Using Japanese Candlesticks To Trade Key Reversals (Part 1)
Seasoned traders know how important the skill is to be able to identify a critical turning point in a market, thereby closing out their prior trend following positions to take an opposing trade. Unfortunately many novice traders are often late to the party and fail to see the unfolding change in trend, often at a considerable loss. Today we are going to help address this problem by studying some of the most successful Japanese candlestick patterns used to identify key reversals.
Early Japanese candlestick charting is thought to have evolved in the 1700s and was used by with great success by Munehisa Homma to trade rice futures during that century. Today they are used by millions of traders worldwide. The appeal of the candlestick methodology is in the ability of candles to visually display the power of bulls and bears to the user. By looking at the height and colour of the real body we can gain an immediate visual clue of the dominant buying/selling force. Candlestick charts can be drawn for any period increments from seconds to months or years.
The diagram below shows an example of two simple candlesticks. Note that where the close of the period is below the open a black real body is drawn, alternatively where the close is above the open a white real body is drawn (although many charting packages will allow users to change the colouring of up and down candles). Where the open and close are the same (the candle has no real body) a horizontal line is drawn. The upper and lower shadows or ‘wicks’ depict extremities of pricing during the period.
Having discussed the basics let’s now examine some of they key candlestick reversal patterns.
The Hanging Man and Hammer
The hammer and hanging man are candles with long lower shadows that are at least twice the length of the candles real body, with little or no upper shadows. The real bodies are at the upper ends of the trading range, the colour of the real body is not important (see images below).
As you can see the two candles appear the same, however three aspects can differentiate them. Firstly a hammer occurs after a downtrend whereas a hanging man comes after a rally. Secondly a hammer is valid even after only short term declines whereas a hanging man must emerge after a prolonged rally. Lastly a hammer doesn’t require confirmation of additional favourable candles whilst a hanging man should have confirmation before action is taken.
Greater weight should be placed on candles with longer lower shadows, shorter upper shadows and smaller real bodies. Hammer and hanging man candles with large lower shadows have experienced significant buying pressure off the lows to see them close back near the period’s highs. As this is a bullish signal for this reason it is recommended that traders wait for exhaustive rallies and confirmation before selling after a hanging man candle. A lower opening or close under the real body satisfies this confirmation depending on ones risk preference.
Engulfing patterns occur during a major reversal. The pattern is composed of two candles with opposite coloured real bodies where the second real body engulfs (wraps around) the prior candles real body; the prior candle may be a doji candle (close at or near the open). The market should be in a definable up or downtrend which can be short or long term in nature.
A bearish engulfing pattern occurs after an uptrend showing that supply has overwhelmed demand whilst a bullish engulfing pattern occurs after a downtrend indicating a swing in favour of buyers. A number of factors increase the likelihood of the engulfing pattern indicating an important turning point, they include; (1) heavy volume on the second real body of the pattern, (2) the pattern occurring after fast or prolonged moves (which can make the market prone to profit taking) and (3) the first day of the pattern having a small real body (indicating a reduction in the prior trends force) and the second day having a large real body (indicating an increase in force backing the new move).
The extremities (extreme high/low) of the engulfing patterns can be used as important support and resistance points on which to base the trade, this is also the case with the hammer and hanging man candles. Unfortunately given that we need to wait for the close to complete the candle(s) we may be faced with the issue of the trade entry being too far away from the extreme high or low for acceptable risk/return metrics. In such scenarios the trader can wait for a retracement toward the extreme before entering the trade, using the extreme as the basis for the stop loss order.
The chart below shows examples of engulfing patterns occurring in the dailies of the AUD/USD in September 2012, note also the hanging man candle occurring only a few weeks prior. All the examples forewarned of the new trend.
(Nb. Colours are blue candles instead of white (up closes) and red instead of black candles (down closes).
The final two patterns we will look at today are the Dark Cloud Cover and Piercing Patterns, both are dual candle patterns. See image below.
Dark Cloud Cover
This pattern occurs where the second black candles open is above the prior white candles high (ideally), however by the close the market has sold off to deeply within the prior strong white real bodied candle. Many technicians require at least a 50% penetration (for the second black candles close) into the prior body of the first white candle for the bearish formation to be valid.
The bullish counterpart to dark cloud cover is called a piercing pattern. It is composed of two candles in a falling market. The first candle has a black real body and the second a white real body. Ideally the second white candle will open lower than the first black candles low, before then penetrating back to at least 50% into the body of the prior white candle on the close.
Both the piercing and dark cloud cover patterns are more significant where the penetration of the second candle into the prior candle is greater; in the case where it entirely penetrates (i.e. wraps around) the prior body we have the previously discussed engulfing patterns. Where an engulfing pattern follows dark cloud cover (or a piercing pattern) caution should be exercised, as this may presage continuation of the prior trend.
Special attention should also be made where the patterns emerge around support or resistance. If on the second day the candle has opened above resistance (dark cloud cover) or below support (piercing pattern) especially on heavy volume then traders with fresh longs (or shorts) will be feeling nervous about their positioning as the market reverses in the opposite direction making them prone to closing out.
We have looked at some of the most important Japanese candlestick reversal patterns. There are many others and the topic is huge, but as a closing comment I would like to say that like any trading, successful candlestick trading requires not only candle recognition but also an understanding of where the patterns exist in the context of the risk/reward equation and the overall market picture. In further articles on this topic we will explore this further by combining candlestick studies with support/resistance, trend-line analysis and oscillator analysis to improve our trade timing execution.