Candlestick Patterns How to Identify and Interpret Trading Signals

Technical Analysis assumes that history repeats itself. This concept is essential to understanding how the approach works.

It would be beneficial to investigate this assumption more thoroughly now, as candlestick patterns rely heavily on it.

Let’s assume that some changes in a particular stock have occurred. Let’s call this phenomenon:

Factor 1- The stock has experienced a downward trend in the previous four trading sessions.

Factor 2- Today is the fifth time this stock has seen a decline, but it has experienced relatively low trading volumes.

Factor 3- Today, the stock has traded in a much narrower range than it has over the past four days.

With these influences in the air, let us assume that on the next day, the decline of stock is halted, and it increases to a positive finish. Consequently, the stock rose on the 6th day due to the three elements.

It’s been a few months, and the same set of conditions has persisted for the last 5 trading days. What will likely happen on the 6th day?

We can assume that, as in the past, history tends to repeat itself. However, we must factor in that this is only true if the set of conditions leading up to the event are identical; then, we likely will see a similar outcome.

Thus, it is likely that the stock cost will increase during the 6th trading session once again.

Candlestick patterns and what to expect

The candlesticks are employed to identify trade trends, which in turn give the technical analyst a chance to establish a position. Patterns are created by bringing together two or several candles following a certain order, yet, sometimes, even one candlestick can produce a strong trading signal.

Hence, candlesticks can be broken down into single candlestick patterns and multiple candlestick patterns.

In this lesson, we will cover the single candlestick pattern. 

1. Marubozu
2. Bullish Marubozu
3. Bearish Marubozu
4. Doji
5. Spinning Tops
6. Paper umbrella
7. Hammer
8. Hanging man
9. Shooting star

Multiple candlestick patterns are a combination of multiple candles. Under the multiple candlestick patterns, we will learn the following:

1. Engulfing pattern
2. Bullish Engulfing
3. Bearish Engulfing
4. Harami
5. Bullish Harami
6. Bearish Harami
7. Piercing Pattern
8. Dark cloud cover
9. Morning Star
10. Evening Star

Without a doubt, you may be pondering the significance of the given titles. As mentioned earlier in the preceding chapter, certain patterns have kept their Japanese origin name.

Candlestick patterns assist traders in forming a comprehensive perspective. These formations feature their risk management system, providing insight into the ideal entry and stop-loss prices.

Few assumptions specific to candlesticks

Before hopping into the material, we should bear in mind a couple of assumptions pertaining to candlesticks. These are imperative for us to understand and remember because we’ll frequently refer back to them later.

At this point, these assumptions may not be clear to you; however, please keep them in the back of your mind as I explain them in depth further on.

1. Buy strength and sell weakness: Every time you buy, it should be on a bullish (blue) candle day, and when it’s time to sell, make sure it’s a bearish (red) candle day. 

2. Be flexible with patterns (quantify and verify)– Although the textbook definition of a pattern has certain criteria, there may be slight changes due to market conditions. Therefore, some level of flexibility must be allowed, yet only within predetermined limits; this calls for quantification of such flexibility.

3. Look for a prior trend – If you’re observing a bullish pattern, the preceding trend should have been bearish, and if it’s the bearish pattern you seek, then the prior trend should have been bullish.

In the following chapter, we’ll start by focusing on single candlestick patterns.