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.
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:
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.
Traders use many different formations to identify a potential market turning point. From single-candle to multi-candle arrangements, every pattern is unique.
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The hammer is a single-candlestick formation that signals the bottom of a bearish trend. It exhibits several distinct characteristics:
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.
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:
A bullish engulfing pattern has an opposite configuration and is found near the bottom of a periodic extreme:
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.
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:
The morning star appears in downtrends, signaling growing bullish participation:
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.