A Guide to Common Candlestick Patterns
While there are entire books dedicated to the subject, over time most traders will find that there are only a few candlesticks that they tend to use. The dizzying array of possibilities can often lead to “paralysis by analysis”, and as a result it is difficult for some to discern possible trading opportunities. However, if a trader was to limit the candlesticks used as signals to just a few very widely used ones it allows them to take trades with more confidence as there will also be many other traders using the same signals.
Many traders will come across the idea of “going against the herd” when it comes to trading. Sadly, this is one of those axioms that have gained traction over the years. However, the truth is that you need the rest of the market to move with you if you want to be profitable. Quite often, the best technical setups are the ones that are most obvious. With that in mind, we look at the following candlesticks:
Like many candlesticks, this pattern has a bullish and bearish version. The bullish one is called the hammer as it looks like one. The shooting star takes a little bit more imagination, but it looks a bit like a shooting star, with the tail being visible.
The hammer features a long wick to the downside, but opens and closes at roughly the same level. The opening will see selling into the time period, but in the end the buyers come back and push prices much higher and to the virtually unchanged level. This suggests that the sellers have failed to keep prices down, and that exhaustion may be setting in for the sellers. These are most important when at the end of a downtrend, and can often signal a trend change. (Insert hammer.png)
The shooting star on the other hand is the exact opposite. You will see the open followed by a sharp rise in price. The buyers fail to hold prices higher, and by the end of the session the close is either the same or close to the opening price. When this candlestick appears at the top of an uptrend, this can often signal exhaustion by the buyers, and can signal a trend change.
Bullish/Bearish Engulfing Candlestick
The engulfing candlestick is simply a candlestick that completely engulfs the previous one. In order to do this, it takes a wild and volatile session. This candle represents a serious struggle that has settled in the favor of one of the sides. It helps if the candle closes within the last 20% of the range in order to show conviction. In other words, in a bearish engulfing candlestick, you want to see it close in the bottom 20% of the range. The candlesticks can often signal that there is a move in the direction of the candlestick coming, as momentum builds and follow through comes along.
The doji is the most common of the candlesticks in this article. A doji simply is a candlestick that is undecided. In a way, the shooting star and hammer are both specialized forms of the simple doji, simple differentiated by the fact they show exhaustion. A true doji however, is simply a candlestick with a range that fails to break in one direction or another. There are many different types of dojis, but in the end they all mean the same thing: indecision. If we get that indecision, it only makes sense that once we move – it means something. The idea is when the range is broken to either the upside or downside, the market has suddenly made a decision, and traders will follow that move to push it even farther. In the attached graphic, you can see the doji formed, and then the breakout over the next session signaled a move higher.
Aggressive or Patient?
There are different ways traders will play these candlesticks. However, it should be noted that by far the most conservative and careful way is to wait to see where the following candle closes. Some who are more aggressive will place the trade as soon as the candlestick is broken to the upside or down, but as you can see in the doji example above – that would have got the trader into a whipsaw situation. By waiting for the close, the trader would have seen that the bullish momentum had built up.
Also of note, as with all things technical analysis related, the higher the timeframe one of these candlesticks appear – the more reliable they tend to be. This is of course because there are more trades represented by the candle, and therefore more information.