Technical analysis is not always about tracking indicators and plotting price movements on line graphs. Japanese candlestick charts can be incredibly useful in studying prevailing market trends. They can also signal potential trend reversals. If you are looking for a suitable price point to enter or exit a trade, candlestick reversal patterns can help you identify when a trend change is in the offing.
Let us examine what a trend reversal candle pattern is and explore some common patterns that may warn you of changing market sentiments.
What is a candlestick reversal pattern?
A candlestick is a graphical representation of four key price points of a trading session — namely the opening price, closing price, highest price and lowest price. These price points are represented as a candlestick. Plotting the candle for each successive session results in a candlestick chart.
Over time, you can notice distinct candlestick patterns on the price chart based on how the prices move. Candlestick reversal patterns are single or multiple candles that appear in a specific order and indicate that the prevailing trend may be about to reverse. Depending on when they appear, trend reversal candles may be one of two types:
- Bullish reversal patterns: These are trend reversal patterns that occur at the end of a downtrend and suggest that the price may be about to start rising again.
- Bearish reversal patterns: These patterns occur at the end of a prevailing uptrend and indicate that prices may be due for a downward reversal.
How to confirm a bullish reversal?
Several candlestick patterns are formed with multiple candles and require a confirmation candle to strengthen confidence in a trend prediction. A bullish reversal is an indicator that the buyers have overcome the selling pressure in the market. However, without a confirmation candle, it remains uncertain whether new buyers will push the price even higher. At best, this may form a support level and be a neutral indicator. As candlestick patterns are majorly used to spot short-term trends, traders look for a confirmation candle that should appear within approximately three days of spotting a potential trend reversal. The confirmation can be through a long white candlestick, gap up, or high volume advance.
Existing downtrend is necessary for a reversal downtrend to reverse
For a price upturn to be considered a reversal, an existing downtrend should be present. For instance, even though the criteria for the bullish engulfing pattern can be met at a new price high, it cannot be considered a sign of a price reversal because of where it appears on the chart. At best, it can be a continuation pattern signalling consistent buying pressure.
Downtrends can be spotted by utilising peak or trough analysis, moving averages, or trend lines. You can predict the downtrend of a security if it fulfils any of the following conditions:
- Trading lower than its 20-day EMA (Exponential Moving Average)
- Each subsequent peak and trough forming lower than the former
- Trading below the trade line
Keep in mind that these are not all, but only a few popular methods of spotting downtrends. Depending on your trading style, you may want to refer to other methods as well. For instance, if you are a short-term trader, the 10-day EMA might better suit your objectives and preferences.
Useful trend reversal candlestick patterns you should know
Now that you know what candlestick reversal patterns are, let us explore some of the common indicators in this category.
1. Hammer
The hammer is a single-candle bullish candlestick reversal pattern that resembles its namesake. The candle can be red or green (meaning the day’s closing price may be lower or higher than its opening). But it has the following distinct characteristics:
- A short real body
- A long lower wick that is around twice as long as the body
- A short or non-existent upper wick
2. Inverted hammer
The inverted hammer is also a single-candle pattern that signals a possible reversal at the end of a downtrend. It can also be either red or green and is marked by the following characteristics that make it resemble an inverted hammer.
- A short real body
- A long upper wick that is around twice as long as the body
- A short or non-existent lower wick
3. Doji
The Doji is another single-session trend reversal candle pattern that represents a period of indecision in the market. Depending on where it occurs, it may indicate a bullish or bearish trend change. If it occurs at the end of a downtrend, you may need to prepare for a bullish trend reversal (and vice versa). The Doji’s appearance has the following features:
- A thin body that is often just a horizontal line as the opening and closing prices are equal
- Long or short upper and lower wicks
Also read: What is the difference between gross and net profit?
4. Hanging man
The hanging man is a single-session trend reversal candle that indicates a bearish reversal. It forms at the end of an uptrend and resembles a hammer in its appearance. It has the following physical characteristics:
- A short real body
- A long lower wick that is around twice as long as the body
- A short or non-existent upper wick
5. Shooting star
The shooting star is a visual copy of the inverted hammer. However, unlike the latter, this trend reversal candle occurs at the end of an uptrend and signals a possible upward change in the prices. You can identify this candlestick pattern using the following features:
- A short real body
- A long upper wick that is around twice as long as the body
- A short or non-existent lower wick
5. Bullish engulfing pattern
The bullish engulfing pattern occurs as a prevailing downtrend is coming to an end and signals a possible reversal upward. It consists of two candles with the following physical characteristics:
- A short bearish first candle
- A taller bullish second candle
- The real body of the first candle entirely covered by the second, indicating rising buying pressure
6. Bearish engulfing pattern
The bearish engulfing pattern is also formed over two trading sessions. It is a bearish candlestick reversal pattern that is commonly found at the end of an uptrend. You can identify it using the following characteristics:
The bullish engulfing pattern occurs at the end of a downtrend and signals a possible reversal upward. It consists of two candles with the following physical characteristics:
- A short bullish first candle
- A taller bearish second candle
- The real body of the first candle entirely covered by the second, indicating rising selling pressure
7. Morning star
The morning star candlestick pattern is formed over three trading sessions and signals a potential bullish reversal. The physical features of the three candles are as follows:
- A tall bearish first candle
- An extremely small bullish or bearish second candle signalling indecision
- A tall bullish third candle that indicates rising buying pressure
8. Evening star
The evening star is the opposite of the morning star pattern. It occurs at the end of an uptrend and may indicate an incoming bearish reversal. You can identify it over three trading sessions as follows:
- A tall bullish first candle
- An extremely small bearish or bullish second candle signalling indecision
- A tall bearish third candle that indicates rising selling pressure
Conclusion
These candlestick reversal patterns can all indicate a reversal in the prevailing market trend. However, they are not always reliable when used on a standalone basis because the market can be unpredictable. For a more powerful reversal signal, consider using technical indicators like Bollinger Bands, Moving Averages (MAs) and Relative Strength Index (RSI) alongside trend reversal candles.
