Analysis of Selected Candlestick Formations

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Most candlestick formations identify either a slowdown in a market trend or a trend reversal. It is important to understand that there is a close relationship between reversal candlestick patterns and reversal patterns in the chart analysis. For example, a key-reversal day in the chart analysis can also be shown in the candlestick analysis by using a bullish belt-hold or a bearish belt-hold.

Traders like working with candlestick charts because they show investor behavior in a different, but simple, price picture that is easy to combine with other trading tools. Candlestick charts can be analyzed without any time lag, and investor behavior can be examined just by looking at the relationship between the open, high, low, and close at every price bar.

The following candlestick chart patterns are seen often and combine well with the Fibonacci trading tools. The interested reader will find many books that describe candlestick patterns in detail.

Hammer and Hanging Man

A candlestick chart pattern is called a hammer if it has a long shadow and a small body (black or white) that is very close to the high of the day. At the end of a downtrend, the hammer is considered a bullish reversal signal.

Hammer and hanging man should both have a long shadow. Ideally, the shadow should be about three times as long as the body. The long shadow shows that the market price dropped very sharply after the opening and then recovered at the end of the trading session. The opening and closing price should be close together, which will result in a small body on the candlestick chart.

At the end of an uptrend, the same candlestick chart pattern is called a hanging man. The hanging man is also a reversal pattern. To get a sell signal, the market price should trade below the lowest low of the hanging man in the following days. It might be even safer to wait until the close of a day is below the lowest low of the hanging man candlestick pattern (see Figure 3.14).

Bullish and Bearish Belt-Hold

The bullish belt-hold is a candlestick formation with a white body, which means that the opening price was very low, the market started a rally, and the closing price is very high. The opposite holds true for the bearish belt-hold. In this case, the opening price is very high and the closing price is very low. The bigger the body in the belt-hold candlestick pattern, the more important is this pattern for a trend reversal.

If the opening price of the next day is higher than the bearish belt-hold candlestick pattern, it is likely that the market will go higher. On the other hand, if the opening price of the next day is below a bullish belt-hold, traders can expect that the market will continue to go lower (see Figure 3.15).

Bullish and Bearish Engulfing Pattern

While hammer and hanging man as well as bullish and bearish belt-hold are single candlestick formations (consist of one candlestick), the bullish and bearish engulfing patterns always need a pair of candlesticks to complete the pattern.

The bullish engulfing pattern is a reversal pattern at the end of a downtrend. This formation is completed when a large white candlestick body completely covers a smaller black candlestick body from the previous day. It is not important that the big, white candlestick body covers the shadow of the previous day as well.

A bearish engulfing pattern is important at the end of an uptrend. In this case, a big black candlestick body covers a small white candlestick body of the previous day (see Figure 3.16).

Harami Pattern and Harami Cross

The harami pattern needs two candlesticks and is the exact opposite of the engulfing pattern. In the traditional bar chart analysis, the harami pattern is called an inside day.

Figure 3.17 Harami pattern and harami cross.

The harami pattern has a small body (black or white) that fits completely into the big (black or white) body of the previous day. It is not important whether the shadow of today's small candlestick pattern goes higher or lower than the previous candlestick shadow. The harami pattern has greater importance if, at the end of a downtrend, today's small candlestick body is white, whereas the big candlestick body of the previous day is black. The reversal signal is even stronger when today's candlestick body is very small. The harami pattern can be a bullish signal after a downtrend or a bearish signal at the end of an uptrend.

The harami cross is a special kind of harami pattern. In this candlestick pattern, today's candlestick body is very small, which means that the opening and the closing price are almost identical (see Figure 3.17).

Doji Pattern

The doji pattern identifies when the momentum of markets is slowing down. Doji candlesticks have a very small body (opening and closing prices of the day are almost identical), and there is a long shadow either above or below the candlestick body.

Doji patterns are only interesting at the end of longer upswings or downswings. They have more importance when there is an engulfing pattern on the following day (see Figure 3.18).

Piercing Pattern and Dark-Cloud Cover

The piercing pattern looks much like the bullish engulfing pattern and is only valid at the end of a downtrend. While in the bullish engulfing pattern, the large white body of today's candlestick covers the small black candlestick body of the previous day; the piercing pattern is similar.

A valid signal with a piercing pattern is generated when today's big, white candlestick body covers at least 50 percent of the previous day's black candlestick body. The more the body of the piercing pattern covers the candlestick body of the previous day, the stronger is the reversal signal.

The candlestick formation of a dark-cloud cover is important as a reversal signal at the end of an uptrend. In this case, the big, black body of the dark-cloud cover has to cover at least 50 percent of the previous day's white candlestick body. The more the candlestick body of the dark-cloud cover pattern covers the candlestick body of the previous day, the stronger is the reversal signal (see Figure 3.19).

Morning Star and Evening Star

In a star candlestick formation, a small candlestick body (black or white) is separated through a price gap from the candlestick body of the previous day (see Figure 3.20).

Figure 3.20 Morning star and evening star.

The body of the star can touch the shadow of the previous day's candlestick pattern, but it does not touch the body. If the star does not have a small body, but is a doji (opening and closing price are almost identical), the candlestick pattern is a doji star. Star and doji star are warning signals for an imminent trend reversal.

A morning star is a bottom reversal pattern formed by three candlesticks. The first candlestick has a big black body, for this is still a downtrend. The second candlestick is a star with a very small body that is below the previous candlestick and has no connection to the previous body. The third candlestick has a big, white body that should cover at least 50 percent of the big black body from two days ago. In the ideal form, the third candlestick body should trade with a gap to the body of the star of the previous day. Should the third candlestick be an engulfing pattern, this is also a valid trend reversal signal.

An evening star is a trend reversal pattern after a strong uptrend. This formation also has three candlesticks. The first has a long white body. The following candlestick is a star with either a black or white body that has no connection with the previous candlestick body. The third candlestick has a big black body that covers at least 50 percent of the big black body from two days earlier. Between the body of the star and the last big black body, there also should be a gap. If there is a bearish engulfing pattern, this constellation is a valid trend reversal signal as well.

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