Using Japanese Candlesticks To Trade Key Reversals (Part 2)
My earlier article on the topic looked at some of the most important candlestick key reversal patterns and candles, today we are going to further the discussion by looking at some other useful reversal candles and candlestick patterns. An introduction on candlestick basics, key reversal patterns and candles can be viewed in my previous article.
A classic doji candlestick is one where the opening and closing prices are the same, although there is some flexibility around this strict interpretation as candlesticks with small differences in the opening and closing prices can also be viewed as variations on the classic doji.
The doji candle is a trend change signal especially during rallies. Reversal likelihood increases where subsequent candles confirm the doji’s reversal potential, where the market is overextended and where doji (plural) don’t appear in large groups together. The four main types of doji are depicted in the image below.
A long-legged doji is one with unusually long upper and lower shadows. If it has a small real body and long shadows it is called a high-wave candle. Both of these candles indicate market indecision, as represented by the markets inability to hold on to gains or losses during the period. The long shadows suggest that the market has lost its sense of direction and is entering a transition point.
The dragonfly doji is a bullish candlestick where the open/close are at (or very near) the session’s highs. Like the hammer it shows a market that has seen strong buying interest counter the earlier selling to see a close back at the highs of the session indicating increased demand.
The gravestone doji is the bearish counterpart of the dragonfly doji seen near market tops. It occurs where market bulls have been repelled and the market has closed back at the open after the rejection from the highs.
Doji Trading and Market Context
Candlestick lines must be viewed in the context of the price and activity before the pattern, this is particularly so with doji candlesticks. Doji are valuable for calling market tops, this is especially true when they appear after a tall white (up) candle or after a prolonged rally, the latter doji is called a Northern doji.
Its counterpart the Southern doji should be treated with more caution for calling market bottoms and can often appear numerous times during a downtrend. Doji candlesticks that appear during periods of lateral price movement follow no trend so therefore warrant less attention as a turning signal although they can be useful when they appear around support or resistance levels within the range. Whilst candle signals (the doji included) are excellent for identifying early reversals they do not predict the extent of the move, so traders should always remember within what context they are appearing (i.e. proximity to support and resistance, old high/lows, trend strength and so on).
Morning and Evening Stars
A star pattern occurs where a small real bodied candlestick (black or white) gaps away from the large real body that precedes it. The real body can be within the prior session’s upper/lower shadow but the bodies shouldn’t overlap*.
The small real body of the star indicates a deadlock between the bulls and bears and should follow a candle with an extended real body, which points to a prior dominant buying/selling force. The final candlestick of the three-candle pattern sees a reversal candle that penetrates deeply into the first candles real body indicating a change in the balance of the bull/bear battle. Ideally a gap would occur between the second and third real bodies however this rarely occurs and the lack of this second gap doesn’t seem to diminish the power of the formation.
An evening star occurs after a rally and the morning star after a sell-off. Where the star is a doji instead of a small real body we have a doji star formation. Stars, especially the doji stars warn that the prior trend may be ending. The image below shows the morning, evening and morning/evening doji star formations.
Factors, which increase the likelihood of star patterns preceding a reversal, include:
(1) A lack of overlap among the first, second and third real bodies
(2) Light volume on the first candle followed by heavy volume on the third candle indicating power in the reversal, and
(3) Deep penetration by the third candle into the first candles real body indicating a swing in the supply/demand equation.
*In foreign exchange markets, which are continuous (apart from weekends/major holidays) there is more flexibility with the definition as the opening of a new candlestick will often be at the close of the prior one.
Shooting Star and Inverted Hammer
The shooting star is a bearish reversal candle, which must come after a rally. It has a small real body at the lower end of its range with a long upper shadow, ideally having a real body that gaps away from the real body of the prior candle, the colour of the real body is not important. The candles long upper shadow indicates a failure of the bulls to retain the gains. Being a solitary candle rather than a pattern formation gives the shooting star less significance as a major reversal signal than the earlier discussed star formations.
The inverted hammer whilst not a star pattern looks exactly like a shooting star, but instead comes after a decline, the colour of the inverted hammer also is not important. Having occurred during a decline and having closed near the lows of the session (bearish signs) means traders should wait for confirmation before acting. This confirmation can occur through the opening or preferably the closing of the following up candle above the inverted hammers real body, this exerts pressure on the prior sessions sellers to cover their short positions. The image below shows the shooting star and inverted hammer candlesticks.
Harami patterns and Tweezers Tops/Bottoms
The final patterns we will examine today form part of a subset of patterns that are typically less powerful reversal indicators than those discussed earlier, although this is not always the case. The harami pattern is a small real body candle, which is contained within the real body of the previous unusually long black or white candle. This is the reverse of the ‘engulfing’ pattern discussed in my first article on candlesticks. The second candle can be either black or white, however in most cases it will be the opposite colour to the prior real body. When the second real body reduces in size to become a doji we have a ‘Harami cross’. The Japanese view the harami cross as a more potent reversal signal than the standard harami pattern which is typically more effective at picking market tops over market bottoms. The small real body of the second candle in the harami pattern reflects the market dissension to the prior strong move indicating the diminished power of the trend. The slides below shows a harami pattern and the harami cross, note also how the second slide illustrates the reverse nature of the engulfing and harami patterns.
The Tweezers Top/bottom are where two or more candlesticks have matching highs or lows. In a rising market tweezers tops are formed where two or more consecutive highs match, tweezers bottoms are formed where two or more lows match in a falling market. Tweezers top and bottoms can be formed with any part of the candlestick including the real bodies, doji and/or shadows. An ideal tweezers formation would occur with a strong long first candle followed by a second candle with a small real body indicating a loss in force of the prior move. Additional weight is given to the tweezers formation where there are other bearish or bullish reversal candle signals that are also tweezers tops/bottoms. The slides below show a few of the many examples of the types of tweezers formations.
Today I have added to my first discussion on the topic by examining additional key candlestick reversal patterns and reversal candles. In my final article on the topic I will look at the applying the previously discussed candlestick reversal indicators to charts in the process combining them with technical indicator studies and support/resistance /trend-line analysis to perfect our Japanese candlestick charting techniques.