Candlestick Reversal Pattern
tl;dr
A candlestick reversal pattern signals a potential change in the direction of a price trend. Common patterns like hammer, inverted hammer, engulfing, and Doji help traders identify when a trend is losing momentum and may reverse. To use these patterns effectively, confirm with volume and other technical indicators, and manage risk with stop-loss orders.
Definition.
A pattern in candlestick charts indicating a potential reversal of price movement.
Real-World Example.
A candlestick reversal pattern occurs when a series of candlesticks signals that the current price trend is likely to change direction. These patterns are crucial for traders because they help identify potential turning points in the market. Traders use reversal patterns to anticipate price shifts, helping them decide when to enter or exit positions.
For example, imagine a stock that has been in a downtrend for several weeks. After forming a hammer candlestick pattern at the bottom of the downtrend, the stock may reverse and start moving upward. The hammer pattern, with its long lower wick, suggests that buyers are starting to step in and that the downward movement may be losing momentum.
Common Candlestick Reversal Patterns:
- Hammer:
- Appearance: A candlestick with a small body at the top and a long lower wick.
- Significance: A hammer often appears at the bottom of a downtrend and signals that the market may reverse to the upside. The long lower wick shows that sellers pushed the price lower, but buyers took control and pushed the price back up.
- Confirmation: The hammer is more reliable if it’s followed by a strong bullish candlestick or other confirming indicators like volume.
- Inverted Hammer:
- Appearance: Similar to a hammer, but with a long upper wick and a small body at the bottom.
- Significance: The inverted hammer typically appears at the bottom of a downtrend, signaling that the market may reverse. The long upper wick suggests that buyers tried to push prices higher but sellers quickly took control.
- Confirmation: A bullish candlestick that follows the inverted hammer can confirm the reversal.
- Engulfing Pattern:
- Appearance: A two-candle pattern where the second candlestick completely engulfs the body of the first one.
- Significance: A bullish engulfing pattern (green candlestick engulfing a red one) suggests that the uptrend is starting, while a bearish engulfing pattern (red candlestick engulfing a green one) suggests a potential reversal to the downside.
- Confirmation: Volume confirmation or a follow-up move in the opposite direction strengthens the pattern.
- Doji:
- Appearance: A candlestick with a very small body, where the opening and closing prices are nearly the same, and wicks of similar size.
- Significance: A Doji candlestick suggests indecision in the market. It can appear after an uptrend or downtrend and signals that the current trend might lose strength and reverse. The type of Doji (like Dragonfly Doji or Gravestone Doji) can provide additional context.
- Confirmation: A Doji pattern is more reliable when confirmed by a candlestick in the opposite direction, such as a strong bullish or bearish candle.
- Morning Star:
- Appearance: A three-candle pattern consisting of a large bearish candlestick, followed by a small-bodied candlestick (often a Doji), and then a large bullish candlestick.
- Significance: The morning star is a strong bullish reversal pattern, typically appearing at the end of a downtrend. It signals that the market sentiment is shifting from bearish to bullish.
- Confirmation: The pattern is stronger when accompanied by higher volume during the third candlestick.
- Evening Star:
- Appearance: A three-candle pattern similar to the morning star, but this one signals a bearish reversal. It starts with a large bullish candlestick, followed by a small-bodied candlestick, and then a large bearish candlestick.
- Significance: The evening star appears at the top of an uptrend and suggests that the market may reverse to the downside.
- Confirmation: As with the morning star, higher volume during the third candlestick strengthens the pattern.
How to Use Candlestick Reversal Patterns in Trading:
- Look for Key Levels: Candlestick reversal patterns are more effective when they occur at significant levels of support or resistance. For instance, if a bullish engulfing pattern forms at a support level, it may signal a price reversal to the upside.
- Confirm with Indicators: Using indicators such as RSI, MACD, or moving averages can provide confirmation of the reversal. For example, a Doji at the end of an uptrend, accompanied by an RSI showing overbought conditions, may provide a stronger signal for a potential bearish reversal.
- Watch for Volume: Volume confirmation is important. A reversal pattern with higher-than-average volume often indicates that the reversal is more likely to be successful. For instance, a morning star pattern followed by strong buying volume is more reliable than one with weak volume.
- Set Stop-Loss Orders: Since reversal patterns aren’t always perfect, setting stop-loss orders can help manage risk. For example, if you enter a trade after a bullish engulfing pattern, you might place your stop-loss just below the low of the pattern to protect yourself from unexpected price movements.
