How to read candlestick patterns, which are a valuable tool for traders and provide rich insights into market trends that can help to forecast future movements and inform trading decisions.
Here we examine eight of the most well-known candlestick patterns and how to use them in your trading activities.
A candlestick represents a trading session, and its color and position on the chart tell us five pieces of information about the market during the trading session.
A green candle indicates that the trading session ended with the price higher than when it started, and conversely, a red candle means that the price went down. The body of the candle, the thickest part, indicates the opening price and the closing price. The “wick” of the candle, the thinnest part, shows the highest and lowest price of the session.
Candlestick patterns are generally thought to have originated from Japan, used by rice traders in the 1800s. They re-emerged in the 1990s after analyst Steve Nison re-introduced them in his book titled Japanese Candlestick Charting Techniques, an excellent reference source for anyone looking to learn more on the topic.
Candlestick patterns frequently come in pairs, with one representing an upward trend and its partner the downward trend. So here, we’ve selected eight patterns that form four pairs, all of which signal that a market reversal could be underway.
The hammer pattern is a single candle with a short body and a long lower wick, shaped like a hammer. It shows that trading went far below the opening price but ultimately closed nearer to the opening price than the session lows.
When a hammer comes after a downtrend, it signals that selling activity is starting to slow, and buyers are beginning to control the market.
The hanging man pattern looks identical to a hammer, with a short body and a long low shadow. However, the hanging man’s significance comes into play at the end of an upward trend, indicating that a reversal could be about to take place.
In this case, the long lower wick on the hanging man tells us that bears staged a significant sell-off during the session, pulling prices down. Even though bulls were able to secure a closing price closer to the opening, their influence on the market may be weakening.
The inverse hammer, or inverted hammer, looks like the hammer but upside down. There’s a short body and almost nonexistent lower wick but a long upper wick.
Like other bullish reversal patterns, the inverse hammer is significant when it comes at the end of a downtrend. The long upper wick indicates that bullish forces were attempting to pull the price up, while the short lower wick could mean that the trend has found its bottom.
The shooting star pattern is the same shape as the inverse hammer with a short body and a long upper wick. In contrast to its bullish partner, the shooting star candle indicates that an uptrend is about to end.
In this case, the long top wick shows that the bulls were attempting to continue pushing prices up, but they weren’t able to keep prices high above the opening for the duration of the session.
The bullish engulfing candlestick is characterized by a smaller red candlestick followed by a far larger (engulfing) green candlestick. The upper wick on the green candlestick is typically shorter, indicating that the session closed near the highest price. This pattern shows that bulls outweigh bears, with the short wick a signal that bullish forces remain.
When the bullish engulfing pattern appears after a series of red candlesticks, it can indicate that a downward trend is about to reverse as bullish sentiments come into play.
A bearish engulfing pattern shows a green candlestick with a small body followed by an engulfing red one. The emergence of shorter lower wicks indicates that bears are forcing prices down.
Mirroring the bullish engulfing pattern, the bearish engulfing candles are significant when they come at the end of an uptrend, signaling that the bears are about to wrest control of the market.
Another bullish reversal pattern, three white soldiers, is a set of three green candlesticks indicating a downtrend. Each candlestick in the three white soldiers pattern has small wicks and a long body with the session opening price close to the closing price of its predecessor.
Three white soldiers is generally considered a more reliable reversal pattern, as it’s a strong indicator that bullish forces are at play over three trading sessions. However, in low-volume markets, it’s possible that anomalous patterns can emerge, so it’s not a flawless model.
Three black crows is the bearish partner to three white soldiers. It’s characterized by three long red candles with short wicks, with session opening prices near to the closing price of the candle before it. It indicates that bearish forces are now likely to control the market following a sustained upward trend.
Reversal indicators can be used in trading to determine when to open or close a position. The bullish indicators given here would be a signal to close out shorts and open longs, while the bearish indicators would have a trader exit longs and enter shorts.
All of these patterns are valuable indicators of market conditions, but they are in no way infallible. Furthermore, candlesticks are only one tool involved in technical analysis, and many traders deploy a range of other techniques, such as indicators or oscillators. Traders should always backtest any new strategy and ensure they have a robust risk management system in place.
All images in this article have been sourced from IG.
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