Trading based on pattern recognition can supplement your fundamental analysis of an investment opportunity. Candlestick patterns, which are a type of technical analysis, can be used to help forecast which way a stock might go. Some of these patterns are moderately more complex than basic candlesticks—like hammers and dojis—which can be easily identified.
Here are 5 advanced candlestick patterns that you may be able to employ in your trading strategy.
Morning star and evening star
A morning star is a bullish pattern, typically occurring after a sustained downtrend, that consists of 3 candlesticks.
The first candlestick is a large dark candle (i.e., a down day when the close is lower than the open) that occurs within a defined downtrend. This candle is followed by a small-bodied candle whose close is below the previous candle, and then a large white candle (i.e., an up day when the close is higher than the open) whose opening price is above the middle candle and whose close is near the center of the body of the first candle. Traders might interpret a morning star as a reversal pattern, suggesting that the existing downtrend could be weakening.
It is worth noting in the chart above that the line portion represents the daily high/low, the box portion represents the daily open/close, and the box shading reflects the daily close relative to the open.
The evening star is the opposite of the morning star. An evening star is a bearish pattern, typically occurring after a sustained uptrend, that consists of 3 candlesticks.
The first candlestick is a large white bar that occurs within a defined uptrend. This candle is followed by a small-bodied candle whose close is above the previous candle, and then a large dark bar whose open is below the middle candle and whose close is near the center of the body of the first candle. Traders might interpret an evening star as a reversal pattern, where the existing uptrend could be weakening.
3 buddha top
This pattern may look familiar to experienced users of technical analysis. The 3 buddha top is the Japanese candlestick name for the head and shoulders pattern. It is identified after an uptrend where there are 2 "shoulders," or 2 highs, surrounding a higher high that acts as the "head" of the pattern.
The first shoulder typically occurs on heavy volume at the end of an existing rally and is followed by a slight correction on less volume. Then, there is a rally that exceeds the first shoulder, followed by another slight correction that takes the price back to the previous correction. Finally, there is a third rally that finishes lower than the head, and on noticeably lower volume than the advance for the left shoulder and the head. This advance will not exceed the high established for the head, and is followed by a decline past the previous 2 corrections (the neckline).
The interpretation of the buddha top is that the security may have peaked, and could break out lower from the right shoulder into a new downtrend. A confirmation signal that the new trend is down may be for the stock to close 3% below the right shoulder. This might be confirmation of a reversal, and the new trend is down.
3 black crows and 3 white soldiers
3 black crows is a bearish pattern that consists of 3 consecutive large dark candles. This pattern suggests a decline if it occurs after relatively high prices or a sustained rally. Each close should be below the previous day’s close.
The opposite of the 3 black crows is 3 white soldiers, a bullish candlestick pattern. This pattern consists of 3 consecutive large white candlesticks, where each new close is above the previous day’s close. It can occur at the end of a downtrend, suggesting a reversal into a new bullish trend.
Dark cloud cover
A dark cloud cover is a bearish candlestick pattern that could suggest the security will move lower. It is composed of a series of candlesticks. The first is a long white candlestick, followed by a dark candlestick that opens above the previous close, and closes below the midpoint between the opening and closing price of the previous day.
Essentially, a "dark cloud" covers the white candlestick, suggesting a move lower. Confirmation might take place the next day with a dark candlestick that closes below the dark candle.
Less frequently observed candlestick patterns are tweezer tops and tweezer bottoms. Tweezer tops are a bearish pattern that can occur at the top of an uptrend. They are 2 consecutive candlesticks that make highs together by touching the same price at the top end and do not rise any further. Note that the body can be the part of the candlestick that touches the higher price, but, more frequently, this pattern is identified when it is the wicks (i.e., the lines that extend from the box on top and bottom) that reach the same higher price. The name "tweezer" derives from how the wicks of the candle can extend to the same price, forming what looks like tweezers.
Conversely, tweezer bottoms are a bullish pattern that can occur at the bottom of a downtrend. They are 2 consecutive candlesticks that touch the same price at the bottom and do not decline any further. Again, the body or the wick can be the part of the candlestick that touches the bottom price. The more commonly identified tweezer bottom is when the wicks touch the bottom price.
Putting candlesticks into action
Much like other technical analysis, it may be worthwhile waiting for confirmation of candlestick patterns before executing a trade. It’s important to consider any candlestick within the context of the broader pattern. Understanding how certain candlestick patterns fit with the broader trend may indicate a tendency for the security to act a certain way in the future.
Investors should also be aware that these candlestick patterns, and technical analysis in general, can be highly subjective; what one trader perceives as a valid pattern may not be confirmed by another. Moreover, the existence of such a pattern does not guarantee that an expected trading action will occur. However, these advanced candlestick patterns may help you spot trends in a stock’s price in advance of a move.
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Technical analysis focuses on market action — specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you're most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation. Past performance is no guarantee of future results.
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