Option Investor
Trader's Corner

Trader's Corner

Printer friendly version

Other Candlestick Reversal Signals

Tweezers top, dark clouds and harami join doji as possible reversal signals. Those potential reversal signals number too many to include or illustrate in a single article, but a few important ones might be valuable to note. (Those who haven't read the previous articles on candlestick charting and would like further background can find those articles in the Saturday, June 11 and 18 editions of the OptionInvestor newsletter.)

In one of Nison's books on candlestick charting, this "father of candlestick charting" organizes the discussion by the number of candles needed to create a reversal signal. That organization seems as workable as any. This article will discuss two-candle reversal signals. 

Nison characterizes a tweezers top or bottom as a double-top or -bottom formation, but many people characterize these formations somewhat differently. 

Annotated Daily Chart of PVN:

Another type of two-candle reversal formation is a bearish or bullish-engulfing candle formation. In an engulfing pattern, the second candle envelopes the prior candle. Ideally, the second candle's body envelopes the first candle's shadows as well as the real body. In other words, the second day's open and close envelopes the prior day's entire range. 

Annotated Daily Chart of AAPL:

The larger the engulfing candle with respect to the prior one, the stronger the signal. In this case, a long red candle engulfs a prior white one, producing a bearish engulfing pattern. In the bullish version, a long white candle engulfs a prior red candle after a downtrend. 

However, there's a time when a long white engulfing candle can be a bearish signal and a long red engulfing candle can be a bullish signal. This occurs when trading produces a last engulfing top or last engulfing bottom pattern. The bearish version occurs when a long white candle engulfs a red one after an uptrend, and the bullish version occurs when a long red candle engulfs a white one after a downtrend. Although this signal might appear counterintuitive on first glance, the last engulfing candles indicate a possible exhaustion of buying or selling interest.

Annotated Daily Chart of G:

Not all two-candle reversal formations require a second candle that matches or exceeds the size of the first candle, as happens with the tweezers and engulfing patterns. Neither the dark cloud cover nor piercing pattern, one bearish and one bullish, requires that the second candle be larger than the first, but each requires that the second candle closes deeply into the prior candle.

Annotated Daily Chart of TXN:

In a classic piercing pattern, the second day's candle opens at a new low for the move, but then prices rise, with the candle closing deep inside the red candle that preceded it, ideally more than midway into the real body of the prior red candle. The analogous bearish formation is the dark cloud cover. In this two-candle pattern, prices open at a new high the day after a tall white candle, but then prices fall, with the candle ideally closing more than midway into the real body of the prior white candle. Some might recognize these candle patterns as being akin to key reversal days.

Another two-candle combination that sometimes signal reversals is the harami. Japanese candlestick enthusiasts denote a harami as a two-candle pattern when a small candle of either color forms inside a preceding longer-than usual red or white candle. Such candle pairs should occur after a trending move, but the candles can come in any color combination. For example, a downtrend can end with a long white candle followed by a short red candle nestled within the real body of the prior candle. In classic harami, the second candle is positioned in the middle of the previous long candle, but it can be near the top, in the case of a high-price harami, or near the bottom, in the case of a low-price harami.

Annotated Daily Chart of CRAI:

While any combinations of colors are possible the red/red combination here would be more bearish than others, because the red candles themselves imply bearishness. 

Nison warns that if the second candle of a harami after an uptrend forms near the top of the prior candle, consolidation may be more likely than a reversal. The opposite is true during a downtrend: a second candle forming near the bottom of the real body of the prior candle may be signaling that consolidation is more likely than a reversal.

Anyone familiar with inside-day candles from traditional chart analysis will recognize harami as inside-day formations. They, like any other reversal formation, require confirmation. If prices exceed the harami in an uptrend or move below one in a downtrend, the formation was instead a continuation formation.

This provides a glimpse into the most important of the two-candle candlestick reversal formations, but there are of course nuances that can't be covered in a single article. Next weekend's article will discuss reversal formations that require three or more candles to complete. As always, those who want more details might find information in Steve Nison's JAPANESE CANDLESTICK CHARTING TECHNIQUES and Greg Morris' CANDLESTICK CHARTING EXPLAINED is another possibility.

Trader's Corner Archives