Candlestick Patterns and Trading...

Candlestick Patterns and Trading Strategies

Chapter 25

Candlestick Patterns and Trading Strategies “What seems too high and risky to the majority generally goes higher and what seems low and cheap generally goes lower.”

Japanese candlestick charts are a favored tool among technical traders. These charts have been around

since the seventeenth century where they were used to track prices of rice. Western line charts, which

display the same information, don’t illustrate market emotion in the same fashion that Candlestick

charts do. Through this session, we are going to discuss candlestick charts and patterns to help manage

more precise entry and exit points when placing trades.

Candlestick Anatomy

If you are familiar with traditional price bars, which reflect an Open, High, Low, and Close, then you have

the foundation needed to learn candlestick patterns. In essence, there is no real difference in the

information provided; it just takes a little time to get used to the visual differences.

Take a look at the illustrations below.

Figure 1: The Anatomy of a Candlestick

Using Figure 1, in the image on the left, a white candle signals a day in which prices closed higher than

they opened, or a bullish day. In the image on the right, a dark candle illustrates a day in which prices


finished lower than they opened, or a bearish day. Visually, you can quickly pick up on whether or not

prices are up or down on the day just by looking at the color of the candle.

Next, understanding the range is an important consideration. A long range day will illustrate consistent

buying or selling throughout the day, which means that trader’s had conviction in the directional

movement of prices. A short range day, especially days in which prices close near where they opened

signal indecision.

Figure 2: A Comparison of Long and Short Daily Ranges

Above is a quick diagram of a short range day on the left, versus a long range candle on the right. As you

can see from the image above, one candle is a lot more bearish than the other.

One candle won’t always offer predictive value. It is the combination of candles that point to reversals,

or upcoming changes in the underlying trend. Through this presentation, we are going to discuss several

candle patterns and how they can help you know where to enter a position, or take profits on an

existing position.

Next, we are going to cover many of the various patterns that will help you in determining entry and exit

points. We’ll start with a couple neutral patterns first.

Neutral Candle Patterns

In using the term “neutral” pattern, it means that the action itself is not necessarily bullish or bearish.

Usually it is a follow-up move (confirmation) after this signal that a trader will use to initiate a position.


Doji

A Doji will form when a security's open and close are virtually equal. The

length of the upper and lower shadows can vary, and the resulting candlestick

looks like, either, a cross, inverted cross, or plus sign. Doji convey a sense of indecision or

tug-of-war between buyers and sellers.

Dragonfly Doji

A Doji where the open and close price are at the high of the day. Like other Doji days, this

one normally appears at market turning points.

Gravestone Doji

A Doji line that develops when the Doji is at, or very near, the low of the day.

Spinning Top

Candlestick lines that have small bodies with upper and lower shadows that exceed the

length of the body. Spinning tops signal indecision.

Bullish Reversal Patterns

A bullish reversal pattern is typically found at the bottom of a downward price swing. This indicates a

possible low in price, and typically a good entry point for traders looking to initiate a long position.

Listed below are some of the most popular bullish reversal patterns.

Hammer

Hammer candlesticks form when a security moves significantly lower after the open, but

rallies to close well above the intraday low. The resulting candlestick looks like a square


lollipop with a long stick. If this candlestick forms during an advance, then it is called a Hanging Man.

Inverted Hammer

A one day bullish reversal pattern. In a downtrend, the open is lower, then it trades higher,

but closes near its open, therefore looking like an inverted lollipop.

Bullish Engulfing Pattern

A reversal pattern that can be bearish or bullish, depending upon whether it appears at the

end of an uptrend (bearish engulfing pattern) or a downtrend (bullish engulfing pattern).

The first day is characterized by a small body, followed by a day whose body completely

engulfs the previous day's body.

Piercing Line

This is a bullish two day reversal pattern. The first day, in a downtrend, is a long black day.

The next day opens at a new low, then closes above the midpoint of the body of the first

day.

Bullish Harami

The Harami is a two day pattern that has a small body day completely contained within the

range of the previous body, and is the opposite color.

Morning Star/Bullish Abandoned Baby

A three day bullish reversal pattern consisting of three candlesticks - a long-bodied black

candle extending the current downtrend, a short middle candle that gapped down on the

open, and a long-bodied white candle that gapped up on the open and closed above the

midpoint of the body of the first day.


A rare reversal pattern characterized by a gap followed by a Doji, which is then followed by

another gap in the opposite direction. The shadows on the Doji must completely gap below

or above the shadows of the first and third day.

Bearish Reversal Patterns

Shooting Star

A single day pattern that can appear in an uptrend. It opens higher, trades much higher,

then closes near its open. It looks just like the Inverted Hammer except that it is bearish.

Hanging man

Hanging Man candlesticks form when a security moves significantly lower after the open,

but rallies to close well above the intraday low. The resulting candlestick looks like a square

lollipop with a long stick. If this candlestick forms during a decline, then it is called a

Hammer.

Dark Cloud Cover

A bearish reversal pattern that continues the uptrend with a long white body. The next day

opens at a new high then closes below the midpoint of the body of the first day.

Bearish Engulfing Pattern

A reversal pattern that can be bearish or bullish, depending upon whether it appears at the

end of an uptrend (bearish engulfing pattern) or a downtrend (bullish engulfing pattern).


The first day is characterized by a small body, followed by a day whose body completely engulfs the

previous day's body.

Evening Star/ Bearish Abandoned Baby

A bearish reversal pattern that continues an uptrend with a long white body day followed

by a gapped up small body day, then a down close with the close below the midpoint of the

first day.

A rare reversal pattern characterized by a gap followed by a Doji, which is then followed by

another gap in the opposite direction. The shadows on the Doji must completely gap below

or above the shadows of the first and third day.

Bearish Harami

A two day pattern that has a small body day completely contained within the range of the

previous body, and is the opposite color.

Use the graphics above as a reference to help you become familiar with these trading patterns. Initially

they will be difficult to recognize and locate on a chart, but with practice you will start to develop an eye

for spotting them. Next, let’s move into a few more defining characteristics that help make these

patterns great trading signals.

Trend

It is critical to get a sense of trend and where prices are within the context of the underlying trend. For

example, a bullish reversal pattern should occur at a relative low rather than a high, within the context

of an upward trend. Conversely, a bearish reversal pattern should occur at a relative high in the context

of a downtrend. Spotting and understanding the trend is just as important as being able to identify the

shape of the pattern. If a pattern is spotted in the wrong place, the implications could be entirely

different than what you are expecting.


Confirmation

The combination of candle patterns and support and resistance levels is a potent mixture when timing

trades. Most traders are looking for ways to get into a position early in order to avoid missing the move,

but want to find balance between an aggressive entry and a confirmed entry point, one in which prices

have confirmed that they are moving in the direction of your forecast. The problem is that confirmation

typically equals missed opportunity. Anticipatory entries are a great solution, but they fail much more

often than having waited for a better confirmation.

Figure 3: A Hammer at Support Indicates a Bullish Reversal

A good solution to this common obstacle is to start by identifying support and resistance on the

instrument you are planning to trade. Taking a bullish position at support or a bearish position at

resistance is a good starting point, but combing candle patterns at these levels is a great way to confirm

your entry point early, and help to increase the probability of success on each trade.


Confirmation is also a term used to confirm a pattern after it has formed. Many like to see more than

the shape of the candles to take a trade, they like the see that the pattern itself is confirmed. This

happens when prices close above a bullish reversal pattern, or below a bearish reversal pattern. Using

Figure 3, the confirmation comes 2 days later when prices close above the hammer.

Developing a Candlestick Strategy

Now that we’ve covered this style of charting, and several reliable trading patterns, the final step in this

chapter is to use these patterns as possible trading signals in your trading approach. You might choose

to use only a handful of patterns in this module to signal entry and exit points, but it is important to

remember that price is king. Changes in price move all other indicators. As prices move up or down,

trading indicators follow. Using price patterns and candlestick patterns will offer more timely entry and

exit points than waiting for other lagging indicators to signal change.

Your candlestick trading strategy should incorporate 5 elements:

The Trend – Defining the underlying trend to determine the stocks path of least resistance.

The Set-Up – Locating the pattern and understanding whether it points to higher or lower

prices.

The Predicted Move – This is projected target price of the pattern.

Entry – This is where you will enter a position.

Exit – This is where you will exit with a profit, and also where you will set your stop.

To give you an idea of a candlestick trading strategy, let’s walk through an example. Let’s assume that

Trader A likes to trade bullish reversal patterns in upward trending stocks. We’ll also assume that the

hammer pattern is one entry signal that Trader A likes to use to enter a position. Figure 4 below

illustrates the Trend and the Set-Up. It is an upward trending stock with a bullish hammer at support.


Figure 4: A Bullish Hammer at Support in an Upward Trending Stock

Here is an example of a Trade Plan for the trading signal in Figure 4 above.

The Trend – The underlying stock is trading in an upward trend. A bullish reversal pattern in the

context of this trend should signal higher prices.

The Set-Up – The stock has a hammer pattern (bullish reversal pattern) at support.

The Predicted Move – Prices should move higher, targeting a move to new highs. As the stock

trends higher, it seems to move above each prior high.

Entry – Enter the trade at the market open tomorrow above the current days high.

Exit – A sell stop order will be set beneath the days low, and a limit order to sell with a profit will

be set above resistance at $147.

In Figure 5 below, here is the trade plan marked up on the chart:


Figure 5: Outlining a Trade Plan

Using round numbers, the entry point is set at $140.00. The stop order will be set at $137.50, and the

price target is set at $147.50. This means that the trader is risking $2.50 (140 - 137.50 = 2.50) to make

$7.50 (147.50 – 140 = 7.50). This is a 3/1 risk reward ratio, which is fantastic.

After the trade was entered, here is how the stock moved post entry:


Figure 6: Target Price Reached

Trader A would now execute an order to sell at the pre-determined target price and book the gains

made on this trade. Not all trades will turn a profit, but what is important is that risk is measured and

defined prior to entry, and a plan is made that details where gains will be taken. Be disciplined in

following your plan.

If risks and rewards are measured prior to entry, you can determine whether or not the system you will

be trading is profitable. For example, if you typically trade with a risk/reward ratio of 3:1, and you have

an average of 60/40 win loss ratio, then your trading system would look as follows:

6 winning trades, average win $3 4 losing trades, average loss $1

(6 x 3 = $18) (4 x $1 = $4)

Net Gains $18 – Net Losses $4 = $14 Net Profit

Summary


Candlestick patterns are just one of many different trading systems that one can use to approach

trading the market. Use the tools discussed here to enhance and build upon your existing trading plan

and overall approach

Candlestick Patterns and Trading...

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