Reversal Candle Patterns

A reversal candle pattern is a combination of Japanese candlesticks that normally indicate a reversal of the trend. One serious consideration that must be used to help identify patterns as being either bullish or bearish is the trend of the market preceding the pattern. You cannot have a bullish reversal pattern in an uptrend. You can have a series of candlesticks that resemble the bullish pattern, but if the trend is up, it is not a bullish Japanese candle pattern. Likewise, you cannot have a bearish reversal candle pattern in a downtrend.

This presents one of the age-old problems when analyzing markets: What is the trend? You must determine the trend, before you can utilize Japanese candle patterns effectively. While volumes have been written on the subject of trend determination, the use of a moving average will work quite well with Japanese candle patterns. Once the short term (ten periods or so) trend has been determined, Japanese candle patterns will significantly assist in identifying the reversal of that trend.

Japanese literature consistently refers to approximately forty reversal candle patterns. These vary from single candlestick lines to more complex patterns of up to five candlestick lines. There are many good references on candlesticks, so only a few of the more popular patterns will be discussed here.

Dark Cloud Cover. This is a two day reversal pattern that only has bearish implications. This is also one of the times when the pattern's counterpart exists but has a different name (see Piercing Line). The first day of this pattern is a long white candlestick. This reflects the current trend of the market and helps confirm the uptrend to traders. The next day opens above the high price of the previous day, again adding to the bullishness. However, trading for Dark cloud; the rest of the day is lower with a close price at least below the mid­point of the body of the first day.

This is a significant blow to the bullish mentality and will force many to exit the market. Since the close price is below the open price on the second day, the body is black. This is the dark cloud referred to in the name. Piercing Line. The opposite of the Dark Cloud Cover, the Piercing Line, has bullish implications. The scenario is quite similar, but opposite. A downtrend is in place, the first candlestick is a long black day which solidifies traders' confidence in the downtrend. The next day, prices open at a new low and then trade higher all day and close above the midpoint of the first candlestick's body. This offers a significant change to the downtrend mentality and many will reverse or exit their positions.

Evening Star and Morning Star. The Evening Star and its cousin, the Morning Star, are two powerful reversal candle patterns. These are both three day patterns that work exceptionally well. The scenario for understanding the change in trader psychology for the Evening Star will be thoroughly discussed here since the opposite can be said for the Morning Star.

The Evening Star is a bearish reversal candle pattern, as its name suggests. The first day of this pattern is a long white candlestick which fully enforces the current uptrend. On the open of the second day, prices gap up above the body of the first day. Trading on this second day is somewhat restricted and the close price is near the open price while remaining above the body of the first day. The body for the second day is small. This type of day following a long day is referred to as a Star pattern. A Star is a small body day that gaps away from a long body day. The third and last day of this pattern opens with a gap below the body of the star and closes lower with the close price below the midpoint of the first day.

The previous explanation was the perfect scenario. Many references will accept as valid, an Evening Star which does not meet each detail exactly. For instance, the third day might not gap down or the close on the third day might not be quite below the midpoint of the first day's body. These details are subjective when viewing a candlestick chart, but not when using a computer program to automatically identify the patterns. That is because computer programs require explicit instructions to read the candle chart, and don't allow for subjective interpretation.