Candlestick chart, Reversal patterns, Continuation pattern

Candlestick chart

Candlestick charts originated in Japan over 100 years before the West developed the bar and point-and-figure charts. In the 1700s, a Japanese man named Homma discovered that, while there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of traders.

The area between the open and the close is called the real body, price excursions above and below the real body are shadows (also called wicks). Wicks illustrate the highest and lowest traded prices of an asset during the time interval represented. The body illustrates the opening and closing trades.

The price range is the distance between the top of the upper shadow and the bottom of the lower shadow moved through during the time frame of the candlestick. The range is calculated by subtracting the low price from the high price.

If the asset closed higher than it opened, the body is hollow or unfilled, with the opening price at the bottom of the body and the closing price at the top. If the asset closed lower than it opened, the body is solid or filled, with the opening price at the top and the closing price at the bottom. Thus, the color of the candle represents the price movement relative to the prior period’s close and the “fill” (solid or hollow) of the candle represents the price direction of the period in isolation (solid for a higher open and lower close; hollow for a lower open and a higher close). A black (or red) candle represents a price action with a lower closing price than the prior candle’s close. A white (or green) candle represents a higher closing price than the prior candle’s close. In practice, any color can be assigned to rising or falling price candles. A candlestick need not have either a body or a wick. Generally, the longer the body of the candle, the more intense the trading.

Candlesticks can also show the current price as they’re forming, whether the price moved up or down over the time phrase and the price range of the asset covered in that time.

Reversal patterns

There are dozens of bullish reversal candlestick patterns. We have elected to narrow the field by selecting the most popular for detailed explanations. Below are some of the key bullish reversal patterns with the number of candlesticks required in parentheses.

Head and shoulders

This pattern happens during an uptrend and as the name suggests, it has four key parts: right shoulder, head, left shoulder, and the neckline. In most cases, it usually leads to a new bearish trend.

The target of the price is estimated by calculating the distance between the head and the neckline. An inverse H&S pattern is a bullish reversal one.

Double Top

A double pattern forms during an uptrend. It forms when an asset price rises to a certain level of resistance, such as $10, and then it retreats briefly. The price then rises and tests the initial resistance level.

This performance usually means that there are not enough buyers in the market to push it much higher. As a result, it will likely lead to a bearish breakout. The target price is usually estimated by measuring the distance between the top and the chin.

Wedges

A wedge pattern is a reversal pattern that happens in both long and short-term charts. A rising wedge is drawn by connecting the key resistance levels and support levels of the chart. The two lines will typically converge in a pattern that resembles a triangle.

The pattern usually leads to a bearish breakout of a chart while a falling wedge leads to a bullish breakout.

Symmetrical triangle

There are three types of triangle patterns: symmetrical, ascending, and descending patterns. The latter two patterns are usually signs of a continuation. For example, an ascending pattern tends to lead to a bullish breakout.

A symmetrical triangle can have a breakout in either direction. Therefore, as shown below, it is not a perfect reversal pattern.

Doji

A doji pattern is one where the asset opens and closes at the same level. The pattern has an extremely small body and small upper and lower shadows as well. As such, it usually looks like a plus.

Hammer pattern

A hammer forms in a bearish trend. It is represented by an extremely small body and a long lower shadow. In most periods, the hammer does not have an upper shadow.

When it forms, the pattern is usually extremely short. An inverted hammer is also usually a bearish sign.

Triple top

The concept of a triple-top pattern is similar to that of a double-top. The price will rise to a certain resistance ($10) and then it retreats to a support level ($8). It will then rise and retest the resistance at $10, and then retrace.

Engulfing

An engulfing pattern is a two-candle reversal pattern that happens during a bearish trend. The pattern is usually characterized by a small bearish candlestick that is then followed by a large bullish candle.

Continuation pattern

Rather than being formed across 10-50 candles like a classic pattern, candlestick patterns form across 1-5 candles. This is true of reversals and continuations. Candlestick continuation patterns are a signal that the short term trend over the prior few candles will resume in its current direction.

The continuation candlestick patterns are typically characterised by sideways movement after a strong directional move. They represent a pause in a trend where buyers in an uptrend or sellers in a downtrend take a breath. However, this is not always the case since some continuation patterns (such as a gap) are a sign that the trend is accelerating.

Benefits of continuation patterns

The concept of a continuation pattern is more in keeping with the idea of trend following. Ie the price has already moved in one direction and the trend follower is looking for opportunities to enter the market and ride the trend further.

Although reversal patterns are more well known, the concept is more one of picking tops and bottoms, which tends to be a harder thing to do and is more prone to false signals.

Types:

1) Gaps

Gaps are one of the most widely-used and well known short term trading patterns. They are not exclusive to Japanese candlesticks and are often used with traditional bar charts.

A bullish gap appears because the open of the second candle is higher than the close of the first candle and the low of the second candle does not reach the close of the first candle. A gap tends to happen at the start of a new trading session due to buyers out numbering sellers while the market was closed. A bearish gap is simply the opposite configuration.

2) Three white soldiers / Three Black Crows

This pattern is easy to spot with three long-bodied candles in a row, typically also with short wicks. Three White Soldiers is bullish, while Three Black crows is bearish.

Without knowing any better you might think this is a trend that is getting exhausted. However the Japanese candlestick interpretation is that it shows a trend with strong momentum that is likely to continue.

3) Rising Three methods / Falling Three methods

This pattern consists of one large body candle followed by three smaller body candles that form in the opposite direction to the first candle. Then a third candle that matches the first candle in size of body and direction.

The pattern looks quite distinctive, making it rarer on the charts, which tends to offer a better success rate.

A variation of this pattern is called the ‘Mat hold’.

4) Separating lines

This pattern involves a first candlestick that goes against the prevailing trend and then a second candlestick that opens at the same price as the first candlestick. It is like an internal gap pattern.