 |
Candlesticks are the soul of Price Action Analysis, as its charts are a reflection of what buyers and sellers are doing, packing data for multiple timeframes into single price bars. As told in a recent post the key to 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, always in conjunction with volume. You need to know which of the following four price reactions each candlestick pattern is telling you: indecision, rejection, confirmation, or reversal.
When price approaches an important S/R level (or key level), a trader has no idea whether to trade or not until getting price action. Cautiously, he waits for the resolution. 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. Is a priority to analyze them in different timeframes for better results.
1- Harami: also called Inside Bar, is a popular rejection two-candle pattern, that indicates a pause in a trend, momentum loss, or indecision and so, could mean a reversal or also continuation, all depending on the power of the trend. Recognize it when its high and low are completely contained by the high and low of the previous candle. Take note of its features:
- 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 as I'm a trend trader, 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.
- Only the double-action (sellers closing positions + buyers opening) causes the reversal to occur.
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 body length (close-open) "engulfs" the previous red candle body length (open-close). The same idea at resistance levels. I found this pattern to be accurate, but, as with all candlestick patterns, needs subsequent price action to confirm the reversal.
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 could occur for a trade.
2- Many rejection candles: means more than one pin-bar rejection candle at an S/R level (the more rejections the better). This basically shows that the price tried over and over to push through the level but failed and a reversal is near. Consider the following:
4- Growing candles: are opposite of the shrinking candles, appear after a rejection at an S/R level, and can be used as a confirmation of a previous trend change or reversal.
As in technical analysis, less is more, with its few technical indicators, the same idea applies to 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. For this, consider that any candlestick has just two parts, the body and the wick (or pin), and these three properties:
1- 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.
2- The size of the wick represents the power of the rejection. Above the body is the rejection of higher prices, and below it, is the rejection of the lower prices. Then, a larger upper wick means a big rejection to higher prices.
3- Finally, the relation body/wick (and color) on a specific candlestick gives you the complete idea of how the 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.
1- 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.
2- The size of the wick represents the power of the rejection. Above the body is the rejection of higher prices, and below it, is the rejection of the lower prices. Then, a larger upper wick means a big rejection to higher prices.
3- Finally, the relation body/wick (and color) on a specific candlestick gives you the complete idea of how the 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.
The key: check candlestick behavior at S/R levels
When price approaches an important S/R level (or key level), a trader has no idea whether to trade or not until getting price action. Cautiously, he waits for the resolution. 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. Is a priority to analyze them in different timeframes for better results.
Let's review briefly the four price reactions mentioned above through the following basic single candlesticks and my favorite two-candle candlestick patterns.
Single candlesticks
1- The 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 basics: the longer the wick, the more rejection of the price, then the "better" the candle.
2- A Momentum Candle: also known as the "confirmation" or no-wick 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 momentum signal. My favorite best usage is after a rejection candle (like a Pin Bar or a Harami) or a reversal candle, such as the Engulfing.
3- The Hammer, a bullish one-candle that appears at the end of a downtrend, represents the bottom of a trend and likely a reversal. Its opposite is 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) forms 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- The Doji candlestick means complete indecision between bulls and bears. So, there is a no-trade signal there.
2- A Momentum Candle: also known as the "confirmation" or no-wick 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 momentum signal. My favorite best usage is after a rejection candle (like a Pin Bar or a Harami) or a reversal candle, such as the Engulfing.
3- The Hammer, a bullish one-candle that appears at the end of a downtrend, represents the bottom of a trend and likely a reversal. Its opposite is 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) forms 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- The Doji candlestick means complete indecision between bulls and bears. So, there is a no-trade signal there.
 |
| One-candle patterns, from most to least strength, bullish and bearish, can be identified in the chart above, taken from slideshare.net, ordered according to the strength of its signal: Momentum Candles (1,6), Hammer (2), Normal Candles (3,8), Neutral Pin-Bar (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 indicates a pause in a trend, momentum loss, or indecision and so, could mean a reversal or also continuation, all depending on the power of the trend. Recognize it when its high and low are completely contained by the high and low of the previous candle. Take note of its features:
- 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 as I'm a trend trader, 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.
- Only the double-action (sellers closing positions + buyers opening) causes the reversal to occur.
- Harami 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 body length (close-open) "engulfs" the previous red candle body length (open-close). The same idea at resistance levels. I found this pattern to be accurate, but, as with all candlestick patterns, needs subsequent price action to confirm the reversal.
- Experience teaches me to avoid the small engulfing candles. The best results are usually achieved when engulfing is formed with large momentum candles, with a length above 1.5 times the stock ATR.
 |
| 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) shows 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. |
Combinations of Candles
1- Big candles: Be careful when you see large candles approaching support or resistance levels. Price is gaining momentum and no price action could occur for a trade.
2- Many rejection candles: means more than one pin-bar rejection candle at an S/R level (the more rejections the better). This basically shows that the price tried over and over to push through the level but failed and a reversal is near. Consider the following:
- No matter the color of the long wick candles.
- No matter the direction, bullish or bearish, of the wick. So, an inverted long-wick also means rejection. This shows that the price tried over and over to push through the level but failed.
- Smart money loves resistance levels with many rejection candles. They know that novice traders place a lot of buy stops above the resistance waiting for the "logic" breakout. Pros buying them at a nice price and starting selling short below resistance... bingo! This bullish trap is a classic form of manipulation, the false breakout. Notice that is also a good place to start a trade, selling the recapture, strictly following price action basics.
3- Shrinking candles: happens with consecutive candlesticks getting smaller bodies as they approach a key S/R level, showing momentum loss. As bullish traders are less interested in the trend and are closing positions or profit-taking, a reversal is likely to occur. Consider these tips:
- A rejection (or many) candles (Pin-Bar, Harami, Doji) appearing after shrinking candles approaching an S/R level is a good reaction signal. Next candles, as an inside bar and a momentum, confirm the reversal.
- Look for a candle color change of the shrinking candle at an S/R level which can reinforce the trend change signal.
3- Shrinking candles: happens with consecutive candlesticks getting smaller bodies as they approach a key S/R level, showing momentum loss. As bullish traders are less interested in the trend and are closing positions or profit-taking, a reversal is likely to occur. Consider these tips:
- A rejection (or many) candles (Pin-Bar, Harami, Doji) appearing after shrinking candles approaching an S/R level is a good reaction signal. Next candles, as an inside bar and a momentum, confirm the reversal.
- Look for a candle color change of the shrinking candle at an S/R level which can reinforce the trend change signal.
4- Growing candles: are opposite of the shrinking candles, appear after a rejection at an S/R level, and can be used as a confirmation of a previous trend change or reversal.
5- Candle color change: if after consecutive candlesticks of one color, the candle color change, it means momentum loss. Again, it better works at key levels, in combination with other candlestick patterns such as shrinking or rejection candles. It can signal a possible trend change.
Good trading,
@BravoTrader
{fullWidth}