Candlestick Chart Patterns

The Japanese Candlestick chart patterns can offer some key indications of potential continuations or reversals of a given stock chart. As I showed on the Stock Charts page, a candlestick symbol can show a number of key things related to price movement for a defined period.

Japanese Candlestick

As shown here, the candlestick symbol can tell us what the open price was, the closing price, the high, the low and who was in control at the close of the period.

The one advantage for me of using a candlestick chart as opposed to a bar chart is that I can quickly see who was in control at the end of the period. A bullish close is indicated by having a open (or white) body as shown here. A bearish close would use a solid (black or red) body.

Candlestick Chart TerminologyOne other key point to cover is some terminology related to candlesticks. The part that indicates the range between the open and close is referred to as the body of the candle.

The part line that extends above or below the body is called the wick (kind of obvious since these are called candlesticks). The candlestick itself can form all sorts of shapes. Some will have no upper or lower wick, some may have mostly a wick and no body to speak of. If you think about what these different formations tell you, it really is pretty powerful.

The real power of using candlestick charts though is in the patterns formed by combinations of two or more candles.

Using candlestick patterns

I don't intend to go into an extensive coverage of Japanese Candlestick Patterns. There are some great resources online and in books. In fact the definitive guide can be found in the book "Japanese Candlestick Charting Techniques" by Steve Nison. In the book, he covers the many different patterns that can be used. The patterns that I use really fall into two categories.

Hammer/Hanging Man

These patterns are formed by one candle but requires confirmation so I consider it a 2 candle pattern.

The hammer is a bullish reversal pattern that is formed at the end of a down trend and as the name suggests, looks a bit like a hammer. Some technicians will say that the chart is trying to 'hammer' out a bottom.

Candlestick Chart - Hammer Example

As this diagram illustrates, the hammer is made up of a small body at the top of the candle with a longer lower wick. Most technical guides will tell you that the wick should be twice as long as the body. There should also be very little upper wick on a hammer.

Let's think about the psychology behind that. The stock opens up and sellers drive the price down to some lower level. However, at some point, buyers come in and overcome the selling to ultimately drive the stock price back up to a point above the open. The longer the tail is, the more selling pressure there is to be overcome, and the more powerful the reversal will likely be.

Many technical guides will tell you that the color of the body doesn't matter. To some extent I agree, but I also think a white body is more powerful since buyers not only overcame the selling pressure but were willing to buy into the close.

Regardless, the other key component of this pattern is that it must be confirmed by a higher close the following day (or period when using something other than a daily chart).

In summary, here are some key rules to keep in mind when using a hammer pattern.

  1. Hammers are most meaningful in a downtrend.
  2. Hammers must be confirmed by the next candle closing above the body of the hammer.
  3. Hammers when confirmed MAY indicate a reversal is taking place. This pattern has a high success rate but isn't perfect.

The hanging man by contrast is a bearish reversal pattern that can signal that an up trend is ending. Notice that the hanging man pattern has a very similar look to the hammer. But it MUST occur in an up trend to be a valid reversal signal.

Candlestick Chart - Hanging Man Example

The candlestick chart above shows a hammer that has a dark body indicating the close was lower than the open. As in the hammer, the lower wick should be at least twice as long as the body and there should be little to no upper wick.

The psychology of this pattern is that the price opens near the high of the trading range for the period but sellers begin to push the price down. However, some point, buyers come back in and push the price back up. While this may seem bullish, when followed by a candle that closes below the body of the hanging man, this is actually a bearish indication.

Rules to keep in mind for the hanging man pattern include...

  1. The hanging man is most meaningful in an up trend.
  2. The hanging man must be confirmed by a lower close of the following candle.
  3. hanging man when confirmed MAY indicate a reversal. Nothing is certain but this pattern does have a pretty high success rate.

Engulfing Patterns

The engulfing patterns are two candle formations as well. Because of the nature of the engulfing pattern, they are self confirming. As the name suggests, the second candle will 'engulf' the previous candle and will be an opposing candle.

The bullish engulfing pattern is a reversal pattern that will show up in a down trend. It will be made up of a bearish candle (lower close) engulfed by a bullish (higher close) candle. To be valid, the second candle must open below the close of the prior candle and must close above the opening price of the prior candle - thus engulfing the prior candle.

Candlestick Chart - Bullish Engulfing Example

In the candlestick chart above, we can see the psychology of this pattern. In the midst of a down trend, the day opened lower than the prior day's close but buyers immediately stepped in and drove the price up to overcome the bearish sentiment of the day before. This can be a powerful reversal signal.

Here are the rules for the Bullish Engulfing pattern.

  1. Most meaningful toward the end of a down trend
  2. The second candle must fully engulf the previous candle
  3. The first candle must be a bearish candle while the engulfing candle must be a bullish candle

The Bearish Engulfing pattern is pretty much the opposite. In this case, it will show up toward the end of an up trend and will begin with a bullish followed by a bearish candle that completely engulfs the prior candle.

Candlestick Chart - Bearish Engulfing Example

The candlestick chart above shows the bearish engulfing pattern showing up at the end of an up trend. We can see that on the second day, the buyers initially continued to drive the price up but sellers eventually overcame the bullish sentiment and ultimately drove the price to a lower close.

Just to be complete, let's go over the Bearish Engulfing pattern.

  1. Most meaningful toward the end of an up trend
  2. Second candle must fully engulf the prior candle
  3. The first candle must be a bullish candle and the second candle must be a bearish candle

Combining patterns with other technical indicators

I'm a firm believer that we can't use any technical analysis tool in isolation. It helps to use other technical indicators to confirm what we might be seeing. This may include using a moving average or support & resistance or an oscillating technical indicator like the stochastic.

Candlestick Chart - Bearish Engulfing with Overbought indicator

In the above example, the stochastic can help give strength to the indication of a bearish reversal of the candlestick chart. Notice that the bearish engulfing pattern is soon followed by a break through the 30 day moving average.

Candlestick Chart - Hammer confirmed by oversold

In the above case, we see a hammer is confirmed both by the successive bullish candle and by the fact that it occurred at an oversold point of the stochastic.

It always helps to have confirmation, not trying to use just one indicator to get a perspective of what is happening. It is also risky to try to have too many indicators line up. It usually won't happen very often and good trades can be missed.

I try to keep it simple. I use support and resistance, the moving average and candlestick chart patterns. In the absence of clear support and resistance for a candle pattern, I will use something like the stochastic to give me more confidence of my assessment.

Here are a few really good books that can provide much more detail on some of these candlestick patterns.

Japanese Candlestick Charting Techniques by Steve Nison
Steve is really credited for popularizing this analysis style in the western world. On top of that, I really like this book because it not only showed the patterns but explained the psychology behind them. Definitely a must read if you intend to use candlestick chart patterns.

Technical Analysis of the Financial Markets by John J. Murphy
John Murphy's book covers a vast number of different technical analysis approaches. In the book, coverage is given to candlestick chart patterns. The chapter is authored by Gregory Morris who also writes a book of his own called "Candlestick Charting Explained". I haven't read his book but the chapter he wrote in Murphy's book is quite good.

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