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The only candlestick patterns I take seriously
🕑 Added 2021-08-29 19:09:30 +0000 UTCI haven't made any content on candlestick patterns since my first shot at creating Kamikaze Cash in 2017. By request, I am reexploring candlesticks now that my technical analysis approach is more developed than it was 4 years ago.
Keep in mind that stocks do all sorts of things for all sorts of reasons. Candlesticks are strongest when they are corroborated with other technical analysis indicators. If you identify a bullish engulfing pattern just as RSI pushes above 50 and MACD crosses over bullishly, then you have a winner. That combination of signals is much stronger than a candlestick by itself, so you as the trader can more confidently take an aggressive bullish bet.
tl;dr: There are only 4 candlestick patterns I take seriously.
Short term patterns: Engulfing patterns (bullish and bearish) and reversal patterns (hammers and gravestones);
Medium term: Head & Shoulders;
Long term: Cup & Handle.
Short Term Patterns
Short term patterns get formed over just a few days, and give you indications of price action that is likely to last over a few days to a few weeks. They are suitable for short term trades and are easy to identify.
Engulfing Patterns
These patterns refer to a day's price action completely overtaking the previous day's. This indicates that the stock is likely to continue the trend of the most recent day.
Bearish Engulfing: If a stock opens higher than the previous day's close, but then loses ground throughout the day to close below the previous open, then the bearish price action completely "engulfs" the bullish. By wiping out the previous day's gain, this pattern indicates that bulls were unwilling to sustain the rally, and buying has given way to selling pressure.
This pattern is most indicative after several days of increase. If this pattern occurs after a consistent uptrend, it tells you that the buyers have run out of steam. To trade based on this pattern, consider taking any gains you've incurred on the bull side, and then switch to a call credit spread with your short strike set at the top of the bearish candle. It is unlikely the stock will retest the intraday high.
More aggressively, buy a put in anticipation of further downside. It is likely that the price decrease will encourage momentum traders to take losses and also trigger stop-loss orders, which sends the price down further until buyers resume control.
Bullish Engulfing: Much like its bearish counterpart, the bullish engulfing opens the day with a continuation of the previous day's trend, but reverses course to completely negate the prior day's price action. It indicates that buyers are optimistic at the current price, and sellers are either running out of shares to sell or are no longer willing to part with their shares at a lower price.
This pattern is most powerful when it follows a set of red days. To trade based on this pattern, selling a put credit spread, selling a naked put, or buying shares outright are all favorable. More aggressively, pick up a call and anticipate that buyers will continue to pick up shares at the lower prices.
Hammer and Gravestones
Hammers and gravestones show a similar trend reversal as the engulfing patterns above, but hit some different points. Hammers and gravestones fail to complete an engulfment, but their tails are much longer.
Hammer: Shaped like Thor's hammer, this pattern shows a probable reversal. During a downtrend, a stock opens lower than the previous day's close and continues lower still. However, the stock hits an intraday low and spends the remainder of the day rising higher to finish green at the daily high.
This pattern is even stronger if the stock closes above the previous day's high, which would make it an engulfing hammer.
The key element to notice is that the stock made an intraday low that the market rejected. Traders determined the low of the day was too low, and therefore they gobbled the shares up. This indicates bullish intent on the way ahead. The market has already bottomed.
Gravestone: The opposite of a hammer. During a bull run, the stock opens higher than the previous day's close, runs higher intraday, and then sells off the entire day's gains. The price action forms a long tail to the upside, identifying the prices the market rejected as too high.
The pattern is even more powerful if the price drops through its open and continues downward until it also wipes out the previous day's gain. This would create an engulfing gravestone, or potentially even just a bearish engulfing pattern with some extra tail to the upside. Either way, the market decided it will not longer buy at higher prices.
Why these short-term patterns work: When a stock is trending strongly in one direction, you end up with a lot of momentum traders piling on. Once that trend is broken (a rising stock breaks the trend and starts falling), momentum traders take their gains to move on to a different stock. This exit of momentum traders pushes the price further into its new trend.
Medium Term Pattern: Head & Shoulders
The H&S is one of the most well-known patterns and also one of the easiest to use. Once you identify the pattern, you can also identify your high-probability entries and exits. In addition to the below, the same principles apply to a Reverse H&S that would mark a reversal higher.
The pattern emerges to confirm that an uptrend has formally ended and a stock is very likely to enter a downtrend. Buyers have become exhausted and the price needs to go down before buyers show interest again.
The pattern consists of several elements:
1) A stock makes a new high for its current uptrend and then has a small pullback. This high of this trend is called the left shoulder;
2) The stock resumes its uptrend and makes a new high, but then gives back all its gains since the last trough. This new high is called the head;
3) The stock recovers from the trough, but starts selling off again before reaching the head. The high of this stage is called the right shoulder.
If you draw a line to connect the lows between the head and shoulders, it forms the neckline. The neckline is your indicator to place your trade.
In an H&S pattern, if the stock breaks the neckline after meeting the right shoulder, then this is very bearish. The selloff after the head and failed recovery at the right shoulder indicates that buyers are not willing to take positions above the neckline. As the stock recovered into the right shoulder, people who bought prior are willing to sell shares and seize gains, even if that means selling before the head's lows.
Once the stock breaks the neckline, it is highly probable that the stock will continue its decline. Most often, the difference between the neckline break and the next bottom will be the same as the difference between the right shoulder and the neckline.
So if the right shoulder formed $15 above the neckline, anticipate the next bottom to be $15 below the neckline. Much of this price targeting is likely the result of a self-fulfilling prophecy caused by traders setting buy limit orders and algorithmic trading.
Why the H&S works: An uptrend indicates that people are buying more as the stock price rises. Buyers were unable to push the price higher beyond the head as willingness dried up, and people took gains to precipitously drop the price back to the previous trough where buyers acquired interest again. As the price recovered, bagholders started selling their positions at the higher price, but this created selling pressure that prevented the stock from recovering fully. Once the price dropped below the neckline, traders and algorithms confirmed the H&S to create the self-fulfilling prophecy.
Long term pattern: Cup & Handle
The C&H is very overused, and WSB posters seem to think everything is a C&H. In reality, a C&H represents a much more specific pattern that is helpful only if you can identify it. The C&H may take more than a year to work itself out, so WSB traders are not going to notice it.
Just like the reverse H&S above, the below principles apple to a Reverse C&H.
The C&H forms when there is underlying pressure pushing the stock higher. The stock will go through the following:
1) After the stock reaches a new high, selling pressure comes in as people take gains. This steady selling pressure can last months as price steadily decreases;
2) Eventually, interest returns, selling pressure subsides, and buyers begin pushing the stock back to its highs;
3) The strike hits its previous high, but sellers return and rapidly push the stock back down as much as 50% of its recovery;
4) Optimism about the stock brings buyers back, pushing the stock to new highs.
You MUST see (4) before there is a C&H. Without the stock breaking to new highs, it's just a double-top pattern. Once the stock breaks its downward pressure in the handle, the bearish selling pressure is negated, and people start talking about how the stock is undervalued.
Once that stock breaks its handle and starts making new highs, a put credit spread, long call, call debit spread, or long shares are all suitable.
Why the C&H works: During an uptrend, a stock makes a new high where people begin to take gains. This pushes the stock down, but no more than 50% of the previous leg up. The stock will begin recovering once buyers come back in at lower prices, pushing it back to the previous high. Bagholders who bought during the initial uptrend will start to sell their position, and those taking gains unload near the top. This results in a big pullback that might take off 50% of the recovery. However, buying interest picks up prior to the previous trough, and once the price does make a new high, FOMO kicks in and buying pressure increases.
