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Visual Guide to 8 Candlestick Patterns Every Trader Must Know Cory MitchellJun 06, 2014 2014-06-06
The Japanese have been using candlestick charts for hundreds of years dating all the way back since the 17th century, which is why candlesticks are often referred to as "Japanese Candlesticks." Candlestick charts have become popular in the West because they are highly visual, making it easier to spot specific patterns that either indicate a continuation of the trend or a reversal. There are dozens upon dozens of candlestick patterns, yet some are more dominant and indicate significant changes in direction. As such, below we highlight some of the most important patterns that traders need to be aware of.
Candlestick Structure
“Down” candlesticks are typically colored red or black, while “up” candlesticks are colored white, blue or green. This allows traders to quickly see if the price moved lower or higher over a period (candlestick). There are two parts to a candlestick, the real body, which marks the difference between the open and close, and the shadows, which mark the high and low points of the period. Shadows are also referred to as wicks or tails.
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Figure 1. Candlestick Construction
Candlesticks that occur in a certain sequence or context, or have a specific appearance can be used to gauge the future of direction of stocks. It should be noted that patterns may occur and not produce the expected outcome. There are no sure things, and candlesticks are often combined with other forms of technical analysis to improve the reliability of the patterns, and filter out candlestick signals that are likely to be irrelevant.
Bullish and Bearish Kicker Pattern
This is the most aggressive reversal signal and it doesn’t occur very often as it indicates a major trend change. It is seen on daily charts, and even more rarely on weekly or monthly charts. There is a bullish and bearish kicker pattern.
A bullish kicker pattern occurs after a downtrend. It is a two bar pattern where there is a long down candle followed by a long up candle. The up candle opens at or above the open of the prior down candle. The up candle closes near the high of the day. Please note that all charts were created using FreeStockCharts.com
Figure 2. Bullish Kicker Pattern - General Electric (GE) Daily Chart
Enter long positions near the close of the second or near the next open. Place a stop loss below the recent low. There is no profit target, as the pattern indicates a major trend change. Therefore, the profit target will depend on the trader’s trade time frame. It is also a signal to exit short positions. A bearish kicker pattern occurs after an uptrend. It is a two bar pattern where there is a long up candle followed by a long down candle. The down candle opens at or below the open of the prior up candle. The down candle closes near the low of the day.
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Figure 3. Bearish Kicker Pattern - General Electric (GE) Daily Chart
Enter short positions near the close of the second candle, or near the next open. Place a stop loss above the recent high. There is no profit target, as the pattern indicates a major trend change. It is also a signal to exit long positions.
Bullish and Bearish Engulfing Pattern
The engulfing pattern is another strong reversal signal. It occurs quite frequently so it is best to use it in alignment with an overall trend. When the overall trend is higher, use the bullish engulfing pattern to signal the end of a pullback and the resumption of the trend. During a downtrend, use a bearish engulfing pattern to signal the end of the bear-market-rally. The engulfing pattern occurs on all timeframes, and can be used to spot major trend changes, but it isn’t as reliable for this function. A bullish engulfing pattern is when the real body of an up candle completely envelops the real body of the prior down candle.
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Figure 4. Bullish Engulfing Pattern - Dominion Resources (D) Daily Chart
A long entry is taken near the close of the engulfing day, or near the next open. A stop loss is placed below the recent low. Once again there is no specific price target, since the trade is in alignment with a longer-term trend. The pattern is also a signal to exit short positions. A bearish engulfing pattern is when the real body of a down candle completely envelops the real body of the prior up candle.
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Figure 5. Bearish Engulfing Pattern - Apple (AAPL) Daily Chart
A short entry is taken near the close of the engulfing day, or near the next open. A stop loss is placed above the recent high. Once again there is no specific price target, since the trade is in alignment with a longer-term trend. The pattern is also a signal to exit long positions.
Piercing Pattern and Dark Cloud Cover
The bullish version of this pattern is called a Piercing pattern, while the bearish version is called Dark Cloud Cover. Both are reversal patterns.
A Piercing pattern occurs after a down move, or pullback within a longer-term uptrend. It is a two candle pattern where the first is a strong down candle. The second candle opens lower, but closes above the mid-point of the prior down candle. The strong reversal shows buyers have re-entered the stock.
Figure 6. Piercing Pattern - Sprint (S) Daily Chart
Enter long (or exit short positions) near the close of the second candle, or near the next open. Place a stop loss below the recent low. Ideally, trades should be made in the direction of the longer-term trend during a pullback. Dark Cloud Cover occurs during an up move, or pullback within a longer-term downtrend. It is a two candle pattern where the first is a strong up candle. The second candle opens higher, but closes below the mid-point of the prior up candle. The strong reversal shows sellers have re-entered the stock.
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Figure 7. Dark Cloud Cover - General Motors (GM) Daily Chart
Enter short (or sell long) near the close of the second candle, or near the next open. Place a stop loss just above the recent high. Ideally trades are made in the direction of the longer-term trend, during a pullback.
Morning and Evening Star
The bullish version of this three candle pattern is a Morning Star; the bearish version is an Evening Star. A Morning Star occurs during a down move and is a reversal signal. The first candle is a strong down candle. The second candle is small and has gapped below the first candle. The third candle gaps above the second candle and closes above the mid-point of the first (up candle).
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Figure 8. Morning Star - AT&T (T) Daily Chart
Enter long or exit short positions near the close of the third candle or near the next open. Place a stop loss below the recent low.
An Evening Star occurs after an up move and is a reversal signal. The first candle is a strong up candle. The second candle is small and has gapped above the first candle. The third candle gaps below the second candle and closes below the mid-point of the first (down candle).
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Figure 9. Evening Star - Illumina (ILMN) Daily Chart
Enter short, or exit long positions, near the close of the third candle or near the next open. Place a stop loss above the recent high.
The Bottom Line
Other than Kicker patterns, which occur infrequently, the other chart patterns can occur with some regularity. Therefore, filter some of these more common signals by trading in alignment with the broader trend. All patterns can be used to spot major reversals; however, just because the pattern occurs doesn’t mean a major reversal will happen. This is a why a stop loss is used when trading candlestick patterns.
Keep in mind also that candlesticks do not provide a profit target, since most of these patterns are used in conjunction with trends (or other technical indicators) to signal reversals; your profit target will most likely depend on your time frame. If you already have a position, candlestick patterns can help you assess whether to maintain your position, or close it based on what the pattern indicates the next most likely direction is for that particular security. Get Email Updates Subscribe to receive FREE updates, insights and more, straight to your inbox Enter Email Address
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