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Basics of Technical analysis

Candlestick Reversal Patterns

While discussing candlestick charts in Unit 2 of this module, we had mentioned that they have the edge over many other types of chart representation due to recognizable chart patterns, which are easy to define and work beautifully in the market.

In this section, we will discuss a few popular candlestick patterns. Candlestick patterns provide entry and stop-loss criteria, but there is no target setup as available in classical chart patterns. 


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Hammer

Hammer is a single candlestick bullish reversal pattern. This occurs after a prolonged down trend. Ideally, there should be a gap down opening and bears should be able to push the price lower as a continuation of a down-move. At this point, bulls should overpower bears and push prices higher and make close to the opening price. The candle formed in this process should have a small body, a big lower shadow, and a negligibly small upper shadow. Ideally, the lower shadow should be at least twice the length of the body. The color of the body can be either green or red, but if the body color is green, then the hammer is considered a little more bullish, as the bulls were strong enough to close the price higher than the open price. The next day or in the next two to three days, ideally there should be a gap up opening or price should move above the high of the hammer candle. This is called confirmation or validation of the pattern. A hammer like a candle, without validation, has no real significance. If price moves above the high of the hammer a buy trade can be taken with a stop loss below the low of the candle.  

Shooting Star

A shooting star is just like a mirror image of a hammer candle. First, there should be a sustained up trend and then there has to be a gap up opening. The bulls should push the price higher in the initial part of the day. Then, later in the day bears should take in the control of the stock and push prices down. Eventually, the closing price should be very close to the opening price, resulting in a candle with a small green or red body, a big upper shadow, and a small or negligible lower shadow. The upper shadow of the candle should be at least twice the length of the body. Now confirmation of the shooting star pattern comes if the price moves below the low of the candle within the next 2-3 candles. On confirmation, a short trade should be taken with stop loss above the high of the candle. A shooting star pattern with a red body is considered slightly more bearish than one with a green body. It is often observed that the shooting star candlestick pattern acts as a bearish reversal pattern and triggers a down move after an uptrend.

Inverted-Hammer

An inverted hammer is a single candlestick bullish reversal pattern. The pattern appears after a sustained down-trend. At the beginning of the day, there should be a gap-down opening. However, bulls should push the price higher during the course of the day. Eventually, the bears should push the price lower during the course of the day and close near the open price. The resulting candle should have a small body, red or green, the upper wick should be at least twice the body of the candle and the lower shadow should be quite small or negligible in size. If the body is green it is relatively more bullish than if it is red. This looks like an inverted hammer as the name suggests. The philosophy is that bears were not able to push the price below the opening price during the course of the day. This pattern, however, is considered to be a little less bullish than the hammer itself, because in hammer bulls are able to force a higher close by the end of the day. The confirmation of the pattern comes once the price moves above the high of the candle. On confirmation, a buy trade can be initiated with a stop loss below the low of the candle. The inverted hammer occurs a little less frequently in the market as compared to the hammer pattern.

Hanging Man

Hanging Man is a single candlestick bearish reversal pattern. This appears after a sustained up-move. The candle looks like a hammer; the only difference is that it appears at the end of an up-trend. The candle should have a small body at the top (red/green) and a lower shadow at least twice the length of the body. There should be very small or no upper shadow. A red colored body of hanging man pattern is more bearish than a hanging man pattern with a green body. The confirmation of the pattern happens when the price moves below the low of the candle. On confirmation, a trader may take short trade with a stop-loss above the high of the candle. The hanging man pattern is the bearish counterpart of Bullish inverted hammer. However, this appears much less frequently than shooting star which is another bearish reversal pattern.


Bullish Engulfing Pattern

Bullish candlestick pattern is a two-candlestick bullish reversal pattern. First, there should be a downtrend. Then we should have a red candle followed by a green candle. The body of the green candle should engulf the body of the first red candle. The idea is in the second candle that constitutes the pattern, the day started below the previous day’s close on a bearish note. However, as the day progresses, the bulls take-over the charge and eventually succeed to close above the previous day’s high. In such a scenario, if the highest point of these two candlesticks is breached on the upside within the next 2-3 candles, the bearish engulfing pattern is said to be confirmed. A buy trade can be initiated upon confirmation with a stop-loss below the low of the two candlestick patterns.

Bearish Engulfing Pattern

Bearish Engulfing pattern is just a mirror image of a bullish engulfing pattern with bearish implication. First, we should be having an up-trend. Then we should have a green candle as a continuation. The next day should see a gap up above the close of the previous day. The 2nd-day candle should eventually close red with its body totally engulfing the body of the first candle. The confirmation comes when within the next 2-3 candles the price moves below the low of the two candles forming the Bearish Engulfing pattern. On confirmation, a trader may take a short trade with stop loss above the top of the two candlestick patterns. Larger the second candle, the more bearish the pattern.

Piercing Pattern

The piercing pattern is just similar to the bullish engulfing pattern; the only thing is that the 2nd candle in the two candlestick patterns does not close engulfing the body of the first candle. Instead, it closes crossing the halfway mark of the body of the first candle. Confirmation comes when price crosses the high of the two candlestick patterns within the next 2-3 candles. On confirmation one may take a buy trade with stop loss below the low of the candle.


Dark Cloud Cover

The Dark cloud cover is a two candlestick bearish reversal pattern and much similar to the bearish engulfing pattern. In this pattern, the second candle, unlike the bearish engulfing pattern falls short of engulfing the first candle, instead, it crosses 50% the body of the first candle. The confirmation comes when a candle breaches the bottom of the pattern. On confirmation, a short trade can be taken with stop loss above the high of the candle.


Doji

The Doji is a single candlestick pattern. The Doji assumes significance when it appears after a trending move, be it up or down. The Doji symbolizes indecision and after a Doji, the incumbent trend can reverse, go sideways or continue the uptrend. However, the appearance of a Doji is a signal of caution that the probability is high that the erstwhile trend may be coming to an end. Doji is a candle that has open and close almost at a similar level. There can be upper shadows and lower shadows of various proportions. 

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