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.
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.
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.