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Trade by candlelight

Here are five candlestick patterns that can help you actively manage your portfolio.

  • Active Trader News
  • – 05/16/2012
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Trading based on pattern recognition can offer an alternative or a supplement to fundamental analysis. Candlestick trading is one such pattern-based system.

What are candlesticks?

Stocks and other tradable securities tend to move in recognizable patterns, and it’s possible to make trades based on these patterns. This method may be applied as a very short-term trading strategy, or it can be incorporated into a broader investment philosophy. For example, if you are interested in investing in a certain company (or selling shares of a company you already own), but aren’t sure at what price to do so, pattern trading can help you set a price target at which to buy or sell.

Candlestick charts combine elements of line and bar charts to depict how a stock or other security trades. Each individual candlestick shows a security’s open, high, low, and close for a day, week, or month, depending on the time frame you choose. Most charting tools enable you to select a candlestick chart, in addition to more commonly used line and bar graphs.

Certain candlesticks have a tendency to produce repetitive patterns. Here are five widely used candlestick patterns that can help you actively trade.

Hammer

When a stock trades significantly lower than the opening price, and then rallies later in the day to close above or near its opening price, a hammer-shaped candlestick is formed. A hammer candlestick typically forms at the end of a downtrend (see chart below).

In the graph above, a hammer formed on January 25 when the stock opened at $41.98, then the price fell to $41.05 intraday, before finally closing at $42.63.

A trader might interpret a hammer candlestick as the market trying to find a bottom. You can think of it as trying to reverse an existing downtrend by “hammering out a bottom.”

Hanging Man

In an uptrend, when a stock sells off intraday and then rallies to close near the open, a hanging man candlestick may be formed (see chart below).

You may notice that the hanging man candlestick shape resembles that of the hammer pattern. It is, in fact, a very similar candlestick. The difference lies in where it occurs within an existing trend. Hammers occur at the bottom of a downtrend, while a hanging man candlestick pattern is found at the top of an uptrend.

In the graph above, a hanging man formed when the stock opened at $108.27 on November 8, then the price fell to $106.50 intraday before closing at $108.86. This formation does not mean that an uptrend is definitely ending, but traders might interpret it as a sign that the bullish momentum is decreasing and that a reversal is possible.

Doji

A doji is a unique candlestick. It looks like a cross or a plus sign. It occurs when a stock closes at or very near to where it opened (see chart below).

You can see that a doji formed when the stock opened at $33.87 on February 7, rose to $34.30, and fell to $33.41 in the session, before closing near $33.86 by the end of the session.

Indecision is the key interpretation of a doji; the market isn’t sure in which direction to go. After a long uptrend, a doji might indicate that buying activity could weaken. Similarly, after a long downtrend, a doji might suggest that selling pressure is weakening. Typically, further confirmation is needed, as a doji by itself is not enough to determine whether a reversal is taking place.

Engulfing

Multiple candlesticks can form patterns when viewed in unison. An engulfing candlestick pattern, for instance, results when one candlestick completely covers the entire previous candlestick. Engulfing candlesticks can be bullish or bearish.

A bullish engulfing pattern may occur when one day’s gains (the white portion of the candle, or the area from where the stock opened to where it closed higher on the day) completely covers the entire trading range of a previous day when it closed lower. The previous day’s tails (the trading range outside the open and close) may be eclipsed by the engulfing candlestick’s gain as well (see chart below). Traders might interpret this as a bullish move, particularly after a longer declining trend.

The chart above illustrates a bullish engulfing pattern. On January 6, the stock opened at $17.90, hit $17.97 and $17.50 intraday before closing at $17.72. The next day, the stock opened at $17.47, fell to $17.23 before rallying to $18.60, and eventually closed at $18.30. Day 2’s gain completely engulfed day 1’s entire trading range.

The bearish engulfing pattern can be thought of as the opposite of the bullish engulfing pattern. It is where one day’s losses completely cover the entire trading range of a previous day’s trading range when there was a gain (see chart below). Traders might interpret this as a bearish move, particularly after an uptrend.

A bearish engulfing pattern formed on November 11 of last year when the stock opened at $39.14, hit an intraday high of $39.53, and closed near the high at $39.52. Then, on the next trading day, the stock opened at $39.60 and fell to $39.01 intraday, before closing at $39.07. Day 2’s loss completely engulfed day 1’s entire trading range.

Harami

A harami pattern swaps the position of engulfing candlesticks. A harami exists when a day’s candle is completely engulfed by the previous day. With a bullish harami, the trading range of a day when there is a gain is completely engulfed by a previous day’s loss.

A bullish harami candlestick pattern may occur when the trading range on an up day lies completely within the previous day’s loss (see chart below). Traders might consider this a positive signal, because the bullish harami could suggest that a downtrend is reversing.

A bullish harami formed on December 19 when the stock opened at $20.12, rose to $20.23 and then fell to $19.00 intraday, before finally closing at $19.05. The next day the stock opened at $19.42, fell to $19.35 and rose to $19.90 intraday, before finally closing at $19.69. Day 2’s entire trading range lies completely within day 1’s loss.

Alternatively, a bearish harami exists when the trading range on a day when there is a loss is completely engulfed by a previous day’s gains (see chart below). Traders would most likely interpret this as a sign that an uptrend is losing momentum and that a reversal may take place.

A bearish harami formed on April 12 when the stock opened at $66.52, fell to $66.32 and rose to $68.57, before closing at $68.33. Then, on April 13, the stock opened at $68.00, rose to $68.13 and fell to $66.59, before closing at $66.67. Day 2’s entire trading range lies completely within day 1’s gain.

Putting candlesticks into action

It’s important to consider individual candlesticks (or groups of candlesticks) within the context of the broader pattern. Understanding how certain candlesticks, and groups of candlesticks, fit in with the broader trend may indicate a tendency for the security to act a certain way in the future.

Candlestick patterns, like the ones described above, can be used to identify trends and reversals, monitor existing positions and potential opportunities, and establish specific buy and sell price targets. A primary benefit of trading based on candlestick patterns is that it can be done relatively quickly. It is generally a simpler strategy to employ, compared with more complex fundamental analysis.

Please note 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.

Investors must recognize that candlestick charting techniques do not incorporate fundamentals that may influence how a particular stock performs. However, candlestick trading is a widely recognized method, and it can be a compelling technical tool in your trading arsenal.

Next steps

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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 what 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 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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