Candlesticks For The Wise

When it comes to candlestick patterns, what you see is a reflection of the psychology of market participants. Understanding the psychology gives you insight into price movement. Three effective and reliable candlestick patterns are easy to follow. They are:

1) Engulfing patterns (bullish/bearish)
2) Three black crows
3) Three white soldiers

ENGULFING PATTERNS
The engulfing pattern is also known as "hugging line." In this pattern, the first candle reflects the existing trend and the second represents the upcoming trend. The bullish and bearish engulfing patterns are reversal signals that appear in downtrends and uptrends, respectively. For the pattern to appear, the trend should be clear. The second real body must engulf the prior real body. The upper and lower shadows of the candlestick, if any, need not be engulfed.

Theoretically, the second real body should not be the same color as the first body. The only exception, which is mentioned in Steve Nison's Japanese Candlestick Charting Techniques, is if the first body is a doji. Nison states that after an extended fall, a doji engulfed by a very large white real body could signal a bottom reversal. In an uptrend, if the doji is engulfed by a large black real body, it could be a bearish reversal pattern. You can also have a spinning top instead of a doji as the first body.

On the weekly chart of the British pound in Figure 1, there is an example of the application of different patterns. The British Pound Index had an extended upside rally of six strong trading weeks beginning at around 196 in June 2007. In the seventh week there was some selling pressure and by the end of the week the seventh candle hugged the prior day's body, forming a bearish engulfing pattern. According to Steve Nison, we can use the high of the red candle as resistance for a future reversal rally. Nison mentions support and resistance as the prime use of the engulfing pattern.

The high at 206 is the resistance, which the index didn't dare to challenge at all. Instead, the index plunged to the 197.77 level within a few weeks. In this bearish reversal pattern, both bodies have small upper and lower shadows. The second body has wrapped the first body entirely.

I would also like to explain one classic engulfing pattern from Japanese Candlestick Charting Techniques. Nison states that at times the body can cover not just one but smaller real bodies of a prior trend in between the two main bodies. For example, in the case of a bullish engulfing pattern, the bullish candle can engulf the first black or red candle and even smaller candles if there are any in between these two candles. As mentioned earlier, engulfing the shadows is not necessary, but the real bodies should be wrapped completely. This classic pattern gives a strong reversal signal. The wise trader will look at one simple pattern in different ways to make optimum use of it.

THE THREE BLACK CROWS
Now we begin with another reversal pattern with three candlesticks, "three black crows." As the name suggests, three black (bearish) declining candles appear consecutively, each one opening within the body of the other and closing at a new low. This pattern is also called as "three winged crows," as the Japanese have an expression that "bad news has wings." Steve Nison writes:

...[t]he three crows are, as the name implies, three black candles. Likened to the image of a group of crows sitting ominously in a tall dead tree, the three crows have bearish implications. The three lines should close at, or near, their lows. Ideally each of the openings should also be within the prior session's real body.

This pattern is more useful for longer-term traders since it completes after the third candle. By then, the market has already corrected substantially and looks as if the declining rally will continue. In Figure 1, 211 was the high made on the previous advance rally. The shooting star candlestick pattern suggested that a top was being formed and a trend reversal was likely.

After two uncertain weeks, the index failed to hold up the high and also closed near the low of the day. This was the first hint of weakness by the first black candle session of the three black crows. The second and third candles opened within the body of the previous candle and formed lower lows at the close.

The third candle completes the pattern, by which time the index had plunged significantly below the high on the index. The size of the first candle of the pattern was smaller compared to the other two. This also reflects the increasing bearish strength as the pattern matures. By then, the bears have grown stronger and taken over, leaving no space for bulls to hide.

FIGURE 1: ENGULFING PATTERNS AND THREE BLACK CROWS. Note how these patterns are indicative of a trend reversal.

The correction continued until an inverted hammer formed. The inverter hammer has a much smaller lower shadow and was confirmed on the next bar by the bullish opening. In addition, the bullish candle that reconfirmed the inverted hammer has engulfed it (inverted hammer). This could mean a bullish move is ahead, but the bears were not ready to give up. The real bullish rally was initiated only after moving lower and close to the previous low, which offered stronger support.

To really understand what kind of reversal signal can actually start a fresh advance rally, we head to the next pattern, the "three white soldiers."

THREE ADVANCING WHITE SOLDIERS
The three white soldiers is a bullish reversal pattern. It is a group of three bullish (white or green) candles, with consecutive higher closings. Each candle opens within the body of the previous one and close at or near the day's high. This pattern indicates steady and healthy growth, provided the candles are not too large in size. All three bodies should reflect the steady move of the market supported by encouraging volume. The shadows appearing at the upper and lower ends should not be longer than the real body.

FIGURE 2: ENGULFING PATTERNS, THREE BLACK CROWS, AND THREE WHITE SOLDIERS.These patterns help you understand the psychology of a marketplace so you can make your trading decisions wisely.

The gapup violated the strong resistance and the second bullish candle opened near the high of first candle and closed at a new high. The third candle showed a similar move, so the three white soldiers raised the index to a new level. The correction appearing after an extended rally is normal till certain support levels are held. After the range breakout, the index has seen a robust up move and marked new highs.

If the second and third or only the third bullish candles shows signs of weakening, then the pattern is an advance block or stalled pattern. This means the rally is slowing down and the journey is about to end. An advance block can be recognized by the long shadows on the second and third candle with a small real body. In a stalled pattern, the first two white candles have large bodies making new highs, followed by a small white candle. Both patterns should be used for protecting long positions and not for initiating short positions.

Figure 2 shows a stalled pattern in February 2008. Initially, the rally began on stronger notes, but later, the bull seemed to have lost its power. The third candle hit the highest level on the rally but later failed to sustain near the highs. In addition, the low of the day was not held, so the bullish force was temporarily reduced.

As the stalled pattern was complete, the index entered a small correction. Those who would have cut their long positions when the stalled pattern formed would have saved their profits. A long trade on three advance soldiers should be watched very carefully with cautious stop-losses.

Figure 2 can help us understand how these patterns can actually be used in your trading. In 2005 after a correction, $XBP entered a consolidation. The breakout of this consolidation lead to a robust upside move. In early April 2005, an "inverted hammer" was formed with the support of the lower range at 172.5. This inverted hammer was the first sign of a reversal rally coming up.

Eventually, the upper range was taken off and three consecutive bullish candles appeared, forming three white soldiers. Thereafter, the British pound continued to head higher and made a new high at 205. Here, we can see the bearish engulfing pattern that dragged the index a few points lower. The pattern was strong and noticeable as it appeared at a new high, indicating a temporary pause in the current rally.

The small descending move established support immediately at 197 and fueled up the prior rally. At a new high, a shooting star was formed, indicating that the index had topped out and a bearish force likely to take over. As the downtrend began, the three black crows reconfirmed the bearish pressure dragging the index much lower. The red inverted hammer signaled the end to the decline but it took a while for the bulls to gain their power.

It wasn't until 2008 that the index regained the strength. Alas, that was a stalled pattern so the bulls still didn't have the strength to carry a rally.

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