Ever since Steve Nison brought Japanese candlesticks to the Western world of technical analysis in 1989, technical traders have never found a charting style that packs the same level of detail. Candlesticks have taken over how price action is visualized on the charts in that it's set as default by most trading packages offered to retail traders. But it takes some familiarization of the most common Japanese candlestick patterns to successfully integrate this nuanced yet critical form of price analysis in the whole technical trading repertoire.
In this article, I've explained five of the most common patterns that traders find on the charts.
The first common formation in this list is the engulfing pattern; it's made up of two candlesticks that can either be bearish or bullish.
This pattern is completed with a larger candlestick gapping up or down the preceding candlestick and closing lower or higher than the previous candle's close (disregarding the highs or lows). In effect, the engulfing candlestick completely erases the move established by the prior candle.
The bullish engulfing pattern happens when an identifiable downtrend in the chart halts at the presence of a healthy green bodied candlestick that takes out the move of the red candle before it.
The opposite happens with the bearish engulfing wherein a clear uptrend stops short upon the presence of a red bodied candlestick that engulfs the green candle before it.
What does this mean?
When traders see this pattern appear on the chart, the interpretation is that the direction of price suggests a potential reversal. An uptrend disrupted by the bearish engulfing pattern risks getting flipped, and the same goes for a downtrend when the bullish engulfing pattern appears.
Of course, this is just one way to detect a reversal. Indicators could serve as supplementary evidence of a change in direction.
It might be strange to utter the name of a tool like "hammer" when reading a chart, but it's actually another candlestick pattern that traders identify for possible reversals.
A hammer is a single candlestick pattern that signals that momentum is shifting to the upside, especially if it prints after a downtrend or a significant support level.
It is easier to remember what a hammer looks like since it resembles what it's named after.
What does it mean?
The interpretation of this pattern is that sellers have dominated for pretty much the entire timeframe. Still, buyers came in the clutch to buoy prices near the opening price before the final value was settled.
Now, often traders question if they should be on the lookout for a red or green bodied candle.
According to Steve Nison's Japanese Candlestick Charting Techniques, the body forming after the candle's wick doesn't have to be in a specific color, but the wick should be at least twice the size of the body.
For this pattern, traders observe the formation of three candles, and much like the two preceding patterns, a "star" also signals a reversal.
The star pattern's first candle is heading in the direction of the prevailing trend, the middle is a small-bodied candle or a Doji, and the third is a candle in the opposite direction of the first candle. Stars can either be a "Morning Star" or an "Evening Star."
The Evening Star appears on the chart during an uptrend. The first candle is a green one followed by a Doji, and the third one is a red candle.
There's a debate whether the middle candle needs to gap higher for this to be a valid pattern, but Nison argues that it would not affect the efficacy of this formation.
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On the other end of the spectrum is the Morning Star; it appears on a downtrend as a way to signal a bottom. The first candle is a red one, and after it again is a Doji, and the third one is a green candle.
What does this mean?
Stars, as mentioned, is indicative of an upcoming shift in the direction of price. The Doji or the small-bodied candle in the middle reflects the market's indecision and causes a disruption in the current trend. The last candle implies a power shift from either bullish to bearish or bearish to bullish.
4. Three Black Crows/Three White Soldiers
This pattern has nothing to do with the Corvus kind, but what it betokens is as ominous. It's hard to miss this on the chart simply because traders only have to find three consecutive candles sloping downwards with each new candle exceeding the previous candle's low.
Three Black Crows
Three Black Crows are significant in an uptrend as it warns that price is in danger of turning lower. However, the entry for this pattern puts a trader in a position where the initial move is skipped entirely.
Despite the selling pressure that's evidenced by the three healthy red candles, it would be better for a trader to vindicate a long-term short if other technical studies are utilized.
Three White Soldiers
The Three White Soldiers, on the other hand, is the opposite of the Three Black Crows. When three bullish candlesticks appear on a downtrend or a critical support area, it hints at a potential price rally.
5. Hanging Man
Finally, the last one here is the "hanging man." Now, this single candle pattern can be confused with the hammer since it shares the same shape.
However, the main difference between the hammer and the hanging man is that the latter is located in an uptrend and signals a bearish reversal.
What does this mean?
When the hanging man pattern is spotted on the chart, it could mean that the market has peaked. The long wick exhibits the selling that took place under the candle's real body, and any efforts of the buyers to revive it is insufficient to move the closing price beyond the open.
These are just some of the most common candlestick patterns that a trader may find on the charts, and they need to remember these patterns to learn what price action could be telling them. Still, one can't rely solely on what the candles mean. Pairing candlestick analysis with a concrete understanding of significant support and resistance areas, as well as utilizing technical indicators, would allow a trader to increase the probability of a trade going their way.
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