The ONE pattern that has made me a fortune.
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In today's video, we discuss candlestick patterns – one of the most basic and useful price formations that can guide the potential moves in the price of any instrument. They are widely used in various financial markets, from stocks to forex to cryptocurrencies, and can be used on different timeframes from intraday to monthly. These patterns can be extremely helpful in analyzing price movements and riding future price movements.
For those who are not so familiar with candlesticks, here is a brief introduction to get you started.
A candlestick chart visually represents price movements over a set time period. Each candlestick typically shows four key pieces of information: open, high, low, and close. These four data points are represented by a "body" and "wicks", also known as shadows, on a candlestick.
The body can be either bullish - usually green or white, or bearish - typically red or black. In a Bullish Candlestick, the close is higher than the open. On the other hand, in a bearish Candlestick, the close is lower than the open.
Candlestick charts display the market's sentiment in a very visual way, helping traders quickly assess trends and potential reversals. Unlike line charts, candlestick charts present much more information to traders to help them make better trading decisions.
At the heart of candlestick analysis is understanding market psychology. Candlestick patterns form because of the struggle between buyers and sellers.
A bullish candlestick signifies that buyers are in control. The price has risen during the time period, and the market sentiment is optimistic or positive and vice versa for a bearish candlestick.
Understanding the psychology behind each pattern helps traders interpret what is happening at a deeper level. When certain patterns form, it shows that a shift in market psychology may have taken place. A market that was previously in a downtrend might be shifting towards a reversal or forming a bullish pattern, or a market that was in an uptrend might be shifting to the downside displayed through a bearish pattern.
These patterns can be particularly useful when they are confirmed by other indicators like the Mack Dee or moving averages. In fact, candle stick formations are at the heart of our breakout strategy, the same strategy I applied in the 2022 US investing Championships. Our scanner developed solely for this reason looks for lateral candle consolidation over several weeks, followed by an upside breakout. The theory is rather simple, the lateral movement suggests an equilibrium between buyers and sellers, whilst the upside breakout confirms that buyers have overtaken sellers, signaling strength in the move. This equity curve shows my last 8 year returns from applying this exact concept, highlighting the power of candlestick formations.
Let’s now look at some other popular candlestick patterns, focusing on their psychology, how to identify them, and how traders typically use them.
Starting with the Doji, which is formed when the open and close price of the candle are identical or close. Resultingly, the candlestick has a very small body and long wicks. The length of the wicks can vary, and the Doji might appear at the top, middle, or bottom of a trend.
There are three kinds of Dojis – Gravestone Doji, Long-legged Doji, and Dragonfly Doji and this is how they look on the chart.
The gravestone and dragonfly doji signal sug
gest a price reversal, while the long-legged doji signal indecisiveness. The psychology behind these candlesticks is simple. It highlights the struggle between the buyers and sellers, and the winner is determined by how close the closing price is to the low or high. In a long-legged doji, there is no one winner and therefore, it depicts indecisiveness.
The Dojis, especially the gravestone and dragonfly doji, are quite similar to other candlestick patterns like the hammer and shooting star. In both these patterns the closing price of the candle period is very close to the opening price and the candle has a long wick.
On the chart, the hammer can represent a bullish reversal signal and is quite useful when you want to catch the reversal in a downtrend. The candle gets formed as sellers fail to keep the prices down during the period and the buyers take over to bring the price back towards the opening price.
The reverse happens in a shooting star pattern when the buyers fail to hold the price up in an uptrend, and sellers take over, taking the price down towards the open.
The best thing about Dojis, hammers, and shooting stars is that they can be quite powerful signals for reversals of secondary trends. So, for example, if you have eyes on an up-trending stock that you want to enter, but you are not sure when to enter, you can look for these reversal patterns within consolidations.
Like, in this weekly chart of Broadcom Inc. the price was in an uptrend once it crossed above the last swing high in this downtrend. In this consolidation, the price gave multiple signals of buyers being in control. There are two hammers and one doji here, which marked the low of this consolidation as the price marched up.
For a swing trader, a low-risk trade could be entering when the price crosses above the high of this hammer, with the stop loss being a close below the low of the hammer. The trade would have been immensely profitable with a very high reward-to-risk ratio as the stock marched up 50% in the next five weeks.
One of the patterns that stands out for me however is the lateral consolidation breakout seen in mid 2023. We see that equilibrium we touched on earlier where buyers and sellers were equal, then we get the overwhelming strength of buyers pushing prices to new highs and beyond. We saw a similar pattern and outcome in this consolidation later in the year.
Let’s move to our next candlestick pattern - the Engulfing pattern
This rare but powerful pattern also marks the reversal of a trend. It consists of two candlesticks - the first is a small candlestick, and the second candlestick completely engulfs the body of the first one.
In a Bullish Engulfing pattern, The second candlestick is a large bullish candle that fully engulfs a smaller bearish candlestick. This pattern typically signals a reversal from a downtrend to an uptrend. The opposite happens in a bearish engulfing pattern.
Psychologically the engulfing pattern shows a clear shift in market sentiment. In a bullish engulfing pattern, the market shows that the buyers have completely overwhelmed the sellers, and there is strong upward pressure. On the other hand, in a bearish engulfing, the sellers have taken over the buyers, signaling a shift to a bearish trend.
For example, in this chart of Morgan Stanley, the price was sideways for more than two years. It touched a new low here, but the sellers lost control soon after, as buyers took over in this bullish engulfing candle. That candle marked the low of the trend and the price doubled in 18 months.
Here is another chart of Royal Caribbean Cruises Ltd. showing a bullish engulfing pattern forming at the reversal of a secondary downwards trend.
The next candlestick patterns you can look for are the Morning Star and Evening Star patterns. These patterns are three-candle reversal patterns.
The morning star pattern is a bullish reversal pattern that consists of three candles:
â—‹ A large bearish candlestick.
â—‹ A small candlestick (either bullish or bearish) that gaps down.
â—‹ A large bullish candlestick that closes above the midpoint of the first candlestick.
The Evening Star pattern is the opposite, with
â—‹ A large bullish candlestick.
â—‹ A small candlestick (either bullish or bearish) that gaps up.
â—‹ A large bearish candlestick that closes below the midpoint of the first candlestick.
Psychologically, In the morning star pattern, the first large bearish candlestick shows the strength of the downtrend, but the small middle candlestick signals that selling pressure is weakening. The final large bullish candlestick confirms that the buyers have overtaken the sellers, and the market could be reversing to the upside.
The opposite happens in the evening star pattern.
For example, in this weekly chart of Reddit Inc. The price was in a short downtrend when it formed this big red candle. It was followed by a small gap down after which the sellers tried to dominate, but buyers swiftly took over, forming a hammer. The next candle was a strong green candle signifying even greater control of buyers as the candle closed above the halfway mark of this red candle. These three candles together formed the morning star pattern. The price reversed from this point and has increased fourfold since.
Here is a very powerful continuation pattern - the Inside candle pattern.
This pattern is a trend-following pattern and is created when a small candle is formed within the highs and lows of the previous trending candle. It is similar to a tight consolidation if we zoom in from the weekly to daily chart. The idea is to enter the trend at the high of preceding candle with a stop loss at the low of the inside candle.
For example, in this chart of Palantir Technologies, the candle here was formed inside the range of this bullish candle. You can see how the price continued to march up after this short consolidation.
When we zoom in to daily charts, this is what the consolidation looks like. It was a small cup with a tight handle. The price broke out but got stuck in market volatility for another week before taking off to new highs, eventually doubling in four months.
The inside candles that are also dojis or hammers, as the case was here, give even stronger continuation signals.
Candlestick patterns are an essential tool in technical analysis and understanding them can help traders gain insight into market psychology and potential price movements. Using these, traders can make more informed decisions about when to enter and exit trades.
They work extremely well on bigger time horizons as those charts dwarf the day-to-day volatility, giving you the eagle’s eye view of the market participants’ psychology. If you are solely trading these patterns, you will have to be extremely patient as these patterns are rare on bigger horizons. However, the returns that you can clock following these patterns can be very rewarding indeed, hence why our members use our scanner on a weekly basis.
For those looking to establish candlestick probabilities, you might want to see one of our previous videos showing a study on just that.
Finally, it goes without saying that no matter how powerful these patterns can be, anything can happen, and your risk management must always be on point.
Over my 30 years of trading I use very similar principles, looking for high quality stocks showing strong momentum with low risk entry opportunities. Those familiar with the channel will have seen the progress of my equity chart seen here over the years, this was achieved by applying these principles. As a result, we developed a scanner to identify the perfect set up of such quality stocks, saving hours and hours of effort. For those interested you can access the scanner or follow my trades by using the links below.
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