The Power of Understanding Candlestick Reversal Patterns by Mark Deaton

 

Traders claim that 'the trend is your friend'. That's true - until the trend reverses unexpectedly. This is why it's critical for you to understand candlestick reversal patterns. A surprise change in trend is likely to be triggered by news. There will almost always be hints or rumors before the information comes out publicly. For example, news from one company may cause speculation about what is happening to competitors in the same or related industries.

Markets will react or prepare for that anticipated news based on speculation. Buyer and Seller behavior actually becomes somewhat predictable at this point. Traders often 'buy on the rumor and sell on the news', in an attempt to beat the crowd.

Clear evidence that lots of people are "in the know" shows up as patterns within multiple trading sessions. Candlestick charts can help you be nimble enough to stay one step ahead of whatever major move is about to occur. You just have to know which candlestick reversal patterns to look for.

Stars - Trend Exhaustion Signals

The Morning Star and Evening Star are two opposite-meaning candlestick patterns. Both indicate a possible change in trend - one up and the other down. They tend to be reliable signals when the trend has been strong for an extended period. There is already a sense that it is time for a market correction.

For example you might have a long candle with very little shadow the first day followed by a Doji (a candle that is all shadow with no body) formed on the second day. A gap in trading appears between the first and second trading sessions. The Doji indicates indecision where the bulls and bears equalize or cancel each other out. The opening and closing the second day are the same price.

The third day gaps again with a long candlestick in the opposite direction from that of the first day. It provides confirmation that a new trend has begun. This single description actually fits both the Morning and Evening Star candlestick reversal patterns. Each predicts a reversal in the opposite direction - but for similar reasons.

In the case of a Morning Star, the bulls have taken control of the market and prices continue upward. In the case of an Evening Star, the bears are firmly in control and prices continue lower on the third day. The old trend is clearly broken as the price closes beyond the midpoint of the first day candle. Why does this move happen?

Value Adjustments

Price trends usually change for reasons that are based on perceived future value. Extreme price movements need to be justified by fundamentals and estimates of true worth. If an upward trending stock suddenly issues an earnings warning, perception of future worth abruptly changes. This explains the diverging pattern associated with the Kicker where trading shifts dramatically in the opposite direction of the former trend. Other, more subtle candlestick reversal patterns occur when the market needs time to evaluate news.

Breakaway Candlestick - This 5 day reversal pattern starts out similar to an Abandoned Baby, except there is slightly more indecision before the major move. In a downtrend, a long black candle forms. The 2nd day gaps down to form a black short day called a star. The next 2 days are consecutively lower candles with the 4th day closing lower than the 2nd. The 5th day opens lower still but trades up and closes within the gap of the 1st and 2nd days. The bearish form of the Breakaway Candlestick starts with the prior trend being bullish instead. The candle formation is flipped and features colors that are the opposite of those described above.

Ladder Bottom - 5 day pattern. Three Black crows form during a downtrend. On the 4th day a short black body forms as an Inverted Hammer. The 5th day is a long white candle that opens above the 4th day body and closes above the opening of the 3rd day.

Three Stars to the South - 3 consecutive black candles in downtrend (paradoxically bullish because shorts in the market have failed to create a new low). The 1st day has a long shadow on the bottom. The 2nd day is a smaller version of the 1st and trades completely within the body and shadow of it. The 3rd day is short and black with no shadows but trades within the complete trading range of the 2nd.

Tri-Stars - 3 Doji in a row indicate a reversal of the current trend because of the extended and extreme nature of the indecision. Tri-Stars can be bullish or bearish candlestick reversal patterns.

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