal after a downtrend but is not as strong as the dragonfly. It is formed when the shadow is at least twice the height of the candle's body.
A gravestone is identified by opening and closing near the bottom of the trading range. It is the converse of a hammer and signals reversal when it occurs after an up-trend.
Candlestick Formations
We now look at candlestick patterns that form with clusters. How one candle relates to another will often indicate whether a trend is likely to continue or reverse. Patterns can also signal indecision, when the market has no clear direction.
Engulfing Candlesticks
Engulfing candle patterns are the simplest reversal signals, where the body of the second candle 'engulfs' the first. They often follow or complete doji, hammer, or gravestone patterns and signal reversal in the short-term trend.
Harami Candlestick
Harami patterns, on the other hand, signal indecision. Harami candles indicate loss of momentum and potential reversal after a strong trend. Harami means 'pregnant,' which is quite descriptive. The second candle must be contained within the body of the first, though the shadows may protrude slightly.
Dark Cloud Cover
A Dark Cloud Cover pattern encountered after an up-trend is a reversal signal, warning of "rainy days" ahead.
Piercing Line
The Piercing Line pattern is the opposite of the Dark Cloud Cover formation and is a reversal signal if it appears after a down-trend.
Hanging Man
More controversial is the Hanging Man candlestick pattern. A Hammer candle is a bullish signal in a down-trend. In an up-trend it is called a Hanging Man and is traditionally considered a bearish (reversal) signal. Thomas Bulkowski (Encyclopedia of Chart Patterns) tested the pattern extensively and concludes on his website that the Hanging Man pattern resolves in bullish continuation (of the prevailing trend) 59% of the time. It is therefore advisable to treat the Hanging Man as a consolidation pattern and only take moves from subsequent breakouts.
Candlestick Star Formations
Star patterns highlight indecision. A long body followed by a much shorter candlestick indicates the market has lost direction. The bodies must not overlap, though their shadows may.
Reversal is confirmed if a subsequent candle closes in the bottom half of the initial, long candlestick body.
Morning Star
The Morning Star candlestick pattern signals a bullish reversal after a down-trend. The first candle has a long black body. The second candlestick gaps down from the first and is more bullish if hollow. While the bodies display a gap, the shadows may still overlap. The third candle has a long white body, which closes in the top half of the body of the first candlestick.
Evening Star
The Evening Star pattern is opposite to Morning Star and is a reversal signal at the end of an up-trend. The pattern is more bearish if the second candle is filled rather than hollow.
Doji Star
A Doji Star is weaker than the Morning or Evening Star: the doji represents indecision. The doji star requires confirmation from the subsequent candlestick closing in the bottom half of the body of the first candlestick.
Shooting Star
With a Shooting Star, the body on the second candlestick must be near the low at the bottom end of the trading range, and the upper shadow must be taller. This is also a weaker reversal signal than the Morning or Evening Star.
The pattern requires confirmation from the subsequent candlestick closing below halfway on the body of the first.
Candlestick Continuation Signals
Many clusters will resolve as continuation signals after initially signaling indecision. But there are a few patterns that suggest continuation right from the outset.
Rising Three Methods
The Rising Method consists of two strong white lines bracketing 3 or 4 small declining black candles. The final white line forms a new closing high. The pattern is definitely bullish.
Falling Three Methods
The bearish Falling Method consists of two long black lines bracketing 3 or 4 small ascending white candlesticks. The final black line must form a new closing low to complete the pattern.
Evaluation
Although candlesticks offer useful pointers as to short-term direction, trading on their signals alone is not advisable. To improve trading accuracy combine with volatility, volume, support/resistance and trendlines. See: How to Trade Candlestick Chart Patterns. Jack Schwager, in Technical Analysis, conducted fairly extensive tests with candlesticks over a number of markets, but the results were disappointing.