Rooted in 18th century feudal Japan, candlestick charting techniques were originally devised to track the pricing variations of rice. Early Japanese futures traders used variations of candlestick charts while engaging prominent markets, specifically the Dojima Rice Exchange. It was not until the late 1980s that candlesticks caught on in the West.
One area in which candlestick charts excel is in the identification of market reversal points. Being able to determine trend exhaustion is a powerful tool, and candlestick reversal patterns are great way to accomplish this task.
The Anatomy of a Candlestick
Before a trader can begin scanning the markets for patterns, it’s necessary to understand the anatomy of a candlestick. Each candlestick records the open, close, high, and low price value for a defined period. Based on this information, every candlestick has three basic parts:
- Body: The body of a candle is the range between the opening and closing values. If a candle’s open is above its close, then it is shaded. If the close is above the open, then the body is empty. Various colors may be assigned to each instance, with red and green being among the most frequently used.
- Upper wick: The upper wick is the area between the periodic high value and the top of the body. It is expressed as a single vertical line.
- Lower wick: The lower wick is the area between the periodic low value and the bottom of the body. It is also expressed as a single vertical line.
Anatomy is a key element in the formation of viable candlestick reversal patterns. Pattern formation is directly dependent on the relationship between the body and wicks of single or adjacent candles.
Candlestick Reversal Patterns
Traders use many different formations to identify a potential market turning point. From single-candle to multi-candle arrangements, every pattern is unique.
The hammer is a single-candlestick formation that signals the bottom of a bearish trend. It exhibits several distinct characteristics:
- Body: The hammer has a small body and may be either shaded or empty.
- Upper wick: Very little or no upper wick is evident.
- Lower wick: The length of the lower wick is the key element in the formation of a hammer. It must be extended and at least twice the length of the body.
A hammer illustrates the presence of extreme selling and subsequent buying pressure. This is an indication that price has rejected further extension to the bear and may be poised to rebound or recover fully.
2. Bearish/Bullish Engulfing Patterns
Engulfing patterns are two-candle formations that act as strong evidence that a market reversal may be forthcoming. They are found near the upper and lower extremes of a price range and illustrate that the prevailing trend has been contested and is becoming exhausted.
A bearish engulfing pattern appears near the top of a periodic extreme. It is comprised of the following elements:
- Candle one: A relatively small, empty body with proportionate wick lengths.
- Candle two: A much larger, solid body with proportionate wick lengths.
A bullish engulfing pattern has an opposite configuration and is found near the bottom of a periodic extreme:
- Candle one: A relatively small, solid body with proportionate wick lengths.
- Candle two: A much larger, empty body with proportionate wick lengths.
The key element of an engulfing pattern is that the second candle’s body encapsulates the entire first candle. This illustrates an initial test of an extreme and strong reversal against the established high or low value of the trading range.
3. Morning and Evening Stars
A three-candle formation, morning and evening stars are extremely popular candlestick reversal patterns. Each is found in the midst of a strong trend and depicts a directional move in price, period of compression, followed by a reversal.
The evening star is found in uptrends, signaling growing bearish participation:
- Candle one: Large empty body with relatively short upper/lower wicks
- Candle two: Small empty body with relatively short upper/lower wicks
- Candle three: Large shaded body with relatively short upper/lower wicks
The morning star appears in downtrends, signaling growing bullish participation:
- Candle one: Large shaded body with relatively short upper/lower wicks
- Candle two: Small shaded body with relatively short upper/lower wicks
- Candle three: Large empty body with relatively short upper/lower wicks
Morning and evening stars clarify the process of trend reversal. They feature robust price action, a period of slowing, and a dramatic change of course. Due to their extended duration, stars are often used in risk management, specifically in determining stop loss locations.
Incorporating Candlesticks into Your Strategy
For more information on how candlestick reversal patterns can help elevate your trading, check out the e-book “12+ Candlestick Formations Every Trader Should Know” available at Daniels Trading. It provides an in-depth synopsis of the whats, whens, and hows of approaching the markets using strategies based on candlestick charting techniques.