Just what is a candlestick chart?

Candlestick charts are a graphical way of representing the open, close, high and low of the price of a market over a given period of time. The system was developed in Japan, way back in the 18th century, as an aid to rice trading.

Candlestick reversal patterns are one of the most commonly used technical trading signals in futures and forex trading. While they do not constitute a magic bullet to becoming a millionaire trader, candlestick reversal indications have been proven to be a reliable indicator of trend changes.

The history of Japanese candlestick charts

Candlestick charting, though originating in Japan over 300 years ago, only became well-known in the Western world over the last half-century. Steve Nison, author of Japanese Candlestick Charting Techniques, is widely credited as the pioneer of candlestick charting. In particular, his contribution was to help popularise them just as online trading became a thing. Today, candlestick charting has largely replaced bar charting as the technical trader’s tool of choice.

Advantages of candlestick charts

Better visuals: The major advantage that the candlestick method offers is that a chart representing any chosen time frame (hourly, 4-hour, daily, etc.) provides a much clearer visual representation of the relationship between the opening and closing prices of the time period – i.e. whether the price ultimately ended up higher or lower.

Recognisable patterns: Candles make it easier for traders to see the most salient aspects of the trading action for each period. Candlestick charting offers a further advantage by virtue of the fact that there are clearly defined candlestick patterns to aid us in recognising signals of a potential market trend reversal.

What is a reversal pattern?

There are two main categories of reversal patterns. The first include classical charting pattern reversals, like a “double bottom” or “head and shoulders top”. The second kind are Japanese candlestick reversals, typically made up of two to three candles on a candlestick chart. The ability to recognise both types can be invaluable to any trader, whether serious or part-time.

What is a reversal candlestick pattern?

The purpose of a reversal candlestick pattern is to provide a signal that the short-term direction of the market is likely to change over the next several periods. This is as opposed to continuation candlestick patterns that signal that the trend is likely to keep going in the same direction.

The “message” that technical analysts take from a reversal pattern is that momentum has been exhausted and is now moving in the opposite direction. If it was previously a buyer’s market, the balance is shifting to sellers, or vice versa. 

A bullish reversal pattern is a signal that a price which was going lower may soon be turning higher. The reverse is called a bearish candlestick reversal.

5 best candlestick reversal patterns

What do reversal candles look like? What is the most significant candlestick pattern? Though there is always some room for interpretation, anyone can master the basics.

One: The hammer

One of the most commonly recognised candlestick reversal patterns is the pin bar – called that because it looks like a pin if you squint hard enough. It is also referred to as the hammer pattern when it occurs in a bearish trend, signalling a possible bullish market reversal. If it occurs during an uptrend and signals a potential turn towards the downside, it is called the shooting star pattern.

The key element of the pin bar is the elongated tail. The long tail is formed by bears aggressively pushing prices significantly lower during the time period in question. However, the fact that the closing price is back up near opening levels indicates that the attempt to push the price lower was ultimately rejected. The initial drop in price is followed by a stronger move to the upside that brings the price back near, or even above, the opening price.

Hammer pattern trading strategy

When the hammer pattern is often an accurate indication of an imminent trend reversal, the price does not usually go any lower than the low of the pin bar candlestick in subsequent trading. Therefore, the typical strategy is as follows:

Entry: At market open, after the hammer candlestick has closed.

Stop loss: Underneath the low of the hammer candlestick

Take profit: Risk: Reward ratio of 2:1 

Two: Shooting star

The shooting star pattern – which indicates a potential market reversal toward the downside – is simply the hammer pattern turned upside down. There is a long tail on the topside of the candlestick body, which represents a failed attempt to push the price higher, rather than on the bottom side of the body, as is the case with the hammer pattern. Accordingly, the best way to take advantage of these conditions is the inverse of the hammer-pattern strategy.

Three: Bullish engulfing candlestick

Engulfing candlesticks are another pattern that indicates a possible market reversal. A bullish engulfing candlestick, signalling a possible reversal and rising prices, is one in which the body of an up candlestick (one where the close is higher than the open) completely encompasses the body of the immediately previous down candlestick. 

Bullish engulfing candlestick trading strategy

Assuming that other analyses support the bullish engulfing pattern’s conclusion, it’s generally expected that the price will not subsequently go any lower than the low of the second, bullish candlestick. Therefore, the typical strategy is as follows:

Entry: At market open, after second engulfing candlestick has closed.

Stop loss: Underneath the low of the second engulfing candlestick.

Take Profit: Risk: Reward ratio of 2:1

Four: Bearish engulfing candlestick

A bearish engulfing candlestick may mark the possible end of an uptrend. It is found where a bearish down (normally red or black) candle completely encompasses the previous up candlestick (normally green or white). The most common trade triggered by a bearish engulfing candlestick is the opposite of that associated with a bullish one.

Five: The doji candlestick pattern

A doji (meaning “blunder” or “clumsiness” in Japanese) candlestick is formed when the opening and closing prices of a candlestick are identical, so that the candlestick has essentially no body, only upper and lower tails that extend on either side of the opening/closing price. 

The common interpretation of the doji pattern is that it indicates indecision in the market. The price has moved both up and down but ultimately settled right back where it began. 

Indecision in a market often precedes a trend change, and that’s why the doji pattern is often considered an indicator of possible trend change, although not as strong an indicator as the pin bar or engulfing candlestick patterns.

Doji candlestick pattern trading strategy

If a doji pattern is seen at the end of an over-stretched trend, it can be a reliable signal that a top or bottom is close. Near the beginning of a strong trend, it can be considered as a second chance to enter in the direction of the existing trend.

Entry: Buy stop order above the high of the doji or sell a stop order under the low of the doji.

Stop loss: Placed at the opposite side of the doji to the entry stop order.

Take Profit: Risk: reward 2:1

Candlestick patterns: conclusion

Candlestick reversal patterns can be key indications of a possible trend change, either from uptrend to downtrend or vice versa. When such reversal patterns occur, traders look to other technical indicators – such as moving averages, pivot points, and volume – for confirming indications of a market reversal.

None of these conclusions, by themselves, is written in stone. Japanese candlesticks, like all technical indicators, rely on what’s happened in the past and, as the saying goes: “past performance is no guarantee of future behaviour”.