Top 10 Candlestick Patterns Every Trader Should Know
Candlesticks charts have become the gold standard across the trading world: from #coffeefutures to #bitcoin, these funky little charts are used to display the day’s price action in easy-to-read visual fashion. Since these charts display so much information on price action, they are prized by technical analysts who specialize in predicting future prices based on reading of past prices.
In this article we cover 10 of the most commonly used #candlestick patterns and what they mean for price.
Basics
Each candlestick represents the day’s price action: the high, low, open and close prices of a specific security. Much like other patters in the #technicalanalysis playbook, they produce #patterns and signals that indicate continuation or reversals in #trends.
In my course, I teach that technical analysis is really about trying to interpret crowd #psychology. So when we look at candlesticks, we want to be thinking about what the pattern says about the crowd’s mentality, rather than as a tarot card that predicts the future.
Although these patterns only give “indications” of the future rather than “guaranteed” predictions, they are a great way to look at the psychology of the market participants. Therefore even if you trade fundamentals, candlestick patterns (like other forms of technical analysis) are useful for interpreting current market sentiment.
Trend
In general, technical analysis is based on the idea that markets tend to reprice in trends. Trends are defined by their tendency toward directional price, but lack of uniformity. In other words, prices are generally moving in one direction (for example higher prices), but occasionally moving in the opposite direction. For example in an “uptrend”, prices are mostly moving higher, but occasionally moving lower.
When looking at trends in prices, we are ultimately talking about people trading in the market. People are the ones who make the decisions to buy or sell. An uptrend is characterized by traders who generally agreeing as a group that prices should be higher. This is why I believe that trend following is closely related to crowd psychology.
Slide from Technical Analysis Presentation in Coffee Trader's Course
The challenge when trying to predict the crowd’s behavior is the lack of consistency on any given day. Somedays the market is up, somedays it is down.
This lack of consistency in price direction is what makes trend changes hard to detect. How do we know that the price has changed trend, vs simply having a small counter trend correction?
One way to answer this is with reversal patterns.
Reversal patterns give some indication that prices are changing direction, and not merely having a counter-trend correction. With reversal patterns, we are trying to extrapolate an early warning sign in crowd behavior.
All of the candlestick patterns listed below here are reversal patterns that aim to forecast a change in market sentiment, and therefore trend. Whenever looking at a candlestick pattern (or any other technical analysis pattern), I always teach that it is important to consider what is the underlying psychology that we are trying to identify.
1: "Hammer" / “Shooting Star”
The hammer is a bullish reversal pattern that occurs at end of a price decline and indicates a price reversal to the upside. The candle has a small body and long lower shadow. The long shadow and short body is a result of selling pressure followed by buying that return price near the opening level.
The crowd psychology at play here is we are observing a shift in sentiment from an agreement that prices should be lower, to a new agreement that prices should be higher. This indicates a capitulation of sorts, the market has run out of sellers interested in selling lower and is now dominated by bullish buyers.
In order for this pattern to be recognized, the lower shadow should be at least twice the size of the candlestick’s body. Confirmation can be seen in the following candles, in case prices start rising.
The opposite of the hammer pattern is the shooting star which occurs at the end of an uptrend.
2: "Morning Star" / “Evening Star”
The Morning Star is a bullish reversal pattern made up of three candlesticks. It indicates the end of a downtrend and start of an uptrend. The opposite is the "Evening Star", which signals a bearish reversal.
The pattern is formed in this order:
1) tall red candle
2) “doji” (very small green or red resembling a “spinning top”) candle
3) tall green candle that indicates buying pressure pushing for upside reversal.
The middle candle displays the uncertainty and lack of faith in the current price direction. At this point momentum shifts and the bulls start to dominate the crowd.
The 2nd (middle) candlestick has to be the lowest of the three, and therefore this pattern can only be seen when the 3rd session is closed.
The opposite would be true of the “evening star”. So it would be a tall green candle followed by a doji and a tall red candle with the doji being the highest of the three.
3: "Three Black Crows" / “Three White Soldiers”
Three black crows is a bearish reversal pattern made up of three red candlesticks. It indicates the end of an uptrend and start of a downtrend. The opposite is the "Three White Soldiers", which signals a bullish reversal and is made up by three red candlesticks.
Volume can provide extra help on checking the accuracy of this pattern. Usually, the uptrend leading up to the “three black crows” is relatively low when compared to the volume during the 3 sessions, which is indicative of a superior group of bears taking control of price action.
All 3 candlesticks should be long bodied with short shadows or no shadows at all. Each candle has its close below the last one when it’s “three black crows” while each candle close above the last one when it’s "Three White Soldiers".
4: "Bullish Engulfing" / “Bearish Engulfing”
This simple upside reversal pattern is made up of two candlesticks. The first candle is red (often preceded by other red candles) and second is long green candle that entirely engulfs the first.
The psychology here is that we see a trend shift in crowd thinking. A full day’s bearish trading is completely overshadowed by a new day’s bullish trading.
The bullish engulfing pattern is seen at the end of a downside price movement while the bearish engulfing comes at the end of upward trends.
The opposite of this is the "Bearish Engulfing" pattern.
5: "Bullish Harami" / “Bearish Harami”
This upside reversal pattern comes at the end of bear trends and is made up of 2 candlesticks. The first candle is a tall red one and it is followed by a small green candle which should be well inside the range of the first one.
Here the market is opening well above the close of the previous day, and while it is not rallying much, the higher prices are failing to attract any new sellers from the crowd indicating a lack of selling sentiment.
The opposite of this pattern is the "Bearish Harami" which signals bearish reversal.
6: “Abandoned Baby”
The Abandoned Baby is a variation of the doji star pattern.
As with the Doji Star, the Abandoned Baby is a reversal pattern that is characterized by a Doji in the direction of the trend outside of the previous day's range, however this pattern has a gap between the doji and the previous down day and next up day.
The psychology we are observing here is that the gapped doji start here represents an over reach of sentiment. The doji gaps open indicating the last, most desperate traders, and fails to continue the momentum. The market then gaps in the opposite direction indicating a dramatic shift in sentiment.
The name is the same for the Abandoned Baby, but the direction is indicated with the bullish or bearish prefix, ie “Bullish Abandoned Baby “Evening Star counterpart” is called an “Abandoned Baby” and happens after a drawdown in prices, despite the downer of a name, this is a bullish pattern.
7: "Three Outside Up" / “Three Outside Down”
This is a pattern formed after a bear trend, indicating an upside reversal. It consists of three candlesticks: the first is a short bearish candle, the second candlestick is a large bullish candle which covers the previous and the third candle confirms the trend with a positive close above the second.
The psychology at play here is a short bearish candle indicates waning bearish momentum, with the second bullish candle indicating a weak continuation of the bear trend with an opening lower, this confirms a shift in crowd sentiment on the third day with a full bullish candle.
The opposite is the Three Outside Down, which follows the inverse dynamic and signals a bearish reversal after an uptrend.
See both visual patterns displayed in a USD/BRL chart below.
8: "Three Inside Down" / “Three Inside Up”
This is a downside reversal pattern made up of three candlesticks. The first one is a tall green candle, followed by a smaller red candle contained completely within the body of the first and followed by another red candle closing below the previous one.
At first glance, this might appear to be the inverse of the “outside up” formation, but it is telling an entirely different story. The first bullish candle is showing “just a normal” in a bull market, but the second inside candle is indicating a surprise…the market opens lower than the previous day.
Instead of continuing the bullish trend this candle indicates a day of trading with little conviction in the uptrend but still fearful of trading much lower. The final candle shows the bears gaining confidence and selling the market lower with little resistance from the bulls…hence a shift in market sentiment.
The opposite pattern is the "Three Inside Up" which signals a bullish reversal.
9: "Inverted Hammer"/ “Hanging Man”
The inverted hammer is a bullish reversal pattern that appears at the tail-end of a downtrend. It consists of a short body with long upper shadow that extends upward. It is confirmed with a green candle.
The psychology at play here is a down trend that fails to make very deep new lows. On the contrary, the market actually rises forming the upper shadow. Even though the market ends up retracing most of this rally, the crowd psychology is shaken by this rally. A strong close the next day indicates the sentiment shift is complete.
10: “Piercing Line" / “Dark Cloud Cover”
This is a bullish reversal pattern made up of a long red candle followed by a green candle closes at least 50% higher than the first negative candle.
The opposite pattern is the Dark Cloud Cover, which suggests a bearish reversal.
The psychology here is of a selloff that’s substituted with buying pressure, starting from about the same level, which is enough to undo more than half of the previous losses. Even though it’s not as big a rally as the selloff, the fact that this close is against the momentum (previous downtrend) suggests this could be a trend shift.
Conclusions
Candlestick patterns can be great tools to help analyze the market, since they highlight the crowd psychology behind price movement. Although technical patterns of any kind are indicative rather than a 100% guarantee, they are useful for highlighting potential shifts in sentiment.
Additionally, spec buying and selling activity can have a high correlation with price movement and candlestick patterns are very popular. Therefore even traders that only trade on fundamentals can benefit from understanding signals that are influencing specs.