Traders of stocks and other financial markets often use candlesticks as a great visual aid to what a particular price has done within a certain time period.
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. Sometimes a solid candle can be formed when the open was the low and the close was the high, and thin candles with less of a solid body can be formed when a price is volatile and ranges a lot within the day.
Candlesticks can also give clues to price action and the mood of the market towards a certain stock or index. For example, bullish candles form when a stock opens, moves lower, tests support, then springs back to close at a high.
Many charting platforms recognize candles and can screen stocks to pull up candidates for a trade. But without solely relying on this technology, it’s a good idea to wrap your head around what these patterns look like.
Let’s take a look at four of the most widely used candlestick patterns alongside some actual stock chart examples to show their worth.
1. Bullish Engulfing Candlestick
A bullish engulfing candle pattern is formed when the price of a stock moves beyond both the high and low of the previous day range. It engulfs. Usually this sort of pattern will tell a trader the price has moved down, found some support or buying volume, and then made a bullish move back up by breaking the previous day's high. Often this type of candle can be the signal for a sustained upward move or trend change.
In late December, 2012 Chevron (CVX) was retracing within a newly forming trend. As it was testing lower prices, the drop was sharply rejected to the upside, forming the bullish engulfing pattern. This signaled a new leg of the upward trend and created a higher low. As we can see, price continued up into the early months of 2013.
2. Bearish Engulfing Candlestick
The opposite of a bullish engulfing candle, a bearish engulfing candle pattern will move to test a level above the previous day high, then after finding selling volume will move sharply downwards, breaking the previous day's low. Again this can be a precursor to a sharp sustained drop in price or trend change.
The bearish engulfing pattern can happen at tops or within a trend, signaling further moves downward. In the chart below of Goldman Sachs (GS), the start of the downtrend in March, 2012 was topped by a perfect bearish engulfing pattern. Price attempted a new high and was sharply rejected to the downside, sparking a fresh three month downtrend.
3. Hammer Reversal Candlestick
A hammer type pattern can form when support or resistance is sharply rejected by market participants. In the example below, the price moved lower but found some support or buying volume. At this point the bulls took control and closed the candle around its opening level.
The next day a strong bullish up candle was formed, showing the momentum was continuing. Traders and investors found value and the price began to trend. These types of patterns can happen in either direction, are tend to appear in the shape of a hammer, hence the name “hammer”.
In early 2012, International Business Machines (IBM) had been in a choppy range bound period. Although the trend was certainly up, the swings in late 2011 were not very clear to trade. At the end of this choppy trend there was a retrace which contained a hammer reversal top and bottom. From the bottom hammer reversal, IBM transitioned into an aggressive move upwards which continued for four months.
4. Doji Candlestick
A Doji candle is the name given to patterns which signify indecision in the price action of a stock. Usually these form at areas where the bulls and bears commence battle and are fighting each other for direction.
In a doji candle, the body is usually very small with a close near the open price, and can have long wicks formed to the high and low, which were tested but fought back from by each side. The pattern signifies uncertainty, indecision, and 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 candle.
Although the Doji candle is often not a great entry candle for a trade (due to its nature it could be broken either way by the bulls or bears), it does offer a heads up that sentiment may be changing.
On this example below, Merck (MRK) had found a new high, but the next day a Doji formed. Were the bulls or bears going to win this battle? As we can see, bears won and the first doji highlighted was followed by two very strong down days, starting a new trend.
The second doji highlighted shows how sentiment could be changing. The Doji formed at a low in price and at this point bulls came out of the shadows and saw value. This formed a support area over the next week, and as price made a breakout above the Doji candle, the stock entered a strong uptrend lasting three months.
All in all, these four candlestick patterns, when identified correctly, can be extremely useful for investors. Their movement is an excellent sentiment gauge as long as you can understand what they are trying to tell you. Also, finding them at support or resistance can give you a heads up on direction change and offer an edge in your trading.
This was a guest post written by Pete Southern, technical analyst and market commentator at LiveCharts.co.uk.