Candlestick reversal patterns

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Candlestick charts produce effective reversal signals on a daily and intraday basis. Reversal patterns provide two-sided clues: what to do and what not to do or selection and negative selection.

The reversal patterns imply that a trend has run its course. Trends can and do turn around quickly. However, the goal of astute day traders should be to seize the middle of the move, not the top or bottom. Always wait for prices to confirm that the reversal pattern was authentic. The short-term risk of waiting for this confirmation is that you'll miss the top or bottom part of a trend. This part of the trend has the highest risk. When you stick to trading the middle of the move, your risk profile is lowered.

You'll know that a pattern is confirmed if prices follow in the direction of the reversal. As a day trading entry rule, when prices move above the high price of the bullish reversal pattern, use that as a signal to go long, using 1/8 of a point below the low of the pattern as a stop-loss point. When prices move below the low for bearish reversal patterns, use that as a signal to go short, using 1/8 of a point above the high of the pattern as a stop-loss point.

For example, suppose you spot a hammer, which is a bullish reversal pattern that occurs at the bottom of a downtrend. If the hammer was formed on day 1, with a high price of 21 and a low price of 20, on day 2 you should wait for the price to move above 21 before initiating a long. Once the long is initiated, your initial stop-loss should be placed 1 /8 of a point below the low point of the hammer on day 1, or at 19%.

A danger when trading based on reversal patterns is the temptation to anticipate a change in the trend without waiting for confirmation. This is the equivalent of bottom or top fishing and should be avoided. It is more prudent to use the reversal pattern to take profits from an existing position if there is no confirmation. For example, if you are short 10,000 shares of an NDX stock and the NDX sector puts in an intraday hammer on the 15-minute chart, use that as a sign to cut your short position in half rather than to go long. If prices close above the intraday hammer and your other entry criteria are met, then go long. Remember to wait for confirmation before initiating trades based on reversal patterns. Confirmation means price action taking place above a bullish pattern or below a bearish pattern.

You will increase your risk-reward ratio when you check the intraday sector action with candlesticks before you trade. You will lose less because you will refrain from trading against the odds by going long against bearish reversal patterns, or by going short against bullish reversal patterns. This is negative selection. Develop the habit of watching the NDX 100 and the SPX on intraday candlestick charts. This practice will almost immediately increase your effectiveness as a day trader, because you will have a better view of the mood of the market knowing where your risk-reward is the greatest.

The intraday 15-minute NDX chart in Figure 14-2 shows a bullish reversal pattern. On December 1,1999, the NDX formed a triple bottom accompanied by three bullish candlestick reversal patterns: a morning star, a bullish engulfing pattern, and a hammer.

Figures 14-3 through 14-15 depict the candlestick patterns described here.

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Figure 14-3 Abandoned Baby

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Figure 14-4 Dojis

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Figure 14-5 Engulfing Patterns

Abandoned baby—This is the most powerful variation of the morning or evening star patterns. It occurs when the second day of the pattern is a doji or small body that has gapped away from both bodies; thus, it's abandoned. The gap that the small body has formed is closed by the third part of the pattern, which is a long body. This gap or window in candlestick terms indicates important resistance or support.

Doji—Dojis are reversal patterns that represent an equal tug of war between the bulls and the bears. A doji is formed when the opening and closing prices are the same. The wicks outside of the opening and close could vary in size, ranging from very long to nonexistent. The doji reversal signal is most effective when it is formed near the top or bottom of a trend. Dragonfly doji—This doji has a long lower wick with the opening and close at the top of the formation. This is a bullish reversal pattern when formed at the bottom of a move and is similar to a hammer. When formed at the top of a move, it is bearish and is similar to a hangman.

Gravestone doji—This pattern is the opposite of a dragonfly doji. It has a long upper wick with the opening and close at the low price of the day. The gravestone doji is a bearish pattern when formed at the top of a move, especially after a breakout, similar to a shooting star. If the pattern is formed at the bottom of a move, it is similar to an inverted hammer and is bullish. Engulfing patterns—An engulfing pattern is a reversal pattern that is formed at the bottom of a downtrend or at the top of an uptrend. An engulfing pattern occurs when the current day's body engulfs the previous day's body. When this occurs, the opening and close must be wider than the previous day's opening and close.

Bullish engulfing—This pattern forms when a large white body engulfs a black body at the bottom of a downtrend. The low point of the white engulfing candle becomes the new price support.

Bearish engulfing—This pattern forms when a large black body engulfs a white body at the top of an uptrend. The high point of the black engulfing candle becomes the new price resistance.

Hammer—A hammer is a bullish reversal pattern that is formed at the bottom of a downtrend. The name comes from the concept of hammering out the bottom of a move. Hammers have a long lower wick with a small upper body. The wick should be at least two to three times the size of the body. The body can be any color. The hammer is a powerful and popular reversal pattern. The chart of Microsoft (MSFT) in Figure 14-6a shows the stock putting in a daily hammer on the last trading day of January, at an area of support. MSFT rallied powerfully after the hammer was put in. Inverted hammer—This formation is a hammer turned upside down at the bottom of a downtrend. It has a long upper wick that is two to three times the size of the small lower body. It is an excellent reversal indicator, and is especially useful in intraday charting. The inverted hammer looks like a shooting star at the bottom of a downtrend. It represents that the bears lost the battle to the bulls early in the session, and only through a last-ditch effort were they able to force prices down again. Hangman—A hangman is a bearish pattern that is formed at the top of a move. It has the same look and feel as a hammer, except that it's at the top of an uptrend. Hangman patterns have small upper bodies with long lower wicks that are at least two to three times the size of the bodies.

A hangman shows that the bears were able to knock the stock lower before the bulls managed to muster their last bit of strength to bring the stock back to its opening. This is significant when it is the first time after the uptrend that the bears were able to take control; it could be an indication for future activity. The color of the body is insignificant.

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Figure 14-6 Hammer

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Figure 14-11 Marubozu

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Figure 14-12 Morning and Evening Stars

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Figure 14-13 Piercing Line and Black Cloud Cover

Morning star—The morning star is a powerful bullish reversal pattern. It is a long black body followed by a small white or black body, followed by a long white body. The small body on the second day ideally would have gapped down from the black body. The morning star is usually followed by a small pullback toward the middle of the long white body, before the reversal pattern continues upward. The small body represents the waning of momentum after a down move, while the long white body represents confirmation of the reversal. Evening star—The evening star is the opposite of the morning star. It occurs at the top of an uptrend and is composed of a long white body followed by a small black or white body, followed by a long black body. Ideally the small body would have gapped up from the long white body. The small body represents stalled uptrend momentum, while the long black body provides confirmation that the trend is reversing. The long black body is usually followed by a small pullback toward the middle of that body before downward momentum kicks in. There are variations of the morning and evening star patterns in which the smaller body could be a doji or a spinning top, or could be placed at various distances from the first long body. Piercing formation—This is a bullish reversal pattern that has a long white body that pierces through the midpoint or higher of a long black body. This occurs after a downtrend. It is similar to a bullish engulfing pattern except that the bulls did not show up in complete force to completely engulf the previous day's move.

Dark cloud cover—The opposite of a piercing formation, this bearish reversal pattern occurs at the top of an uptrend. It is a long black body that covers half or more of a long white body. It is similar to a bearish engulfing pattern except that the bears did not force prices down far enough to cover the previous day's up move.

Shooting star—This is a bearish reversal pattern that forms at the top of an uptrend. It has a long upper wick that is two to three times the size of the small lower body The shooting star in Figure 14-4a shows that the bears attacked in force and rescinded most of the gains that the bulls had made for that session. The shooting star represents the first change in sentiment since the uptrend began.

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Rising and falling windows make up another powerful continuation pattern. If a stock is in an uptrend and gaps higher, it means that the trend is a powerful one and should continue higher yet. If a stock is in a downtrend and it gaps lower, then the downtrend is gaining force to the downside. Always trade in the direction of continuation windows. Long white or black bodies often precede continuation windows.

In the chart in Figure 14-18, JDS Uniphase (JDSU) broke out above resistance on October 2. After breaking out, it pulled back and consolidated before marching forward to gain 80 points in less than a month. During this uptrend, it formed a number of continuation patterns, including three rising windows and a number of long white bodies. If you had caught just the middle of this move, you would have profited handsomely.

Technical analysis is the footprint of the market. It takes into account the rational as well as irrational components of price action. Price levels of support and resistance as displayed through technical analysis can become self-fulfilling prophecies. Stocks often move fast because of technical breaks through support or resistance levels. Traders who are keyed into these levels have an advantage, because they understand why the stock is moving.

Candlestick charts are powerful tools when used in conjunction with basic chart formations. Candlestick charts provide a simple, quick, and effective way to utilize technical analysis when making trading decisions. Candlestick charts provide a multi-dimensional view, utilizing color and symmetry to highlight reversal indicators and continuation patterns. Candlesticks incorporate the important opening price, the closing price, and the high and low price ranges to help you interpret a stock's path of least resistance. Candlesticks are effective trading tools from a daily and an intraday standpoint. The more you watch candlestick price patterns develop on an intraday basis, the more effective you will become as a trader.

Under certain conditions, human beings act similarly and predictably. If you develop the habit of watching these patterns as reflected through charts, you will become more effective at spotting those recurring human tendencies.

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