On Tuesday, I introduced you to Munehisa Homma.
But he was much more than the “father of the candlestick chart.”
Not only is Homma credited as being the inventor of technical analysis itself… he’s also considered to be the “God of the markets” (of his time).
And legend has it that he became a rice futures trading mogul – making today’s equivalent of $10 billion.
As a rules-based trader, though, his record is what fascinates me the most…
Homma was so good at identifying profit opportunities using his price patterns that he is said to have landed 100 winning trades in a row.
In fact, he was so respected that he was appointed as an important financial advisor to the Japanese government.
Now I mentioned previously that he developed multiple candlestick patterns.
But today, we’re going to focus on the only eight you’ll need…
Let’s get started.
The 8 Best Candlestick Reversal Patterns You’ll Ever Need
The last time we talked, I said that the purpose of seeing whether a stock closed higher or lower than its opening is to determine who’s in charge of the trend – the bulls or the bears. In Japanese candlestick charting, formations are either continuation patterns or reversal patterns.
I look for reversal patterns the most, though. Reversal patterns give you signs as to whether or not the dominator (the bull or bear) is running out of steam… and that tells me that a mover in the opposite direction may be coming.
There are so many great candlestick patterns Homma used that your eyes will start to glaze over if you try to sort through them all. And once you do, you then face the challenge of deciding which ones are better to use over others.
But I’m going to save you from those headaches…
Today, I’m going to give you the bullish and bearish patterns that I consider to be the best at identifying reversals. And don’t worry… I’m also going to show the trading strategies you should consider using after identifying them.
I need to emphasize that these patterns will not pick market tops and bottoms. I’m sure you’d agree that anyone trying a hand at picking absolute tops and bottoms will find it to be quite the challenge. But if you can get in near a bottom or top, you’ll increase your earnings potential.
One last thing before we dive in…
The patterns we’re about to look at are two and three days in length. Patterns that are longer in length will tell you more about the market “psychology” surrounding a stock. So three-day patterns, for example, are a bit more significant than two- day patterns… two-day patterns are a bit more significant than one-day patterns, and so on…
Now let’s get into my favorite bullish candlestick reversal patterns…
Here’s a refresher on the candlestick bar:
Depending on your charting software, the color coding of the body is usually black or white, but we’re using green and red today.
Red indicates the stock closed lower than its opening price, and green indicates the stock closed higher than it its opening price.
The Piercing Pattern
This is a two-day reversal pattern where the bears were originally in command. On the first day, you’ll see a downward price movement, or bearish candle (the red). On the second day, the stock gaps lower than its close on the first day (the upward trending green) before eventually closing higher than it did on the first day. It’s called a piercing pattern because it pierces through the prior day’s price. The greater the “pierce,” the better… meaning that it would be more ideal for a stock to close 50% higher than the midpoint of the candlestick’s body than if it just nudged into the midpoint.
The Bullish Engulfing Pattern
This is another two-day reversal pattern where a bearish candle day (in red) is followed by a bullish candle day (in green). Unlike the piercing pattern that only pierces or closes the prior day’s candlestick, the real body totally engulfs the previous day’s real body. And this tends to be much more significant than the piercing pattern.
The Morning Star Reversal Pattern
This is a three-day pattern (more significant than one- or two-day patterns). The morning star reversal’s first day is a bearish candle (in red). The second day (or middle candle) is typically a Doji – a day with a very small trading range due to investor indecision. The third day shows a bullish candle (in green). The more the third day’s close pierces the first day’s real body, the better. A close of 50% or more is ideal.
The Bullish Kicker Pattern
This is a two-day pattern, but because the reversal is a bit more dramatic, it is deemed as one of the most reliable two-day candle patterns. The first day is a bearish day, but on the second day, it gaps open and continues on an upward move on for the rest of the day, closing higher than the open. The fact that it opened as a bear before reversing and making a bullish run gives an indication that the bulls are gaining back control – and higher prices are likely to follow.
These are the strategies you’ll want to consider when identifying bullish candlestick patterns:
- Buy calls
- Open a debit call spreads (a loophole trade)
- Open put calendar spreads
- Buy the stock
Time to move on to the bullish pattern’s alter ego: bearish candlestick reversal patterns…
Dark Cloud Cover
This is a two-day pattern where the first day is a bullish day (green). The second day is a bearish one (red) where not only is the closing price of the day lower than it’s opening price – it also closes in the real body of the first day. Like its opposite, the piercing pattern, a close of 50% or more on the second day compared to the first day is ideal.
The Bearish Engulfing Pattern
This two-day pattern is formed when a bullish candle day (green) is followed by a bearish candle day (red). The difference here is that unlike the dark cloud cover, the real body totally engulfs the previous day’s real body. And this tends to be more significant than the dark cloud cover.
The Evening Star Reversal Pattern
This is a three-day pattern, which is more significant than other two-day patterns. The evening star reversal’s first day is a bullish candle day (green). The second day is typically a Doji (a day with a very small trading range due to investor indecision).The third day is a bearish candle day. The more the third day’s close pierces the first day’s real body, the better. Ideally a close 50% or greater is ideal.
The Bearish Kicker Pattern
This is a two-day pattern, but because the reversal is a bit more dramatic, it is deemed one of the most reliable two-day candle patterns. The first day is a bullish day, but the second day gaps open, continuing on for the rest of the day until closing lower than the open (bearish). The fact that it opened with a gap trending in the opposite direction and remained bearish virtually the whole day before finishing lower gives more of an indication that the bears are gaining back control – and lower prices are likely to follow.
These are the strategies you’ll want to consider when identifying bearish candlestick patterns:
- Buy puts
- Create a put debit spread (a loophole trade)
- Create a call calendar spreads
- Short the stock
The Location in the Chart Validates (Or Invalidates) the Pattern
I like to combine Japanese candlestick charting with my other western analysis tools (like Money Calendar), and I encourage you to combine this technique with other forms of technical analysis. If you get a signal you favor along with a bullish continuation or bullish reversal signal, then that should give you extra conviction to purse that trade idea.
But keep in mind that the location of a bullish or bearish pattern formation on a chart either validates or invalidates the pattern itself.
Here’s an example of what I mean…
Let’s say that you see the two-day structure of a piercing pattern in which the current closing price ended up higher than it’s opening price before ending up piercing the prior day’s real body (ideally 50% or more).
You then see that this is happening at a resistance level. This would invalidate that two-day candle pattern as a reversal pattern.
The key is in the label of the pattern: a piercing pattern is a bullish reversal pattern. If a stock is at resistance and is about to reverse, it will reverse to the downside. A bullish pattern doesn’t go down; it goes up. And a stock that is already trending up can’t reverse upward…
So that tells you that you’re not looking at a bullish reversal pattern.
At resistance levels, look for bearish candle reversal patterns so that you can trade to the downside.
At support levels, look for bullish candle reversal patterns so that you can trade to the upside.
Here’s Your Trading Lesson Summary:Candlestick reversal patterns signal a possible reversal in bullish or bearish price movements. These are the top eight types of Japanese candlestick reversal patterns:
- The piercing pattern
- The bullish engulfing pattern
- The morning star reversal pattern
- The bullish kicker pattern
- The dark cloud cover pattern
- The bearish engulfing pattern
- The evening star reversal pattern
- The bearish kicker pattern
Enjoy your long weekend!