In contemporary technical analysis, candlestick patterns are go-to indicators for legions of active traders. From the doji to the evening star, these formations are applied to every conceivable market. That is one of the key benefits of using Japanese candlestick chart patterns: The formations are readily discernible.
Regardless of market or time frame, candlestick charts present price behavior in a unique context. In this blog post, we’ll give you a few tips on how to read candlestick patterns like a seasoned pro.
The Doji
A doji is a single candlestick pattern with an opening value equal or near equal to its close. Dojis are visually similar to a cross or a plus symbol (+), and they signify indecisive market conditions.
Generally, a doji is viewed as being a precursor to a market reversal or breakout. There are four distinct kinds of dojis:
- Normal: The classic doji features a compressed periodic range with a centralized open and close. In many cases, the normal doji forms within the previous candle’s range.
- Long-legged: A long-legged doji has an extended periodic range with an elongated upper and lower tail. The opening and closing values are located near the center of the range. Typically, one tail of the long-legged doji extends outside of the previous candlestick’s extremes.
- Dragonfly: The dragonfly doji features an elongated lower tail with the open and close very near the high. The dragonfly suggests that a bearish trend or bullish pullback may be reversing.
- Gravestone: The gravestone doji exhibits an elongated upper tail with an open and close very near the low. Gravestones suggest that a bullish trend or bearish pullback may be reversing.
In addition to being standalone formations, dojis may be included in multiple-candle patterns. For anyone getting started with Japanese candlesticks, recognizing and understanding the doji is an essential first step.
Advanced Candlestick Patterns
One of the great things about candlesticks is that they readily convey a large amount of information. Every candle discloses an open, close, high, low, body, and market direction. This user-friendly interface allows for advanced interpretations of price action itself.
By far, the doji is one of the simplest candlestick patterns. Here are a few popular formations that feature greater complexity:
Bullish/Bearish Engulfing Patterns
Bullish and bearish engulfing patterns are two-candlestick formations used to signal market direction. The bullish engulfing pattern occurs when a bearish candle (close lower than the open) is encapsulated by a second bullish candle (close higher than the open).
Conversely, a bearish engulfing pattern occurs when a bullish candlestick is encapsulated by a bearish candlestick. Accordingly, the forthcoming market direction is projected to be a continuation of the second candlestick in the sequence. If bullish, buying in just above the second candle is warranted; if bearish, selling directly below the second candlestick is plausible. To manage risk, a trader can place stop losses above or below the first candlestick.
Morning/Evening Stars
Morning and evening stars are three-candle formations thought to signify possible market reversals. The morning star is used to spot a bear market reversal, so it occurs within an established downtrend. The first candle is bearish; the second candle opens gap down and has a compressed range; the third candle is large and bullish and opens gap up.
By contrast, the evening star is the exact opposite of the morning star, signaling a bullish trend reversal. On special occasions, the second candle of the morning/evening star is a doji―this makes the formation an exceedingly rare and powerful reversal indicator. For morning stars, a buy is recommended above the first candle with a stop loss below the second; for evening stars, a sell below the first candle and stop loss above the second is appropriate.
Trading strategies based on candlestick patterns such as these provide traders several key advantages. First and foremost, the pattern defines specific market entry and exit price points. Regardless of whether the pattern is effective or ineffective, the formation identifies an exact stop loss location. This ensures that losing trades are cut off quickly while winning trades are allowed to run.
