Candlestick chart patterns can help you assess the trend guiding your instrument’s prices at any given moment. Their method of doing this is, firstly, in tracking sentiment surrounding your asset over a period of time and, secondly, in learning from the past reactions of traders to gauge what they might do this time around. The signals generated from these patterns don’t lock in a particular outcome with certainty because they don’t have the power to do that. Since the market is a live, dynamic reality, made up of real, emotional human beings, it always has the potential to surprise us by bucking historical patterns.
Candlestick charts are only able to offer clear insights into the past but, in the words of technical analyst Clive Lambert, “if you know what’s been going on up until the present, you can at the very least have an idea as to where things may go in the future”.
A little girl goes in to see the doctor with a sore throat. The fact that she has had tonsilitis four times in the past year indicates quite strongly this may be the case again. The doctor, however, knows it may not be, so he runs the full gambit of tests to ascertain what’s really going on. Jumping to that conclusion could have brought her into the operating theater unnecessarily.
Understanding your trading chart is like knowing your patient has a recent history of tonsilitis. It’s a very useful clue, potentially, for gauging traders’ present feelings on your instrument, but it’s not a positive diagnosis. That kind of information could only come, in the medical world, from an X-ray, which takes a picture of reality as it presently stands. Since that level of certainty isn’t available to us in the trading arena, we have to work with varying levels of probability.
In this article, we’ll look at three powerful candlestick patterns used by traders and explain their bases in human psychology.
Ascending Triangle
Starting off by reading the price history we see in this scenario from the left-hand side to the right: Prices rise in a pronounced rally we see in the trail of long, green candles until they meet resistance at the level marked by the grey horizontal line. They then drop in a series of shorter red candles, but turn around again before having reached their initial starting point. The new bull run meets resistance at a similar level to the first, after which it dips once again, though not as deeply as it did previously, retaining some of its gains once again. Finally, we see prices start to take off out of the confines of the Triangle.
The lower, diagonal line traces the increasing bids of buyers on this security, from which we see proof of growing demand. The upper, horizontal line shows the fact that traders repeatedly rejected price rises beyond a particular point. These two dynamics are narrowing price activity into a smaller and smaller window, and this converges into the apex of the triangle – which gives the pattern its name. On the one hand, the buyers are progressively proving themselves stronger than the sellers but, on the other, lots of traders view the security as overbought at the upper horizontal limit of the Triangle. Something, apparently, has to give, but what will it be?
Traders view this pattern as a continuation signal for the pre-existing uptrend. This means that, once prices jump up near the triangle’s apex, the upper resistance level is likely to be broken, after which prices will search out a new ceiling. The appropriate action to take, then, would be to open a “buy” deal soon after prices extend upwards out of the Triangle.
Don’t jump the gun, though. Wait for a trading session to close with prices hovering safely above the Triangle. Plus, look for increased trading volume on that session. This shows there is active interest in the asset with the force to push prices higher. When you squeeze a hosepipe and feel the water collecting under your hand, you know to anticipate a burst of energy from the built-up pressure once you let go. Similarly here, the increased volume is your evidence that buying pressure is building up behind the scenes. You’re going to hitch a ride on that bullish energy when it’s released.
Bearish Engulfing Pattern
This signal is revered by technical traders because of its high success rate. You will find it within an uptrend where, in the first of its two candles, prices close out with gains once more, which we see in our short green candle above. In the next session, however, after starting off higher than the previous close, prices drop beyond yesterday’s open, completely “engulfing” the rally in red-colored bearishness.
The shadows (i.e. wicks) aren’t important in pattern identification here but, when you see a greater contrast between the sizes of the two candles, especially if the shadows of candle number one are also engulfed in the body of candle number two, you have a stronger signal to go on.
What do the two candles actually communicate to us? The small green candle tells us the pre-existing bull run is losing conviction. This message is clearer when that rally was either sharp or prolonged. Either of these two conditions could make the market overextended, which lends a bearish projection – like the one we’re looking for – more weight. The red candle, especially when accompanied by high trading volume, shows us that heavy, active selling interest has taken control of the market. Traders believe that this pattern will likely lead to further bearish pressure in sessions to come, so they’ll react to it by preparing to sell or by closing off their bullish positions.
Jot it down in your notebook if you see Bearish Engulfing patterns forming at a similar price level with breaks of several weeks in between. This shows that traders have positively been rejecting price rises beyond that point. When we see prices shoot up beyond it, we have good reason to believe they will surge further since they have penetrated through a significant resistance level. Thus, the Bearish Engulfing pattern can potentially send you a powerful buy signal.
Bullish Abandoned Baby
The pre-history of the Bullish Abandoned Baby is a clear downtrend in prices. Within this bearish movement, you may spot a three-candle figuration similar to the one circled above. The first candle on the left-hand side is – in line with the prevailing sentiment of its predecessors – a long, red one. Following on its heels, however, we have a doji formation, in which prices close at approximately the same level where they opened. Immediately upon seeing this, we can deduce the sellers are losing their self-belief. Instead of progressively pushing prices lower, as they have been until now, they were driven back to their starting point by the buyers.
The third candle – a long, green one – opens higher than the doji closed and propels prices quite a way up. Behind the scenes, it seems that all the trader indecision we saw in the doji culminated in a clear decision to buy. Traders take this as an indication prices will continue to rise from here, and will choose an entry point where prices surge beyond candle number three.
Just to note a couple of characteristics your Bullish Abandoned Baby should exhibit: There is a clear gap between, not only the bodies of candle number one and candle number two, but also between their shadows. Similarly, the doji is separated by a gap from candle number three’s shadow. It’s all implied in the name of this pattern because the “baby” – i.e. the doji – is completely abandoned on both sides, without any sign of his parents at all, even their shadows. And yet we’re supposed to feel bullish about all this!
Wrapping Things Up
As we said, these signals only describe traders’ reactions to given scenarios on past occasions, not their present moods. Yet, as technical analysts will tell you, people do tend to react in similar ways to particular stimuli as time goes by. One big reason for this is that, when they notice these patterns forming on their price charts, they anticipate other traders will react in certain ways, which they duly imitate. Candlestick patterns are, then, self-fulfilling prophecies.
Still, it’s good to remind yourself that the market doesn’t follow any rules at all and tends to surprise even seasoned traders. Once you have these three (and one or two other) candlestick patterns under your belt, though, and employ them in the context of a worked-out trading strategy, taking risk management into consideration, you can feel quietly assured since you’re in tune with some key considerations. Looking ahead, you’ll need lots of humility, patience, and diligence but you do have what it takes to compete meaningfully in the markets.
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