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The 5 Most Powerful Candlestick Patterns
Candlestick charts are a technical tool that packs data for multiple time frames into single price bars. This makes them more useful than traditional open-high, low-close bars or simple lines that connect the dots of closing prices. Candlesticks build patterns that predict price direction once completed. Proper color coding adds depth to this colorful technical tool, which dates back to 18th-century Japanese rice traders.
Steve Nison brought candlestick patterns to the Western world in his popular 1991 book, “Japanese Candlestick Charting Techniques.” Many traders can now identify dozens of these formations, which have colorful names like bearish dark cloud cover, evening star and three black crows. In addition, single bar patterns including the doji and hammer have been incorporated into dozens of long- and short-side trading strategies.
- Candlestick patterns, which are technical trading tools, have been used for centuries to predict price direction.
- There are various candlestick patterns used to determine price direction and momentum, including three line strike, two black gapping, three black crows, evening star, and abandoned baby.
- However, it’s worth noting that many signals emitted by these candlestick patterns might not work reliably in the modern electronic environment.
Candlestick Pattern Reliability
Not all candlestick patterns work equally well. Their huge popularity has lowered reliability because they’ve been deconstructed by hedge funds and their algorithms. These well-funded players rely on lightning-speed execution to trade against retail investors and traditional fund managers who execute technical analysis strategies found in popular texts.
In other words, hedge fund managers use software to trap participants looking for high-odds bullish or bearish outcomes. However, reliable patterns continue to appear, allowing for short- and long-term profit opportunities.
Here are five candlestick patterns that perform exceptionally well as precursors of price direction and momentum. Each works within the context of surrounding price bars in predicting higher or lower prices. They are also time sensitive in two ways:
- they only work within the limitations of the chart being reviewed, whether intraday, daily, weekly or monthly.
- their potency decreases rapidly three to five bars after the pattern has completed.
Top 5 Candlestick Patterns
This analysis relies on the work of Thomas Bulkowski, who built performance rankings for candlestick patterns in his 2008 book, “Encyclopedia of Candlestick Charts.” He offers statistics for two kinds of expected pattern outcomes:
- reversal – Candlestick reversal patterns predict a change in price direction
- continuation – while continuation patterns predict an extension in the current price direction.
In the following examples, the hollow white candlestick denotes a closing print higher than the opening print, while the black candlestick denotes a closing print lower than the opening print.
- Three Line Strike
The bullish three line strike reversal pattern carves out three black candles within a downtrend. Each bar posts a lower low and closes near the intrabar low. The fourth bar opens even lower but reverses in a wide-range outside bar that closes above the high of the first candle in the series. The opening print also marks the low of the fourth bar. According to Bulkowski, this reversal predicts higher prices with an 84% accuracy rate.
- Two Black Gapping
The bearish two black gapping continuation pattern appears after a notable top in an uptrend, with a gap down that yields two black bars posting lower lows. This pattern predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. According to Bulkowski, this pattern predicts lower prices with a 68% accuracy rate.
- Three Black Crows
The bearish three black crows reversal pattern starts at or near the high of an uptrend, with three black bars posting lower lows that close near intrabar lows. This pattern predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. The most bearish version starts at a new high (point A on the chart) because it traps buyers entering momentum plays. According to Bulkowski, this pattern predicts lower prices with a 78% accuracy rate.
- Evening Star
The bearish evening star reversal pattern starts with a tall white bar that carries an uptrend to a new high. The market gaps higher on the next bar, but fresh buyers fail to appear, yielding a narrow range candlestick. A gap down on the third bar completes the pattern, which predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. According to Bulkowski, this pattern predicts lower prices with a 72% accuracy rate.
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- Abandoned Baby
The bullish abandoned baby reversal pattern appears at the low of a downtrend, after a series of black candles print lower lows. The market gaps lower on the next bar, but fresh sellers fail to appear, yielding a narrow range doji candlestick with opening and closing prints at the same price. A bullish gap on the third bar completes the pattern, which predicts that the recovery will continue to even higher highs, perhaps triggering a broader-scale uptrend. According to Bulkowski, this pattern predicts higher prices with a 70% accuracy rate.
The Bottom Line
Candlestick patterns capture the attention of market players, but many reversal and continuation signals emitted by these patterns don’t work reliably in the modern electronic environment. Fortunately, statistics by Thomas Bulkowski show unusual accuracy for a narrow selection of these patterns, offering traders actionable buy and sell signals.
Putting the insights gained from looking at candlestick patterns to use and investing in an asset based on them would require a brokerage account. To save some research time, Investopedia has put together a list of the best online brokers so you can find the right broker for your investment needs.
Using Bullish Candlestick Patterns To Buy Stocks
Candlestick charts are a type of financial chart for tracking the movement of securities. They have their origins in the centuries-old Japanese rice trade and have made their way into modern day price charting. Some investors find them more visually appealing than the standard bar charts and the price actions easier to interpret.
Candlesticks are so named because the rectangular shape and lines on either end resemble a candle with wicks. Each candlestick usually represents one day’s worth of price data about a stock. Over time, the candlesticks group into recognizable patterns that investors can use to make buying and selling decisions.
How to Read a Single Candlestick
Each candlestick represents one day’s worth of price data about a stock through four pieces of information: the opening price, the closing price, the high price, and the low price. The color of the central rectangle (called the real body) tells investors whether the opening price or the closing price was higher. A black or filled candlestick means the closing price for the period was less than the opening price; hence, it is bearish and indicates selling pressure. Meanwhile, a white or hollow candlestick means that the closing price was greater than the opening price. This is bullish and shows buying pressure. The lines at both ends of a candlestick are called shadows, and they show the entire range of price action for the day, from low to high. The upper shadow shows the stock’s highest price for the day, and the lower shadow shows the lowest price for the day.
Bullish Candlestick Patterns
Over time, groups of daily candlesticks fall into recognizable patterns with descriptive names like three white soldiers, dark cloud cover, hammer, morning star, and abandoned baby, to name just a few. Patterns form over a period of one to four weeks and are a source of valuable insight into a stock’s future price action. Before we delve into individual bullish candlestick patterns, note the following two principles:
- Bullish reversal patterns should form within a downtrend. Otherwise, it’s not a bullish pattern, but a continuation pattern.
- Most bullish reversal patterns require bullish confirmation. In other words, they must be followed by an upside price move which can come as a long hollow candlestick or a gap up and be accompanied by high trading volume. This confirmation should be observed within three days of the pattern.
The bullish reversal patterns can further be confirmed through other means of traditional technical analysis—like trend lines, momentum, oscillators, or volume indicators—to reaffirm buying pressure. There are a great many candlestick patterns that indicate an opportunity to buy. We will focus on five bullish candlestick patterns that give the strongest reversal signal.
1. The Hammer or the Inverted Hammer
The Hammer is a bullish reversal pattern, which signals that a stock is nearing bottom in a downtrend. The body of the candle is short with a longer lower shadow which is a sign of sellers driving prices lower during the trading session, only to be followed by strong buying pressure to end the session on a higher close. Before we jump in on the bullish reversal action, however, we must confirm the upward trend by watching it closely for the next few days. The reversal must also be validated through the rise in the trading volume.
The Inverted Hammer also forms in a downtrend and represents a likely trend reversal or support. It’s identical to the Hammer except for the longer upper shadow, which indicates buying pressure after the opening price, followed by considerable selling pressure, which however wasn’t enough to bring the price down below its opening value. Again, bullish confirmation is required, and it can come in the form of a long hollow candlestick or a gap up, accompanied by a heavy trading volume.
2. The Bullish Engulfing
The Bullish Engulfing pattern is a two-candle reversal pattern. The second candle completely ‘engulfs’ the real body of the first one, without regard to the length of the tail shadows. The Bullish Engulfing pattern appears in a downtrend and is a combination of one dark candle followed by a larger hollow candle. On the second day of the pattern, price opens lower than the previous low, yet buying pressure pushes the price up to a higher level than the previous high, culminating in an obvious win for the buyers. It is advisable to enter a long position when the price moves higher than the high of the second engulfing candle—in other words when the downtrend reversal is confirmed.
3. The Piercing Line
Similar to the engulfing pattern, the Piercing Line is a two-candle bullish reversal pattern, also occurring in downtrends. The first long black candle is followed by a white candle that opens lower than the previous close. Soon thereafter, the buying pressure pushes the price up halfway or more (preferably two-thirds of the way) into the real body of the black candle.
4. The Morning Star
As the name indicates, the Morning Star is a sign of hope and a new beginning in a gloomy downtrend. The pattern consists of three candles: one short-bodied candle (called a doji or a spinning top) between a preceding long black candle and a succeeding long white one. The color of the real body of the short candle can be either white or black, and there is no overlap between its body and that of the black candle before. It shows that the selling pressure that was there the day before is now subsiding. The third white candle overlaps with the body of the black candle and shows a renewed buyer pressure and a start of a bullish reversal, especially if confirmed by the higher volume.
5. The Three White Soldiers
This pattern is usually observed after a period of downtrend or in price consolidation. It consists of three long white candles that close progressively higher on each subsequent trading day. Each candle opens higher than the previous open and closes near the high of the day, showing a steady advance of buying pressure. Investors should exercise caution when white candles appear to be too long as that may attract short sellers and push the price of the stock further down.
The chart below for Enbridge, Inc. (ENB) shows three of the bullish reversal patterns discussed above: the Inverted Hammer, the Piercing Line, and the Hammer.
The chart for Pacific DataVision, Inc. (PDVW) shows the Three White Soldiers pattern. Note how the reversal in downtrend is confirmed by the sharp increase in the trading volume.
The Bottom Line
Investors should use candlestick charts like any other technical analysis tool (i.e., to study the psychology of market participants in the context of stock trading). They provide an extra layer of analysis on top of the fundamental analysis that forms the basis for trading decisions.
We looked at five of the more popular candlestick chart patterns that signal buying opportunities. They can help identify a change in trader sentiment where buyer pressure overcomes seller pressure. Such a downtrend reversal can be accompanied by a potential for long gains. That said, the patterns themselves do not guarantee that the trend will reverse. Investors should always confirm reversal by the subsequent price action before initiating a trade.
While there are some ways to predict markets, technical analysis is not always a perfect indication of performance. Either way, to invest you’ll need a broker account. You can check out Investopedia’s list of the best online stock brokers to get an idea of the top choices in the industry.
16 candlestick patterns every trader should know
Candlestick patterns are used to predict the future direction of price movement. Discover 16 of the most common candlestick patterns and how you can use them to identify trading opportunities.
What is a candlestick?
A candlestick is a way of displaying information about an asset’s price movement. Candlestick charts are one of the most popular components of technical analysis, enabling traders to interpret price information quickly and from just a few price bars.
This article focuses on a daily chart, wherein each candlestick details a single day’s trading. It has three basic features:
- The body, which represents the open-to-close range
- The wick, or shadow, that indicates the intra-day high and low
- The color, which reveals the direction of market movement – a green (or white) body indicates a price increase, while a red (or black) body shows a price decrease
Over time, individual candlesticks form patterns that traders can use to recognise major support and resistance levels. There are a great many candlestick patterns that indicate an opportunity within a market – some provide insight into the balance between buying and selling pressures, while others identify continuation patterns or market indecision.
Before you start trading, it’s important to familiarise yourself with the basics of candlestick patterns and how they can inform your decisions.
Six bullish candlestick patterns
Bullish patterns may form after a market downtrend, and signal a reversal of price movement. They are an indicator for traders to consider opening a long position to profit from any upward trajectory.
The hammer candlestick pattern is formed of a short body with a long lower wick, and is found at the bottom of a downward trend.
A hammer shows that although there were selling pressures during the day, ultimately a strong buying pressure drove the price back up. The colour of the body can vary, but green hammers indicate a stronger bull market than red hammers.
A similarly bullish pattern is the inverted hammer. The only difference being that the upper wick is long, while the lower wick is short.
It indicates a buying pressure, followed by a selling pressure that was not strong enough to drive the market price down. The inverse hammer suggests that buyers will soon have control of the market.
The bullish engulfing pattern is formed of two candlesticks. The first candle is a short red body that is completely engulfed by a larger green candle.
Though the second day opens lower than the first, the bullish market pushes the price up, culminating in an obvious win for buyers.
The piercing line is also a two-stick pattern, made up of a long red candle, followed by a long green candle.
There is usually a significant gap down between the first candlestick’s closing price, and the green candlestick’s opening. It indicates a strong buying pressure, as the price is pushed up to or above the mid-price of the previous day.
The morning star candlestick pattern is considered a sign of hope in a bleak market downtrend. It is a three-stick pattern: one short-bodied candle between a long red and a long green. Traditionally, the ‘star’ will have no overlap with the longer bodies, as the market gaps both on open and close.
It signals that the selling pressure of the first day is subsiding, and a bull market is on the horizon.
Three white soldiers
The three white soldiers pattern occurs over three days. It consists of consecutive long green (or white) candles with small wicks, which open and close progressively higher than the previous day.
It is a very strong bullish signal that occurs after a downtrend, and shows a steady advance of buying pressure.
Six bearish candlestick patterns
Bearish candlestick patterns usually form after an uptrend, and signal a point of resistance. Heavy pessimism about the market price often causes traders to close their long positions, and open a short position to take advantage of the falling price.
The hanging man is the bearish equivalent of a hammer; it has the same shape but forms at the end of an uptrend.
It indicates that there was a significant sell-off during the day, but that buyers were able to push the price up again. The large sell-off is often seen as an indication that the bulls are losing control of the market.
The shooting star is the same shape as the inverted hammer, but is formed in an uptrend: it has a small lower body, and a long upper wick.
Usually, the market will gap slightly higher on opening and rally to an intra-day high before closing at a price just above the open – like a star falling to the ground.
A bearish engulfing pattern occurs at the end of an uptrend. The first candle has a small green body that is engulfed by a subsequent long red candle.
It signifies a peak or slowdown of price movement, and is a sign of an impending market downturn. The lower the second candle goes, the more significant the trend is likely to be.
The evening star is a three-candlestick pattern that is the equivalent of the bullish morning star. It is formed of a short candle sandwiched between a long green candle and a large red candlestick.
It indicates the reversal of an uptrend, and is particularly strong when the third candlestick erases the gains of the first candle.
Three black crows
The three black crows candlestick pattern comprises of three consecutive long red candles with short or non-existent wicks. Each session opens at a similar price to the previous day, but selling pressures push the price lower and lower with each close.
Traders interpret this pattern as the start of a bearish downtrend, as the sellers have overtaken the buyers during three successive trading days.
Dark cloud cover
The dark cloud cover candlestick pattern indicates a bearish reversal – a black cloud over the previous day’s optimism. It comprises two candlesticks: a red candlestick which opens above the previous green body, and closes below its midpoint.
It signals that the bears have taken over the session, pushing the price sharply lower. If the wicks of the candles are short it suggests that the downtrend was extremely decisive.
Four continuation candlestick patterns
If a candlestick pattern doesn’t indicate a change in market direction, it is what is known as a continuation pattern. These can help traders to identify a period of rest in the market, when there is market indecision or neutral price movement.
When a market’s open and close are almost at the same price point, the candlestick resembles a cross or plus sign – traders should look out for a short to non-existent body, with wicks of varying length.
This doji’s pattern conveys a struggle between buyers and sellers that results in no net gain for either side. Alone a doji is neutral signal, but it can be found in reversal patterns such as the bullish morning star and bearish evening star.
The spinning top candlestick pattern has a short body centred between wicks of equal length. The pattern indicates indecision in the market, resulting in no meaningful change in price: the bulls sent the price higher, while the bears pushed it low again. Spinning tops are often interpreted as a period of consolidation, or rest, following a significant uptrend or downtrend.
On its own the spinning top is a relatively benign signal, but they can be interpreted as a sign of things to come as it signifies that the current market pressure is losing control.
Falling three methods
Three-method formation patterns are used to predict the continuation of a current trend, be it bearish or bullish.
The bearish pattern is called the ‘falling three methods’. It is formed of a long red body, followed by three small green bodies, and another red body – the green candles are all contained within the range of the bearish bodies. It shows traders that the bulls do not have enough strength to reverse the trend.
Rising three methods
The opposite is true for the bullish pattern, called the ‘rising three methods’ candlestick pattern. It comprises of three short reds sandwiched within the range of two long greens. The pattern shows traders that, despite some selling pressure, buyers are retaining control of the market.
Practise reading candlestick patterns
The best way to learn to read candlestick patterns is to practise entering and exiting trades from the signals they give. You can open an IG forex account and start to trade. If you don’t feel ready to trade on live markets, you can develop your skills in a risk-free environment by opening an IG demo account.
When using any candlestick pattern, it is important to remember that although they are great for quickly predicting trends, they should be used alongside other forms of technical analysis to confirm the overall trend.
The Engulfing Candle Day-Trading Strategy
Trading with the trend is one of the most advantageous things a trader learns to do. Using an engulfing candle day-trading strategy for stocks, currencies, or futures is one way to get into trending moves just as momentum is picking up.
In a candlestick price chart, the wide parts of candlesticks are called “real bodies.” In a down or bearish candle, the top marks the opening price and the bottom marks the closing price for the period you’re observing. The real body of a down candle is often black or red in color. In an up or bullish candle, the top marks the closing price and the bottom marks the opening price. The real body of an up candle is often white or green. The high and low prices for the period may be indicated by thin lines that look like wicks of the candle and that extend beyond the real body.
A bearish engulfing candle occurs when the real body of a down candle completely envelops the real body of the prior up candle. A bullish engulfing candle occurs when the real body of an up candle completely envelops the real body of the prior down candle.
These engulfing candles indicate a strong shift in direction, and when combined with observation of the price-trending direction that precedes it, this shift creates the opportunity for a trading strategy.
Isolate the Trend
The first step in applying the engulfing candle day-trading strategy is to determine the dominant trend direction, and thus the direction you will trade-in.
An uptrend is defined by higher-swinging highs and higher-swinging lows in price. Prices move in waves, advancing, pulling back, and then advancing again. In an uptrend, the advancing waves are larger than the pullbacks lower, creating overall progress higher. During an uptrend, you should take only long positions, buying with the intention of selling later at a higher price.
A downtrend is defined by lower-swinging lows and lower-swinging highs in price. In a downtrend, the declining waves are larger than the pullbacks higher, creating overall progress lower. During a downtrend, you should take only short positions, selling a borrowed asset with the intention of buying and returning it later at a lower price.
Watch for an Upward or Downward Pullback
Once the trend is established, wait for a pullback. If there is no trend, or it is unclear, don’t utilize this strategy.
Waiting for a pullback means you’re getting advantageous pricing for the next wave of the trend when—and if—it unfolds.
If the trend is down, watch for an upward pullback. The pullback should not rally above the high of the prior pullback, as this violates the rules of a downtrend.
If the trend is up, watch for a downward pullback. The pullback should not drop below the low of the prior pullback, as this violates the rules of an uptrend.
A pullback should be composed of at least two price movements, indicating the price has actually corrected. Pullbacks may move in the opposite direction of the trend or may just move sideways.
Entering the Trade
With the trend isolated and a pullback occurring, wait for the engulfing candle strategy trade signal.
During a downtrend, wait until a down candle engulfs an up candle. Enter a short trade as soon as the down candle moves below the opening price (the bottom of the real body) of the up candle in real-time. There is no need to wait for the candle to be completed.
For an engulfing candle strategy signal during an uptrend, wait until an up candle engulfs a down candle. Enter a long trade as soon as the up candle moves above the opening price (the top of the real body) of the down candle in real-time.
Once a trade is initiated using the engulfing candle strategy, place a stop loss above the recent high for short positions, and below the recent low for long positions.
Exiting the Trade
The engulfing candle that occurs after a pullback in an overall trend is designed to get you into a trade as the next wave of the trend is likely to unfold. (It doesn’t always.) Trends can persist for a long time or can fail quickly. Therefore, this method does not have a specific exit.
A rule of thumb is to make sure your winners are at least one-and-one-half times as big as your losers; two times bigger is even better. Therefore, measure the distance between your entry point and where you placed the stop loss. For example, if it is 30 cents, that is your risk. Your target price should be at least one-and-one-half times greater than that, or 45 cents. Therefore, hold the trade for at least a 45-cent gain to compensate yourself for the risk you’ve taken.
If the trend threatens to reverse—by making a higher high and higher low (not necessarily in that order) during a downtrend and short trade or by making a lower high and lower low during an uptrend and long trade—exit the trade.
If you’re trading using a short time frame, such as a one-minute or, say, a 30-tick chart, be “quick on the draw.” (A tick chart is based on the number of transactions rather than on time.) If an engulfing candle signal is potentially imminent, plan where you’ll place your stop and then quickly calculate what your minimum target price for the trade is.
Engulfing patterns won’t occur after every pullback, which means potentially missed opportunities. To help avoid this, consider allowing multiple candles to create an engulfing pattern. For example, if after a pullback in an uptrend, it takes two up candles to engulf the prior down candle, consider this a valid signal of a shift in momentum back in the trending direction.
An engulfing candle strategy signal doesn’t mean the trend will always resume. That is why a stop loss is mandatory.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
8 Candlestick Trading Strategies for Forex
8 Candlestick Trading Strategies for Forex
When it comes to trading price actions, finding opportunities in the market by looking for candlestick patterns is one of the best ways to go about it. Candlesticks represent price and they show all data points at one glance. Candlestick trading strategies involve determining the timing of market entry based on high probability patterns and managing the trade according to some predetermined rules that conform to your money management policy.
Since Japanese rice traders developed the Candlestick by incorporating open, high, low and closing prices, traders have identified a number of patterns that offer high probability trading opportunities. Candlestick patterns come in different sizes and shapes. There are single period candlestick patterns like the pin bars, but also, you can find patterns that involve more than two bars, like the Three White Soldiers.
However, not all patterns offer the best win rate in Forex. We have identified eight major candlestick patterns that actually work in Forex. LetвЂ™s take a look at how you can benefit from identifying these patterns and develop trading strategies around them.
The 8 Candlestick Trading Strategies
#1: Pin Bar Reversals Patterns
Pin bars are the most effective ways to trade candlesticks as these formations tend to create high probability price action trading setups. A pin bar forms when the price goes up or down during a single time period, but the closing price remains within the previous bar.
Figure 1: Pin Bar Trading Strategy
In Figure 1, we have identified two pin bars, a bullish one and a bearish one. The way you trade pin bars is you wait for the assetвЂ™s price to break above or below the high or low, respectively. At that point, you enter the market.
Pinbar setups are triggered once the price of the next candlestick breaks above the body of the pinbar. Once your order is triggered, you can look for next support and resistance levels to find your primary profit target. If you are a short-term trader, you can simply target a reward to risk ratio of 3:1 or any other ratio that suits you.
However, when you find pin bars forming at the extreme high or low of a sustained trend, it would signal a complete reversal of the prevailing trend. Hence, trailing your open position based on ATR or X-bar stop losses could be a good strategy as it would maximize your profit in the long-run.
#2: Bullish and Bearish Engulfing Patterns
Just like pin bars, bullish and bearish engulfing candlestick patterns also signal a reversal of the prevailing trend. In the western trading industry, these patterns are better known as Bullish Outside Bars (BUOB) and Bearish Outside Bars (BEOB). If you see a bar has higher highs and higher lows compared to the previous bar, it is an outside bar. If the closing price is lower than the opening price, then it is a BEOB and if the closing price is higher than the opening price, you guessed it right, it is a BUOB.
Figure 2: Bearish Outside Bar Triggered Downtrend
In figure 2, we can see a large bearish candlestick has engulfed the previous, smaller, bullish candlestick. By definition, it is a Bearish Outside Bar (BEOB). If you have placed a sell stop order few pips below the low of the BEOB candlestick and targeted the next pivot zone, it would have turned out to be a winning trade with a decent reward to risk ratio.
While it is best to look for Engulfing candlestick patterns at the top or bottom of a trend for reversal signals, you can also trade these during a more range-bound market. Engulfing candlesticks often breaks above or below a range and you can catch some nice breakout trades with these patterns.
Since Engulfing candles are usually longer than pin bars, the size of your stop loss needs to be rather high. One way to mitigate this problem is by drawing Fibonacci retracements based on the high and low of the engulfing bar itself and setting a stop loss at a certain Fibonacci level.
#3: Inside Bars For Reversals and Continuations
Most candlestick trading strategies are either suited for trend reversal or trend continuation. However, inside bars are those rare gems that can signal both, depending on where in the chart they form. An inside bar is like the opposite of an engulfing bar. Its high and low are shorter than the previous bar and it sits inside the previous barвЂ™s high and low.
However, keep in mind that trading these means you need to wait for the assetвЂ™s price to break above or below the high or low of the previous (longer) barвЂ™s high and low, respectively.
Figure 3: Inside bars Can Signal Both Reversal and Trend Continuation
In figure 3, we can see that after the large bullish bar, two smaller bars formed within the high and low of the previous large bar. Inside bars like these can range from a single bar to several and it really does not matter if these inside bars are bullish or bearish. As long as these smaller bars do not cross the high or low of the larger bar, this would be considered as a valid inside bar pattern.
Once you see price breaking above the high of the larger bar, which is often called a Mother bar, it would signal a start of a momentum trade. In figure 3, the break above the high of the mother bar triggered a bullish trend.
However, if you find these inside bar patterns during a strong trend, it can also signal trend continuation. In either case, you should set your stop loss above or below the mother bar. If your money management strategy requires a smaller stop loss, aggressively setting the stop loss above or below the range of inside bars can also be a good strategy. However, it is rather risky and if you are a beginner trader, sticking to set stop loss around the mother bar would be preferable.
#4: Doji Bars Signal Indecision
A Doji is formed when the opening and closing prices are almost the same. Well, the official definition is that both the opening and closing price has to be the same. However, the difference can be a pip or two, but no more, and you can still consider it as a Doji.
There are several variants of Doji based on which way the price moved first then reversed. For example, if the high and low are situated at equal distance from the open and closing prices, it is called a Star Doji. If the price goes up and down but returns to close at the opening price, it will be considered as Gravestone and Dragonfly Doji, respectively. These two patterns look like the letter T and an inverse letter T and considered bullish and bearish signals.
When you see a Doji formation, it screams indecision in the market. But you should also consider the location of the Doji bar. If a Doji forms during a strong trend, it can signal trend continuation if the price breaks above the Doji.
Figure 4: Doji Signals Indecision, but You Should Focus on Which Way It Breaks
In figure 4, a Doji formed during an uptrend and signaled temporary equilibrium in the market. However, as soon as the assetвЂ™s price broke above the high of the Doji, the uptrend continued.
If you have placed a buy stop order a few pips above the high of the Doji Sar bar, you could have increased your long exposure or entered the market for the first time. Regardless, since Doji bars are rather small in size, you can always get away with setting a tight stop loss and maximize your reward to risk ratios.
#5: Three Bar Reversal Patterns
Three bars are the easiest candlestick patterns to identify. There are two types of three bars, the Three White Soldiers that signal a bullish reversal and Three Black Crows that signals a bearish reversal.
As the name suggests, when three subsequent bullish and bearish bars form at the top or bottom of a sustained trend, these signals a reversal.
Figure 5: Three White Crows Triggered a Bearish Trend
In figure 5, we can see three rather decent looking bearish bars formed at the top of an uptrend. Keep in mind that the first bearish barвЂ™s high was not the highest peak in the trend and that is fine. As long as the three bearish bars form near the top of a bullish trend, it should be considered as a Three Black Crows pattern.
As you can see, once the assetвЂ™s price broke below the low of the lowest bearish bar, the downturn continued. Sometimes, after the low is broken, the price may retrace a bit but that is fine. You should set your stop loss above the high of the highest Crow.
The same principle can be applied to Three White Soldiers, which is a bullish signal pattern.
#6: Hanging Man Signals Bearish Reversal
A hanging man pattern forms when there is a large bearish movement, but the price ends up closing near the opening price, leaving a long shadow that is usually twice the size of the body of the Candle. Hanging man looks a bullish pin bar but usually forms at the top of an uptrend, often with a gap. But it is fine if there is no gap.
Keep in mind that Hanging Man patterns should be always considered as a bearish signal and you should not place a bullish order if the price breaks on the upside. Nonetheless, there is a similar-looking pattern that forms at the bottom of downtrend, which is called a Hammer and that signals bullishness in the market.
Figure 6: Hanging Man Triggers Bearish Trade
In figure 6, we can see a hanging man candlestick pattern forming and as soon as the low of the bar is broken, it triggers a bearish trend that lasted for several bars. Here, you should set a stop loss just above the high of the Hanging Man pattern.
#7: Rising and Falling Three Methods
The Three methods of candlestick trading strategy is a bit tricky. Tricky in a sense that the rising three method pattern has three smaller bearish candlesticks after forming a large bullish candlestick. By contrast, the falling three method pattern incorporates three smaller bullish candlesticks after a large bearish candlestick is formed.
For the rising three method pattern to form, a large bullish bar has to appear, followed by three smaller bearish candlesticks that remain above the low of the first large bullish candlestick. Then, a fifth bullish candlestick must form that breaks above the high of the first bullish candlestick and closes above it. Pretty complicated when you read it, but letвЂ™s take a look at an example chart and it should be pretty clear.
Figure 7: Rising Three Method Trend Continuation Signal
In figure 7, we can see a large bullish candlestick and three smaller bearish ones. The fifth bullish candlestick engulfed the three bearish candlesticks and closed above the high of the first candlestick, completing the rising three method pattern.
The best way to trade these patterns would be to wait for the close of the fifth candlestick, then enter with a market order. Aggressive traders may set a stop loss below the low of the third bearish bar and more conservative traders may choose to put a large stop loss below the low of the first bullish candlestick.
For falling three method patterns, you can trade similarly on the opposite side.
#8: Harami Cross As Reversal Signal
The Harami Cross pattern consists of a bullish or bearish candlestick at the top or bottom of its trend, followed by a Doji that remains within the range of the previous candlestick. If a bullish candlestick form, then you see a Doji that sits inside high and low like an inside bar, you can expect a bearish retracement soon.
Figure 8: Harami Cross Signals Bearishness
In figure 8, we can see a Harami cross, forming at the top of a bullish trend. However, you should wait for the assetвЂ™s price to break below the low of the bullish candlestick and the best way to do so would be placing a Sell Stop order a few pips below the low.
The Bottom Line
Candlestick pattern-based strategies are easy to trade as most of the time you just need to wait for the pattern to form and place a buy or sell stop entry order above or below the candlesticks. This way, you enter the market right when the trade confirmation happens.
While entering the market with the candlestick strategies we discussed would be easy, to successfully implement these strategies would require prudent money management as well as how and when you decide to exit.
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