4 Candlestick Patterns You Need to Know for 2023
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Traders often find candlestick charts provide additional insights into market action beyond a traditional line chart. Though they provide essentially the same information as a bar chart, candlestick charts present that information more vividly.
Candlesticks are formed by showing a candle “body,” a solid area between the open and close price, and “wicks,” which represent the high and low. Candles (the terms “candles” and “candlesticks” are used interchangeably) are often colored to indicate whether it indicates an up move or a down move. For a more detailed description of candlestick charts, have a look at How to Read Stock Charts.
Many chart watchers believe specific shapes of individual candles or candlestick patterns can offer clues about the prevailing mood of a market. Steve Nison’s book "Japanese Candlestick Charting Techniques" introduced the discipline to Western investors and is essential reading for anyone who wants to become a skilled candlestick chart reader.
The nice thing about candlestick patterns is that the rules are fixed. That matches up nicely with what computers do well, so it’s not surprising that several brokers and charting packages now offer automated candlestick pattern recognition.
Before relying on a computer app, you should spend some time practicing spotting them yourself. Then you will see them in the context of other market indicators and eventually decide whether candles are your thing or not.
Will you become any richer solely from trading candle patterns? Probably not. That would be too easy. There are no — well, very few — free lunches on Wall Street. But candlesticks can be combined with volume analysis, moving averages and/or any number of other charting techniques. Candlesticks are just another tool in the ol’ toolkit.
What are some must-know candlestick patterns?
Let’s take a look at four of the most widely used candlestick patterns along with some actual stock chart examples. The four patterns we’ll look at here are the bullish engulfing pattern, the bearish engulfing pattern, umbrella lines, and dojis. Even if candlesticks aren’t your thing, almost everyone agrees the pattern names are vivid.
Bullish engulfing candlestick
A bullish engulfing candle pattern is formed when a candle’s body (the difference between the open and close) is longer than the prior candle with both a lower open and a higher close. It engulfs. Usually, this pattern suggests the price has found support. Often this type of candle can signal a sustained up move or trend change.
Below are, first, an example of a bullish engulfing pattern and, next, how it foretold a change in trend.
Chart source: eToro
Bearish engulfing candlestick
The opposite of a bullish engulfing candle, a bearish engulfing candle pattern will open higher than the previous bar’s close, then after finding selling volume will move sharply downwards, breaking the previous day's open. This can foreshadow a sharp sustained drop in price or trend change. Below is an isolated example of a bearish engulfing pattern, followed by where I plucked it from in a chart.
Chart source: eToro
An umbrella line can form when support or resistance is sharply rejected by market participants. They are small bodies with long lines underneath. A hammer indicates a potential reversal of a downward trend. Below is an example of a hammer in the midst of some market action.
Chart source: eToro
If an umbrella line appears in an uptrend, it also points to a potential reversal and is aptly called a “hanging man.” Yikes. Below is an umbrella line pointing to a reversal.
A candle that lacks a real body is called a “doji.” They are formed when the opening price and the closing price of a bar are the same. Many traders believe this is where the bulls and bears are fighting each other for direction. A doji candle can have long wicks formed to the high and low, which were tested but fought back from by each side. The pattern signifies uncertainty. The market is waiting for either the bulls or bears to take control. Often the next direction is an upwards or downwards sustained move in price as the stock breaks beyond the doji.
The doji candle is not a great entry candle for a trade because the trend can go either way. What it does offer is a heads-up that sentiment may be changing. Options traders might use it as a signal to put on a straddle. Below is a doji signifying the possible end of an uptrend.
Chart source: eToro
All in all, these four candlestick patterns, when identified correctly and used in combination with other analysis techniques, can be very useful for investors, as long as you understand what they are trying to tell you.
How many types of candlestick patterns are there?
There are an almost infinite number of patterns possible, but investors tend to focus on established continuation and reversal patterns. Some of the most well known are engulfing patterns, dojis, and umbrella lines.
What is the three candle rule?
The three candle rule is to invest against the trend after an extended move in one direction. When three long-bodied candles appear in the same direction, the trend is expected to reverse, reminiscent of the phrase “three steps forward and two steps back.”
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