Best Candlestick Patterns for Price Action Analysis

Candlesticks charts are a reflection of what buyers and sellers are doing, as it packs data for multiple timeframes into single price bars. The key for a better Price Action Analysis with candlesticks is to "read" them at a glance and the patterns it forms, mainly when price approaches a support/resistance level, doing always in conjunction with volume. You need to know what price reaction each candlestick pattern is telling you: indecision, rejection, confirmation, or reversal.  

In Price Action Analysis, less is more with technical indicators: a few of them are enough. The same idea for candlestick patterns. You can find dozens of candlestick chart patterns, but I feel comfortable with a few of them, the most accurate in my point of view.  No need to memorize others, especially those three-candle patterns and their curious names, just understand the mechanics behind this tool. 

Consider that any candlestick has two parts: the body and the wick (or pin):

- The size (range) of the body represents the strength behind the move. Its color, the direction: green are buyers in control, red the sellers. So, larger body, large strength. And a larger candlestick size than the previous ones means more momentum.

- The size of the wick represents the power of the rejection.  Above the body is the rejection of higher prices, and below it, the rejection of the lower prices. So, larger wick, large price rejection.

- Finally, the relation body/wick (and color) on a specific candlestick gives you the complete idea of how price is moving. Always check the price close relative to the range, to know who, buyers or sellers, are currently in control of the market.

Let's review briefly the four price reactions through the main single and two-candle candlestick patterns: 

Single candlesticks

1- Pin Bar (or long-wick candle): this candle means that indecision began, as buyers tried to push the price higher but failed, causing the wick to show, meaning a rejection. There are bullish pin bars (the longer wick below the small body, been green or red), and bearish pin bars (the longer wick above the small body, been green or red). Again, consider the basic: the longer the wick, the more rejection of the price. And never trade blindly a bullish or bearish pin bar. Always respect the trend in a major timeframe.

2- As a derivative of this, a Momentum Candle represents that price bias is gaining strength in one direction. So, a big green candle without a wick is its most bullish pattern, and a big red candle without a wick is its the most bearish.  And if this candle body is bigger than the previous candle body, it reinforces the signal. Its best usage is after a rejection candle (like a Pin Bar or a Harami) or a reversal candle, as the Engulfing.

3- Inside the reversal one-candle ones you have at the end of a downtrend the bullish Hammer, which represents the bottom of a trend, and the Shooting Star, an inverted hammer forms after an uptrend movement, signaling a trend reversal to the downside. Less powerful are the variations of them: the less bullish Inverted Hammer (upper tick longer than the lower tick) form after a downtrend and the less bearish Hanging Man, the end of an uptrend. All these reversal patterns need an increased volume, necessarily greater than the previous candle, otherwise, its signal fades.

4- Finally, the Doji candle means complete indecision between bulls and bears. So, there is a no-trade signal there.

One-candle patterns, bullish and bearish, can be identified in the chart above, taken from slideshare.net, ordered according to the strength of its signal: Momentum Candle (1,6),  Hammer (2), Normal Candle (3,8), Neutral Pin-Bar or Spinning Top (4,9), Inverted Hammer (5), Shooting Star (7), Hanging Man (10), Doji (11) Gravestone Doji (12) and Dragonfly Doji (13).

Two-candle pattern

1- Harami: also called Inside Bar, is a popular rejection two-candle pattern, that could mean a reversal or a continuation in the trend. Its high and low are completely contained by the high and low of the previous candle. It can indicate a pause in a trend, momentum loss, or indecision. 

- Its best usage is at support/resistance levels: if the inside bar is also a Pin Bar or a Doji, it reinforces the probable reversal trend. 

- Another usage, and my favorite for a Harami, is during an uptrend after a strong breakout: is a good place for adding shares in the continuation of the trend. Obviously, the same works for downtrends. See it in the chart below.

- Didn't work fine when price action is choppy, moving inside a range.

2- Engulfing is my favorite bullish/bearish pattern by far. Many traders think the same. Consists of a two-candle pattern that anticipates possible reversals.  At a support level, a bullish trend can appear if a rejection green candle length (close-open) "engulfs" the previous red candle length (open-close). The same idea at resistance levels. I found this pattern to be very accurate, but need subsequent price action to confirm the reversal.

The key: check candles behavior at support-resistance levels

When price approaches an S-R key level, you have no idea whether there will be a trade or not until you get price action. At that level, a candlestick pattern forms, as a result of profit-taking, new positions opened, or a combination of both, and the strength of its signal is increased. So, three possibilities come for price at that level: a reversal move, a continuation of the trend, or ranging due to indecision.

1a- For a bullish reversal: confirm the stock is trending higher in a major timeframe, and wait for a pullback towards the support of your minor (entry) timeframe, waiting there for a bullish Engulfing pattern. A much large green body of the second candle signals a strong rejection and gives more odds to your entry.

1b- For a bearish reversal: confirm the stock is trending lower in a major timeframe, and wait for a pullback towards the resistance of your minor (entry) timeframe, waiting there for a bearish Engulfing pattern. A much large red body of the second candle signals a strong rejection and gives more odds to your entry.

2a- For a bullish continuation pattern, as told above, check for a red Harami candle after the bigger green one. Buyers are taking a breathe there with enough force to continue its uptrend. Look for this pattern after the stock ranges and breakout your resistance, and enter long in the next confirmation candle.

2b- For a bearish continuation pattern, check for a green Harami candle after the bigger red one. Sellers are taking a breathe there with enough force to continue its downtrend. Look for this pattern after the stock ranges and breakout your support, and enter short in the next confirmation candle.

Another powerful continuation candlestick pattern is the popular flag, as seen in the chart taken from Rayner Teo's candlestick guide. The "Rising Three Methods" pattern (three small red candles between two large bullish candles) show there, is basically a flag. Form in a minor timeframe, it's seen as a Harami in a larger timeframe. The other Harami showed also works fine. Both are great places for adding more shares in an uptrend.

Finally, consider these other combinations formed by single candlesticks, always at support/resistance levels:

1- Big candles: Be careful when you see large candles approaching support or resistance levels. Price is gaining momentum and no price action occurs for a trade.

2- Many rejection candles: means more than one pin-bar rejection candle of an S-R level (the more rejections the better). This basically shows that price tried over and over to push through the level but failed and a reversal is near. Consider that no matter the color of the long wick candles.

3- Candle color change: if after consecutive candlesticks of one color, the candle color change, it means momentum loss. Best use at key levels, in combination with other candlestick patterns as shrinking or rejection candles. It can signal a possible trend change.

A simple Scalping trade with Candlesticks

There are many interesting "candlestick strategies" around there, for every timeframe. The current take advantage of the size of the momentum candlesticks when price approaches an important resistance level.  If they are shrinking or decreasing each one, it means momentum loss. Bullish traders are losing steam due to they are less interested in the trend and are closing positions or taking profits.

- When the price reaches the resistance level with a small candle, check if the next is an engulfing candlestick. That signals a high probable reverse in the trend for the short-term.

- When the price reaches the resistance level with a small candle, check if the next is a rejection or indecision candle (Pin Bar, Doji, or Inside Bar). In this case wait for one more, as a momentum candle, for a better signal of a trend reversal in the short term.

The simple strategy, described above also works for supports and a bearish trade.  Check the grey circle in the SPY 1-min chart above: three red candles were shrinking when approaching important support $277.20, followed then by a big green engulfing candle with increased volume. The odds for a trend reversal are huge at that point. Then check the next resistance for an exit point: in this case, $279 seems difficult to crossover, due to many rejection candles there.  Try it.

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