Candlestick Charting I: Basic Patterns

Candlestick charting is one of the best ways to understand what a trader should do. Candlesticks outperform many other types of charts because the trader can 1) visually depict stock data easily, 2) establish strong price relationships and 3) catch possible reversals quickly.  The basic candlestick is shown in Figure 1.

Figure 1.  Candle sticks.

A green or white candle signifies a positive (up) day and a red or black candle signifies a negative (down) day.  The forth pattern to the far right is called a doji, which signals indecision, and one of the many basic patterns. 

There are 11 categories of basic and major candlestick patterns and are the most common patterns seen in charts (shown in Figure 2).  Descriptions will be given for each, along with a real-life example.  An indication of the “reliability” levels for each pattern: extremely high, high, medium, low, extremely low will be noted. Below are the categories:

Figure 2.  Candlestick patterns. 

Doji

Doji are a pattern for days where the open and close are identical or nearly identical.  The candle will look like a cross and is a primary signal for indecision and a potential reversal.  It is important to note that doji in the middle of a trend usually continues the trend, while doji located at the bottom of a trend obviously mark reversals.  Whenever a doji is noted, note its location within a chart.

There are three types of doji: gravestone, dragonfly, and long-legged (Figure 3).  A gravestone doji simply means that a stock opened at the low of the day, reached a high, but fell back down to close at/near its open at the low of the day.  The dragonfly doji is the opposite where a stock opened at the high of the day, reached a low, but bounced back up to close at/near its high of the day.  A long-legged doji signals extreme indecision and volatility.  Every doji has the potential to signal a sharp and sudden move.

Figure 3.  Doji patterns on STEC chart.

 Engulfing 

Engulfing patterns, both bullish and bearish (Figure 4), are reversal patterns that may signal the end of a trend.  Bullish engulfing patterns have the potential to end a downtrend and bearish engulfing patterns have the potential to end an uptrend.  Both patterns are highly reliable in signaling reversals.

Bullish engulfing patterns are formed when a green candle gaps down (opens lower) and closes much higher than the open of the previous day’s red candle. If you look at the pattern, you can see how the green candle completely “engulfs” the red candle.  This shows that there was intense buying pressure sometime during the day to negate the selling pressure at the open.  Bearish engulfing patterns are just the opposite and they are formed when a red candle gaps up (opens higher) and closes much lower than the open of the previous day’s green candle.  This shows an immediate sentiment change during the day and cancelled out the previous day’s gains.  

Figure 4.  Bullish and bearish engulfing patterns.

Harami

Harami means “pregnant” in Japanese and the term is derived by observing a small candle “within” a larger candle.  The long candle is the “mom” and the small candle is the “baby”.  The second or smaller candle’s open and close must both be located within the open-close range of the first or long candle.  This pattern is also known as an “inside day”.  A harami can signal a slowdown in the current trend and a possible reversal.  However, the reliability of the pattern is low and it is recommended that the trader waits for the next day to “confirm” a reversal.  Figure 5 shows both bullish and bearish haramis.

Figure 5.  Bullish and bearish haramis.

Kicker

Kickers are perhaps the most important and powerful reversal signals in candlestick charting. They represent the most dramatic and sudden shift in sentiment. Kicker candles are most commonly compared to breakaway gaps.  The longer the candle, the more powerful the price reversal is.  These signals have the ability to completely end a trend and start a new one, all in a single day.  This is why they are so powerful and of course, their reliability is extremely high. 

A bullish kicker (Figure 6) is formed when the first candle is red and the second candle is green but the open and close of the green candle exceeds the open-close range of the previous day’s red candle.  This is because the gap up is forceful to the upside.  The bearish kicker is just the opposite where a red candle gaps down so hard, that the open-close range are well below the open-close range of the previous day’s green candle. 

Figure 6.  Bullish kicker.

Dark Cloud Cover

The dark cloud cover is a bearish reversal signal (Figure 7) consisting of a green and red candle.  The red candle must gap up (open higher) above the green candle and then the bar turns into a red candle and must close at least 50% below the mid-point of the green candle.  The dark cloud cover’s reliability is medium. 

Figure 7.  Dark cloud cover.

Piercing

The piercing pattern is the opposite of the dark cloud cover and it is a bullish reversal pattern (Figure 8).  This pattern also consists of a green and red candle but the green candle must gap down (open lower) below the red candle.  This green candle must close at least 50% above the mid-point of the red candle.  The piercing pattern’s reliability is medium. 

Figure 8.  Piercing pattern.

Shooting Star

The shooting star is a bearish reversal pattern (Figure 9).  It consists of a green candle and during the day it was a long candle, but for some reason, there was a sell-off that “shaved down” the long candle by at least 2/3 (this is flexible and can be less).  This means that the candle opened up, reached a high, but closed near its open.  The candle is still above the previous day’s candle.  The shooting star is an extremely reliable pattern to determine high-probability tops.

Figure 9.  Shooting star pattern. 

Hammer & Hanging Man

Both patterns are reversal patterns (Figure 10).  The Hammer occurs at the bottom of a downtrend and a hanging man occurs at the top of an uptrend.  What happens is that these candles open, sell off during the day but somehow manage to rally back close to their open.  The shadow has to be at least 2/3rds larger than the body of the candle.  The term “hanging man” is exactly what it is…a man hanging.  Both patterns have high reliability.

Figure 10.  Hammer and hanging man in STEC chart.

Morning Star

The morning star is a bullish reversal pattern at the end of a downtrend.  This is a three candle formation with the first candle being red, the second neutral, and the third, green.  The second candle can be anything, but in most cases, it is a doji.  What happens here is that the downtrend is exhausted and there is a lack of sellers pressuring the stock down. The second day, being an indecisive day, becomes “middle ground”.  If the bulls win the next day, the green candle completes the morning star pattern.  The third candle must close at least 50% above the mid-point of the red candle. 

The morning star (Figure 11), and its counterpart, the evening star, are two of the most highly reliable reversal patterns in candlestick charting.  The failure rates are extremely low and the morning star and evening star are two of the most sought-after patterns by technicians.

Figure 11.  Morning star pattern on Goldman Sachs.

Evening Star

The evening star (Figure 12) is the complete opposite of the morning star and it is a bearish reversal pattern.  At the end of an uptrend, the stock exhausts itself and may form a doji top, signaling a stalemate between the bulls and bears.  This is an indication that the majority of traders have bought the stock if there is no price progress made.  The third candle, a red one, indicates panic-driven selling as a result of a lack of buyers.  The downtrend usually continues for quite some time.  Opposite of the morning star, the third red candle must close at least 50% below the mid-point of the green candle.

Figure 12.  Evening Star in Merck chart.