Explanation of different types of candlestick patterns
If you want to try predicting the markets using a candlestick chart, here are some of the most popular and useful patterns to keep a lookout for. The patterns can be separated into two groups; reversal (for when a market switches direction) and continuation (for when the market continues its trend in the same direction):
Engulfing Candlestick Patterns
The Engulfing pattern is considered to be a very strong and simple reversal pattern as it involves only two candles. The premise behind it is that the market has been moving in a direction and a trend, as signified by the first candlestick. However, the market then changes direction and engulfs the first candle within the second candlestick. This shows a change in sentiment.
As it occurs often and is easy to spot, this pattern is a very popular tool for identifying a potential turning or a reversal point. However, caution is advised because every time frame has its own larger trends and within these trends you may find turning points of the smaller trends. Choose your time frame carefully and be aware of the larger trends. Secondly, keep in mind that most patterns require confirmation. For example, when you see a reversal pattern that does not mean you have to sell automatically - the pattern is stronger when it occurs around a support or resistance area.
As seen, Engulfing patterns are made of two Candlesticks, one bullish and one bearish (in whichever order). The important thing is that the second candle totally engulfs the first one. The size of the first candle is not important, however in the case of the second candle the bigger the better. The second candle will confirm for us the strength / momentum of the reversal.
If we would like to use the Candlestick Patterns effectively we must determine the direction of the existing trend. Moving Averages, recent highs and lows or trend lines will always help us to see the big moves on the market. When we combine the pattern analysis on a high timeframe with correct money management the Engulfing pattern is a very reliable charting tool.
The Harami, another popular candlestick pattern, occurs when a large bar is followed by a smaller candle whose body is located within the vertical range of the large body. The bullish Harami gives a sign of a reversal of a downward trend. While a bearish Harami highlights a turning point in an uptrend. The chances of a reversal increase when the body of the second candle is smaller or a doji.
Morning Star / Evening Star pattern
These are two common patterns that look inverse to each other. The Morning Star is a bullish reversal candle pattern while the Evening Star is for a bearish turning point. Essentially, the pattern includes three candles.
- The first candle is a large bear candle. Sellers are dominating the market.
- The second candle has a gap between the first and the third candle, and can be bullish or bearish. Usually the body of the candle is smaller than the others. The gap, (which is more prevalent in markets with set open and close times such as equity markets) confirms the buyers or sellers dominance.
- The third candle is a large bullish candle. The buyers came into action and it is suggesting a turning or a reversal point.
The Evening Star pattern is the opposite formation of the Morning Star.
- First candle is a long bull candle
- Second candle opens, with a gap and a smaller candle which can be either bullish or bearish. The gap does not always happen in every market condition, and it’s not a must have criteria for this pattern.
- The third candlestick selling dominates, therefore it is a large bearish candle.
The important thing to remember is that Morning or Evening Star patterns carry much more weight when they form around a supply or a demand zone, like other reversal candle patterns.
Of course, no candlestick pattern by itself is a guarantee that a market trend is going to reverse. If you’re going to make a trade based on candlestick patterns, you should always manage your risks. Read more about risk management here.
Rising or Falling Three Methods
We look for the Rising Three Methods candlestick pattern in an uptrend within the context of a continuation. The Falling Three Methods happens when the trend is already bearish and the price continues to fall.
Rising Three Methods:
- The first candle of the pattern is a large bullish candle.
- The following three candles are small bearish candles. They should be within the range of the first candle of the pattern.
- The last candle of the pattern is another long bullish candle that creates a new high which suggests that the buyers are back in control.
Falling three Methods:
- This is the opposite of Rising Three Methods pattern. Just reverse the logic.
- The first candle is a long bearish candlestick within the downtrend.
- Followed by small-bodied candlesticks that trades within the range of the first candlestick.
- The fifth candle is a long red candlestick which creates a new low.
These are some of the most popular Japanese candlestick patterns and provide very useful and easy to spot indications of reversals or continuations. In addition, there are many more patterns and you should feel free to research and test others that appeal to your style. We believe that candlesticks should form a vital role in your technical analysis of the markets.