Option Investor
Trader's Corner

Candlestick Reversal Signals: Multiple Candlestick Formations

HAVING TROUBLE PRINTING?
Printer friendly version

Recent Traders Corner articles on candlestick charting established a common theme: candlestick and candlestick formations possess colorful names. Multiple candlestick reversal formations certainly fit that theme. They feature names such as evening star, rising three methods, and three black crows.

Those names sometimes prevent an intuitive understanding of candlestick formations, but most reversal signals build on basic and easily understood ideas. A doji represents indecision; a harami, a possible slackening of a trend's strength; and an engulfing pattern, a renewal of buying strength after a downtrend or of selling strength after an uptrend. Many multiple-candlestick reversal signals build on those basic ideas. For those who want a review of the previous articles in the series on candlestick formations can find those Traders Corner articles in the June 11, 18, and 25 editions of the weekend OptionInvestor newsletters.

The doji often serves as the second candle in the three-candlestick formations known as evening-star and morning-star formations. Two weekends ago, the article on the doji briefly described these formations. They can sometimes also feature a small-bodied candle as the second candle. (Note: Charts were searched for examples of reversal signals, so will not reflect current values for indices or stocks.)

Annotated Weekly Chart of the TRAN:

The morning-star formation serves as the bullish version of the evening-star formation. In the bullish morning-star version, a doji or small-bodied candle follows a red candle after a downtrend. A long white candle completes the three-candle formation. In the optimum setup, the doji or small-bodied candle will form below the candles that precede and follow it.

Some multiple-candle reversal signals appear to be non-classic variations on the evening or morning-star formations. For example, a tri-star bullish reversal pattern consists of three doji. Two take the place of the long red and white candles, and the middle doji gaps below the first and third. Another difference lies in the candles that precede the tri-star formation. In a long downtrend, the real bodies of the candles will have grown smaller before the tri-star's formation. In a morning-star formation, the preceding action often produces long red candles.

The ladder-bottom formation also resembles a morning-star formation in many respects.

Annotated Daily Chart of LEH:

With the exception of the requirements for the three red candles, this formation could be considered a morning-star formation. Traders could recognize it as a reversal signal even if the ladder bottom name or variation were not known. That's going to be true of many of the multiple-candle reversal signals discussed in this article.

Although a bit of a stretch, the unique three rivers bottom formation might be seen as either a morning-star or harami variation. A small-bodied candle follows a long red candle, with the real body of the second candle forming within the real body of the long red candle. The second candle has a lower shadow stretching down to a new low. The third day's trading produces a white candle, but not a tall white candle as in the typical morning-star formation. The white candle is a small-bodied white candle with a close below that of the second day.

Variations of the evening-star formation occur, too. Two crows is one example.

Annotated 60-Minute Chart of TWP:

Other formations build on harami or engulfing candle formations. After a downtrend, the bullish concealing baby swallow formation consists of four candles, all red. The third candle of the formation gaps below the previous two long red, shadowless candles, pierces the body of the second candle and falls back. The last candle of the four engulfs the third candle's small body and upper shadow. Those who don't recognize the concealing baby swallow pattern would still likely recognize the engulfing pattern of the last two candles as a potential reversal signal.

The three outside up formation consists of three candles, and it's built on an engulfing pattern, too.

Annotated Daily Chart of CPST:

This variation provides extra confirmation of the bullishness of the engulfing candle pattern. The three outside down pattern serves as the bearish variation of this engulfing candle pattern. After a climb, a tall candle engulfs a small-bodied candle. The third day produces a red candle that closes lower than the second day's candle. Both variations would be recognized as reversal signals even if the particulars of the variations weren't known.

The bullish three inside up formation consists of a two-candle harami followed by a white candle that closes higher than the second day's close. For those familiar with inside-day patterns, this would be a familiar long signal.

A three inside down formation serves as the bearish variation of this three-candle formation. This harami and confirming third candle occurs at the top of a climb.

Annotated Five-Minute Chart of LF:

This article makes the point that many of the multiple-candle signals prove to be specialized versions or slight variations on already known two- and three-candle formations. These variations illustrate again that it's important not to get hung up on the colorful names attributed to candlestick formations. Understanding the doji, harami and engulfing patterns allow traders to pinpoint most of these other reversal signals, too.

A few patterns cannot be described as variations of doji, harami or engulfing patterns, but instead are distinctive patterns of their own. The bearish advance block pattern comprises one of these, but even this pattern offers bearish hints to those who might not have known the name or recognized the pattern. After an uptrend, trading produces three white candles, each opening within the body of the previous day's candle and each closing higher than the other. Yet each of the three shows progressive signs of weakness. Each day's body might be smaller than the previous day's, for example, and the second and third day might produce long upper shadows.

Traders might also recognize the bearishness of the three black crows and identical three crows reversal signals, too, although neither of them is built on a doji, engulfing candle or harami. Each occurs after an uptrend. The three black crows pattern requires three red candles with each open within the body of the previous red candle and with each close below the previous close. The identical formation requires three red candles. Each candle opens at the close of the prior candle, rather than inside that candle, and then closes lower than the prior candle.

The three white soldiers pattern serves as the bullish version of a three black crows pattern. After a downtrend, trading produces three white candles, the second and third opening within the body of the previous candle and each closing higher than the previous candle.

Some bullish reversal signals prove more difficult to link to any other pattern or recognize intuitively as bullish signals. Examples include the stick sandwich and three stars in the south patterns. Don't worry too much about these patterns, however. A several-hours search of daily and intraday charts turned up only one stick sandwich and no three stars patterns. With the goal of providing as comprehensive a list of multiple-candle reversal signals as possible, their descriptions will be provided, however. In the strictest sense, the stick sandwich formation is built on an engulfing pattern, but nothing about the pattern appears bullish on first glance. After a decline, a long white candle opens within the body of a long red candle but closes above it. Then, the third day opens higher than the second day's open, but then produces a long red candle that closes back near the first day's close. Candlestick enthusiasts reason that the pattern shows that prices might be bottoming, establishing a support level near the close of the first and third candles. It could also be considered a consolidation pattern.

The three stars in the south pattern includes three red candles, each with lower closes than the previous day's candle. On the first day, prices reached to a new low but bounced off that new low. On the second and third days, each day's low is higher than the previous day's low.

Since some of these formations prove relatively rare, charts didn't offer examples of all, and this article would have proven too long for the newsletter if they had. The point wasn't to give an exhaustive illustration of rare candlestick formations with the goal of persuading readers to memorize multiple small variations. The goal was to suggest that, despite the strange names, most of these patterns would be easily recognized by those familiar with the basic doji, harami and engulfing patterns. Those who want more details and would like to memorize each particular of each variation might find information in Steve Nison's JAPANESE CANDLESTICK CHARTING TECHNIQUES, Greg Morris' CANDLESTICK CHARTING EXPLAINED and various online sites.
 

Trader's Corner Archives