This is part four of a series on technical analysis. Click here for the series overview in part one. Click here for part two on the history of technical analysis. Click here for part three on an overview of candlestick charts.
Candlestick charts have played an important role in technical analysis for centuries. Being able to read them and understand what they mean is a crucial part of the process. In addition to knowing what data is being displayed, being able to recognize common candlestick patterns is essential to understanding what can be learned from studying them.
Let’s start with the basics. Some of these candlestick patterns are easier to spot than you might think, but recognizing them is only half the battle. The other part of reading these candlestick patterns is knowing what types of signals they indicate.
For example, a Doji forms when the opening and closing prices are about the same. The lengths of the candle wicks or “shadows” might vary, but this pattern is easily recognizable on the candlestick charts because it appears as a small cross. When a Doji appears on a chart, it signals indecision on the part of the market. Some Dojis are not particularly significant, but if you see one when the market is obviously trending upward or downward rather than sideways, you should pay attention.
A Doji appearing at the end of a long uptrend or downtrend on candlestick charts suggests the market is becoming indecisive. Thus, it could suggest that a reversal has arrived or is just around the corner. A Doji appearing on its own is neutral, but the longer the legs of the cross are, the more indecision is signaled.
Two variations on the Doji are the Gravestone and Dragonfly. The Gravestone looks like a long vertical shadow sticking up from a single horizontal line. This Doji variant is an even stronger signal that the trend could be close to a reversal. The Gravestone appears when the opening and closing prices are the same and at the lowest price of the day.
The Dragonfly is the opposite of the Gravestone, in that it has a long bottom shadow hanging from a horizontal line. It indicates that the opening and closing prices are the same and were at the highest price of the selected timeframe. Like the Gravestone, the Dragonfly is a strong signal that a reversal could be underway.
The Hanging Man and the Hammer
The Hanging Man is a small candle with a long bottom tail and little to no shadow on the top. The tail must be at least two times the length of the body. When this candlestick pattern appears during an uptrend, it’s considered a bearish signal.
The Hammer is similar to the Hanging Man, except it has a smaller body with little to no upper wick and a longer bottom shadow. The bottom shadow must be at least double the length of the body, and the body must be toward the upper end of the price range. This candlestick pattern signals a possible bullish reversal when it appears within a downtrend. Many chart technicians will wait to see if buyers have really taken control of the asset by seeing if the opening price on the next time period is higher than the closing price of the current period.
The Inverted Hammer and the Shooting Star
A variant on the Hammer is the Inverted Hammer, which signals a possible bottom reversal. It basically just looks like an upside-down hammer and consists of a small body with a longer top wick.
The Shooting Star looks the same as the Inverted Hammer, but the key difference is that the Shooting Star is found in an uptrend, while the Inverted Hammer is found in a downtrend. Because of this difference, the implications are different as well. The Shooting Star is considered a bearish signal within a broader uptrend, while the Inverted Hammer can be a bullish signal if the next candle’s opening and closing prices are higher.
The Shooting Star has a small body with a long upper wick and little or no bottom shadow. Since it appears in an uptrend, it signals that a reversal could be about to occur. This specific candlestick pattern indicates that sellers started to pressure the asset’s price, pulling it down close to the opening price. Since this candlestick pattern appears in an uptrend, it suggests that the trend could be about to reverse and become a downtrend.
The Spinning Top and Marubozu
The Spinning Top is generally seen as a neutral signal, although it can take on different meanings when it appears within other candlestick patterns. A Spinning Top is a candlestick with a small body and longer shadows on the top and bottom. The shadows can vary in length.
This pattern also signals indecision, which is why it’s generally a neutral signal. The long upper and lower shadows indicate that both the buyers and sellers had control of the asset price at some point. When a Spinning Top appears after a longer uptrend or downtrend, it can signal that a reversal is right around the corner.
The Marubozu is a long candle with no wicks on either end, meaning that the high price and the low price represent the opening and closing prices. This is considered to be a continuation pattern, which means the price has moved steadily in one direction or the other. If the candle is white or green, it’s a very bullish signal which suggest the buyers will remain in control. On the other hand, if the candle is black or red, sellers are in control, and it’s a very bearish signal.
The Falling and Rising Windows and gaps
These two candlestick patterns are formed by two candlesticks with a gap in between them. In both patterns, the gap between the two candles is significant. In the case of a Falling Window, the gap signals possible resistance, while in a Rising Window, the gap suggests support for the selling pressure.
In an upward trend, a gap appears with the highest price of one time period is lower than the lowest price of the next time period. In a downward trend, the lowest price of one time period is higher than the highest price of the following time period.
There are four types of gaps which signal different things on candlestick charts. A breakaway gap occurs when there’s a breakaway from an area of price congestion. It suggests that the shift in sentiment is strong and signals a probable powerful move in the near future, either up or down.
A common gap appears when the price is range-bound between the support and resistance levels, which are levels the price is struggling to break below or above. If the gap is filled in the following days, then a common gap is fairly insignificant.
An exhaustion gap signals the end of a move, whether that’s sideways, up or down. However, it can be difficult to tell the difference between an exhaustion gap and the fourth type, a measuring gap. When an exhaustion gap appears at the top of an uptrend, it signals that the market is tiring of the upward momentum, especially in the case of high volumes. A measuring or runaway gap appears halfway through a price move, so there is an important distinction between it and the exhaustion gap. An important way to tell the difference between these two types of gaps is looking at the volume. High volume suggests an exhaustion gap rather than a measuring gap.
There are many more patterns to keep an eye out for when studying candlestick charts. However, the others are more complex than these. Complex patterns involve a series of candles in particular shapes. These patterns are more advanced and require the study of a larger number of days (or whatever time period has been selected for the candlesticks). We’ll discuss some common bullish and bearish patterns in the next article in this series.