Introduction to Patterns
There are two types of analysis for all financial instruments (including stocks): fundamental and technical. While Fundamental analysis looks at company performance over the years and is used to determine what to buy/sell, technical analysis is primarily concerned with the current Trends and Patterns, regardless of performance, to help traders determine when to buy/sell it.
Let's look at a scenario where you have decided to purchase a car. Without doing any fundamental analysis, you went to the expo where showrooms of three automobile companies are located. You just stand in a corner and observe all the showrooms to find the showroom which has the maximum crowd. This exercise will help you to find the current trend for these three vendors and you can make an assumption that the showroom attracting the maximum crowd is selling the best car of all three.
You might be wondering how to apply the above use case for the stock market as trying to figure out the reason behind the buying and selling is always a daunting process. Fortunately, charts create patterns by consolidating demand and supply into a single framework and come to our rescue. These chart patterns allow traders/investors to look for trends in movement of the stock and position themselves accordingly by anticipating future price direction of the stock. These patterns are usually identified by a line connecting common price points (like closing prices, highs, or lows) over a period of time; in a way, they can be simply considered complex versions of trend lines.
Candlestick charting, although very popular, is quite complex. Sometimes it can get difficult to understand trends using them. But with so many Candlestick patterns formed on the price charts every day, traders/investors can use these patterns to anticipate the future direction of the stock. In this blog, we will look at how easy it is to analyse the Candlestick chart offered by ComponentOne Studio's FinancialChart. We'll use 9 different candlestick patterns and explain what it can tell you about a stock. To showcase these patterns, we will be rendering actual stock data of Apple Inc, Twitter Inc, and Dell Technologies in the FinancialChart control.
Try ComponentOne Studio FinancialChart
Need for Candlestick Patterns
Many traders consider candlestick charts as visually appealing and easy to interpret. In a Candlestick chart (available in FlexChart/FinancialChart), data is visualized through Open, Close, High, and Low stock prices for the specified duration in the series. (You can read more about Candlestick charts in How Heikin-Ashi and Renko Charts eliminate market noise)
The relationship between the open and close values is considered vital information for the identification of trends and forms the essence of candlesticks. Hollow candlesticks, where close is greater than the open, indicate buying pressure. Filled candlesticks, where the close is less than the open, indicate selling pressure.
However, it is not just the relationship between the open and close of a single candle which is of paramount importance as several patterns can be drawn using one or more candlesticks. Let’s understand 9 commonly used candlestick patterns– we will start with single candle patterns and then move on to two candles and eventually to more complex patterns.
Understanding Candlestick Patterns
Hammer price pattern can be formed on either filled or hollow candlestick with following characteristics:
- Small body near the high price.
- Little or no upper shadow.
- Long lower tail (at least twice the size of the body).
Long trades can be opened when a strong Hammer pattern is formed at the end of a downtrend.
The above chart shows a hammer candlestick formed at two locations for Twitter stock data. After a week of trending upwards, Twitter stock reached the highest level on 8th February and a hammer pattern appeared with a signal that an uptrend could be over. Over the next three sessions, stock price reached its lowest from 19 to 15. Again, after trending upwards, Twitter stock reached the highest level on 15th February and a hammer pattern appeared with a signal that the temporary uptrend could be over. However, the second hammer lower tail was not as long as the first one. In such cases, the true confirmation of the hammer candle can be made when the very next preceding candle closes with a higher low than the hammer candle. The candle formed on 16th February confirmed this and stock price reached its lowest from 16.8 to 15 over the next three weeks.
2. Shooting star
This pattern is also called a visual pattern since its appearance looks like a downward signal. It can be formed on either filled or hollow candlestick with following characteristics:
- A small body near the close price.
- A long upper shadow.
- A little or no lower tail.
Short trades can be opened once a shooting pattern is formed on an uptrend.
The above chart depicts data from Dell Technologies rendered in the FinancialChart control. It clearly shows a shooting star pattern formed on 13th February with a signal that an uptrend could be over. This confirmed that the buyers drove prices up at some point during the period in which the candle was formed, but encountered selling pressure which drove prices back down for the period to close near to where they opened. As predicted by this pattern, next few sessions saw stock price starting to decrease, and a sharp decrease is noted a week after this pattern was formed. Eventually, the stock price was reduced from 64.8 to 62.3 in 3 weeks.
The word Marubozu means “bald head” or “shaved head” in Japanese and is considered as a continuation pattern formed on either filled or hollow candlestick with following characteristics:
- A long body (filled or hollow).
- No or little shadow (upper and lower shadow).
A bullish Marubozu indicates that the buyers were willing to buy stock at every price point during the time period of the candle. Whether the prior trend was a downtrend or an uptrend, Bullish Marubozu indicates that a long trade can be opened now.
The above chart depicts data from Apple Inc. rendered in the FinancialChart control. It shows a clear bullish Marubozu formed on 14th February on an uptrend with a signal that the uptrend will continue. Over the next few sessions, price actually increased from 135 to 140. Thereafter, a bearish Marubozu is clearly visible on 2nd March with a signal that an uptrend is over and a likely reversal is possible.
This pattern signals a strong price reversal and can be formed anywhere in the chart. However, it becomes more significant when it appears at the breakout (as in the above chart).
Additionally, this candlestick pattern provides an easy to spot signal with a very clear meaning:
- If a hollow marubozu occurs at the end of an uptrend, a continuation is likely.
- If a hollow marubozu occurs at the end of a downtrend, a reversal is likely.
- If a filled marubozu occurs at the end of a downtrend, a continuation is likely.
- If a filled marubozu occurs at the end of an uptrend, a reversal is likely.
4. Dragonfly Doji
The Doji pattern is considered to be one of the most widely used Candlestick patterns. A generic Doji pattern signifies equality or indecision between buyers and sellers as it is formed when opening and closing prices are virtually the same while the lengths of the shadows can vary. It gives a signal that the current trend is losing its strength and might reverse.
The generic Doji pattern has several variants, one being the Dragonfly Doji, a relatively difficult chart pattern to find. This pattern can be a formed on either filled or hollow candlesticks with following characteristics:
- Opening and the closing prices are at the highest of the day.
- Long lower shadow and no upper shadow.
Since the Doji pattern is formed because of indecision between buyers and sellers; it does not give a clear buy or sell signal. The next candle formed after Doji usually becomes the deciding candle.
The chart depicts data from Twitter Inc. rendered in the FinancialChart control. It shows a clear Dragonfly Doji pattern formed on 8th February with a signal that the trend is about to change direction. The long lower shadow in Dragonfly Doji implies that the market tested to find where demand was located and found it. As predicted by this pattern, price was reduced from 19 to 15 in three sessions.
In case of longer lower shadows, a single Dragonfly Doji candle is sufficient to signal the trend reversal. In the case of a shorter lower shadow, the next candle to Dragonfly Doji is the confirmation candle for trend reversal. In the above chart, this pattern was formed in an uptrend and the next bearish candle formation confirms that the price will now downtrend and it happened exactly like that.
5. Long-legged Doji
Long-legged Doji is another variant of the Doji pattern formed when the opening and closing prices are nearly equal (as with all Doji patterns). However, there is a lot of upward and downward price movement in the stock. This pattern can be formed on filled or hollow candlesticks with following characteristics:
- Opening and closing prices are virtually the same.
- Long lower and upper shadows.
The above chart depicts stock data from Dell Technologies rendered in the FinancialChart control. It shows a clear Long-legged Doji pattern formed on 16th February with a signal that an uptrend is reaching its highest limit and that trend reversal will happen soon. As signalled, the stock prices did decrease significantly from 66 on 16th February to 62.4 on 6th March.
6. Dark Cloud Cover
This bearish candlestick pattern is formed with following characteristics:
- A filled candlestick is formed after a long hollow candlestick.
- Filled candle closing price is below the mid-point between open and closing prices of the previous hollow candle.
If the closing price of a filled candle is lower than the open price of the previous hollow candle then it is not a dark cloud cover pattern, rather it is a strong bearish engulfing pattern. Since this pattern is just an indication that prices might do down, a strong dark cloud cover is needed to make the correct decision of selling the stock. A strong dark cloud cover is a pattern in which the first candlestick should be a big bullish candle and the second bearish candle should cover between 90-100% of the first candlestick body.
The above Chart depicts stock data from Apple Inc. rendered in the FinancialChart control. It shows a clear Dark cloud cover pattern formed on 2nd March. This dark cloud cover pattern will be categorized as weak since the filled candle is covering 50% of the first candlestick body. This signal that the prices will remain constant however since the next day (3rd March) candle is Marubozu, therefore the prediction is that an uptrend for this stock is now over and prices will reduce in next sessions.
7. Three white soldiers
This bullish pattern has the following characteristics:
- Three long hollow candlesticks that trend upward like a staircase.
- Closing price of all three hollow candlesticks to be higher than the previous day.
- Open price of all three hollow candlesticks to be within the body of the previous candle.
- Both shadows (upper and lower) to be small.
The above Chart depicts stock data from Dell Technologies rendered in the FinancialChart control. It shows a clear Three White Soldiers pattern formed with three candles on 2nd, 3rd and 6th February with a signal that the stock price will increase further. As predicted, this happened in the next 3 sessions when price rose from 64 to 66.
8. Evening Star
Evening Star is a bearish reversal pattern with following characteristics:
- First candle is a tall hollow candlestick that carries an uptrend to a new high.
- Second candle can be a filled or hollow candlestick with small body size and the closing price is higher than that of first candle.
- Third candle is a filled candlestick that opens below the second candle and closes near the centre of the first candle.
The above Chart depicts data from Twitter Inc. rendered in the FinancialChart control. It shows a clear evening star pattern formed with three candles on 14th, 15th and 16th February. Since this pattern is formed on an uptrend, it signalled that an uptrend was over and a price reversal would happen. As predicted, this happened in the next 8 sessions when stock price decreased from 16.6 to 15.3. Usually, this pattern predicts a broader scale downtrend so further reduction in price is possible unless a bullish pattern is formed.
9. Abandoned Baby
Abandoned Baby is a bullish reversal pattern formed with following characteristics:
- First candlestick is in the direction of the primary trend.
- Second candlestick is a Doji pattern candle with no overlap of body or shadow of the first candle.
- Third candlestick is completely opposite of the first candle.
The above Chart depicts data from Twitter Inc. rendered in FinancialChart control. It shows a clear Abandoned Baby pattern formed with three candles on 23rd, 24th and 27th February. Since this pattern was formed when prices were becoming stable, it gave a signal that further price reduction was possible. As predicted, in the next 5 sessions, this stock price decreased.
You can also download a sample application showcasing all these 9 candlestick patterns using the ComponentOne FinancialChart Control.
Download Candlestick Chart Patterns Sample: WinForms | WPF