Trading with candlestick chart patterns (part 2)
As we covered in our first article, Candlestick charts provide a quick visual representation of price movements. Traders use them to analyze market trends and spot opportunities if the market has just turned or is showing signs of reversing direction.
With their origins in Japan and rice trading centuries ago, they have become an integral part of almost every trader's toolkit today. Over time, many patterns have been cataloged and attributed to certain types of market cycles and events precipitating or confirming a change in market direction. While the empirical evidence supporting their use is limited, they remain popular because of their simplicity and application across all markets and products.
More candlestick patterns
Candlestick charts are typically watched for signs of a trend reversal, where a previous bull or bear cycle ends. Here are several more patterns that are commonly tracked by traders today:
Simple reversal patterns
The Morning Star pattern forms on daily charts (usually where there's a break in trading between periods) after a downtrend has ended abruptly, with the market gapping down on the open after the previous period saw a long red bar. This usually marks a liquidation point with many stop-loss orders triggered. However, once that is over, the market bounces back to a little above where it opened. Then, with the star-shaped candlestick changing color, the selling pressure dries up, so the next period sees a higher gap again with fresh buyers.
The opposite pattern is called the Evening Star. A period of strength suddenly reverses after opening much higher. It's typically followed by a period of weakness represented by further downward candlesticks.
Three Inside Up
This is another multiple candlestick pattern showing a breakout from a wedge-like shape after a period of downward price movement.
The second candlestick is completely contained inside the body of the prior candlestick. Also, the first candlestick will have little to no shadow or wick on the top or the bottom. Once the price breaks up, there is strong buying, and the new uptrend is confirmed.
Three Inside Down
The reverse case is the Three Inside Down pattern, where momentum fails and a push to new high collapses:
The Hanging Man is a favorite of traders waiting for the market to top out, as it offers a great chance to sell close to the high once the candlestick has been completed. A long downside wick characterizes it but a relatively short body of the candlestick. This represents a new high traded shortly after the market opened, followed by a selloff and a rebound that failed to make a still further high. With the buyers' efforts exhausted and holding too much risk, the next candlestick period will likely see them sell out to manage their risk. Observing this pattern forming and being ready to sell on the opening of the next bar makes this a potentially very profitable pattern to watch out for!
The bullish counterpart to this one is called the Inverted Hammer, and it's the favorite pattern for traders lying in wait for the low and looking for a quick rebound.