Just as many traders look to bar charts for double tops and bottoms,
head-and-shoulders, and technical indicators for reversal signals, so
too can candlestick formations be looked upon for the same purpose. A
reversal does not always mean that the current uptrend/downtrend will
reverse direction, but merely that the current direction may end. The
market may then decide to drift sideways. Candlestick reversal patterns
must be viewed within the context of prior activity to be effective. In
fact, identical candlesticks may have different meanings depending on
where they occur within the context of prior trends and formations.
Hammer -- a candlestick with a long lower shadow and small real
body. The shadow should be at least twice the length of the real body,
and there should be no or very little upper shadow. The body may be
either black or white, but the key is that this candlestick must occur
within the context of a downtrend to be considered a hammer. The market
may be "hammering" out a bottom.
Hanging Man -- identical in appearance to the hammer, but appears
within the context of an uptrend.
Engulfing Patterns -- Bullish -- when a white, real body totally
covers, "engulfs" the prior day's real body. The market should be in a
definable trend, not chopping around sideways. The shadows of the prior
candlestick do not need to be engulfed.
Bearish -- when a black, real body totally covers, "engulfs" the
prior day's real body. The market should be in a definable trend, not
chopping around sideways. The shadows of the prior candlestick do not
need to be engulfed.
Dark-Cloud Cover (bearish)-- a top reversal formation where the
first day of the pattern consists of a strong white, real body. The
second day's price opens above the top of the upper shadow of the prior
candlestick, but the close is at or near the low of the day, and well
into the prior white, real body.
Piercing Pattern (bullish) -- opposite of the dark-cloud cover.
Occurs within a downtrend. The first candlestick having a black, real
body, and the second has a long, white, real body. The white day opens
sharply lower, under the low of the prior black day. Then, prices close
above the 50% point of the prior day's black real body.
Stars
These candlestick formations consist of a small real body that gaps away
from the real body preceding it. The real body of the star should not
overlap the prior real body. The color of the star is not too important,
and they can occur at either tops or bottoms. Stars are the equivalent
of gaps on standard bar charts.
Stars make up part of four separate reversal patterns:
-Morning Star
-Evening Star
-Doji Star
Shooting Star (Inverted Hammer)
Morning Star-- this is a bullish bottom reversal pattern. The
formation is comprised of 3 candlesticks. The first candlestick is a
tall black real body followed by the second, a small real body, which
gaps (opens), lower (a star pattern). The third candlestick is a white
real body that moves well into the first period's black real body. This
is similar to an island pattern on standard bar charts.
Evening Star --- a bearish top reversal pattern and counterpart
to the Morning Star. Three candlesticks compose the evening star, the
first being long and white. The second forms a star, followed by the
third, which has a black real body that moves sharply into the first
white candlestick.
Doji Stars -- When a doji gaps above a real body in an uptrend, or
gaps under a real body in a falling market, that particular doji is
called a doji star. Two popular doji stars are the evening star and the
morning star.
Evening Doji Star -- a doji star in an uptrend followed by a
long, black real body that closed well into the prior white real body.
If the candlestick after the doji star is white and gapped higher, the
bearishness of the doji is invalidated.
Morning Doji Star -- a doji star in a downtrend followed by a
long, white real body that closes well into the prior black real body.
If the candlestick after the doji star is black and gapped lower, the
bullishness of the doji is invalidated.
Shooting Star -- a small real body near the lower end of the
trading range, with a long upper shadow. The color of the body is not
critical. Not usually considered a major reversal sign, only a warning.
Inverted Hammer-- not really a star, but does look like a
shooting star. When occurring within a downtrend, may be a turning
signal. Body color is not critical.
Final Thoughts and Credits
It is important to realize that this introduction is just that, an
introduction to candlestick analysis. After having read this, you will
have merely scratched the surface of the many patterns and variables
that can go into candlestick analysis. No attempt was made to provide a
thorough analysis of each and every pattern. In fact, many formations
were left out as they cross the border into more complicated analysis.
For a more complete overview of candlestick analysis, it is highly
recommended that you read the book that is referred to below.
A large portion of the material in this introduction is taken from an
excellent book called
Japanese Candlestick Charting Techniques: A
Contemporary Guide to the Ancient Investment Techniques of the Far East.
(You can find this book in The
PitMaster's Bookstore.) In some cases,
sentences were taken almost verbatim, as there was no better way to say
what Mr. Steve Nison, the author, already said. In his book, Mr. Nison,
completely explains candlesticks and their formations, but more
importantly explains how to combine candlestick analysis with
traditional technical analysis. It is highly recommended that you
consider purchasing this book.
As traders, we need as many trading tools in our arsenal, and a basic
knowledge of candlesticks provides a trader much needed ammunition. Also
remember that no matter what the trading tool, no matter how advanced or
ancient, it is only effective when put into practice properly. This is,
of course, your job as the trader.
