- August 30, 2021
- Posted by: CoachShane
- Category: Trading Article
Why are we looking at reversal candlestick patterns and not continuation patterns in this guide?
Steve Nison stated that reversal candlesticks patterns are more meaningful because they will allow a trader to:
- Enter a position when the current trend may be turning and a move in the opposite direction
- Exit a position with a reversal signal before the trend reverses too far taking back profits
Focus On The Body
We will also focus on the open and closes of the candlestick (real body) and generally not concern ourselves with the shadows. A small body candle tells a much different story than a long body.
While nothing will predict with 100% certainty, some reversal candlestick patterns perform better than others. You will be surprised that this guide will not cover popular and basic candlestick patterns such as:
Many academic studies focus on the reversal as well so there is evidence to suggest that reversal candlestick patterns are where we should focus. It’s not that continuation patterns are not important but getting into a market during the trend turn lessens the risk of entering an extended market.
For traders looking for the best trading indicator, you are looking at it – technical analysis using price movement.
Reversal Candlestick Directional Types
Having a bullish trend or bearish trend in place is where you will find reversal useful. Reversal candles can form in several areas:
- During the corrective move of a market for pullback traders. Reversal candles can assist in your trade entry locations
- Markets trend and reverse and finding that point where we can see a prolonged correction or a complete reversal can be important
- Markets forming a trading range patterns – traders can look for reversals at the support level or resistance level of the price range (lower time frame trending)
We can categorize reversals into:
- Bullish reversal pattern – when a down trend turns to an uptrend forming a potential support level, or the end of a corrective move
- Bearish reversal pattern – uptrend turns to a down trend forming a potential resistance level, or the end of a corrective rally when a market is in a down trend
We are going to use daily candlesticks for these examples and focus on single candlesticks, 2 day candlesticks, and 3 day candlesticks.
Bullish Candlestick Patterns
Bullish patterns are where we have price in a down trend or in a corrective decline and we are looking to trade in the new direction.
Let’s take a look at the top 1, 2, and 3 day bullish candlesticks you should know.
Opening White Marubozu
This single candlestick pattern can be found in a trend which will suggest a continuation of a trend. Since we are focusing on the reversal candlestick, we will also look for these after a prolonged down trend or at the end of a corrective pullbacks.
While some will argue the end of a corrective move is a continuation pattern, technically a higher time frame corrective move can be a complete down trend on a lower time frame.
- High is greater than the closing price
- Close is greater than the open price
- Open is the same as the low
- Body must make up over 51% of the total candlestick height
The difference between the opening white marubozu and the white marubozu is the close is the high of the day or time period.
The OWM on the left is shown inside of a range with lower highs while the right OWM is forming after a corrective decline in this stock.
This is a 2 candle pattern where, when looking for the bottom of a downtrend or correction, the first candles body engulfs the body of the second candle which must be a white (green) candle.
- Open of the first candle is greater than the close of the second candle
- Close of the second candle is greater than the open of the second candle
- Open of the second candle is greater than the close of the first candle
- Real body of first candle is greater than the real body of the second candle
Looking for these reversals on the weekly charts can set you up for a good run on the lower time frame charts. As an example:
- The correction on the left ran over 300 pips
- The middle pullback resolved into a 860 pip upside run
- The last highlighted bullish harami ran for 840 pips
You would not have gotten all the move however you certainly could have banked some pips off the daily Forex chart when this weekly chart produced the reversal.
Tip: Look left to see where the two last candlesticks bounced from. You will see there was market structure and these reversals came at potential turning points in the market.
When looking to trade a full trend change, ensure the market is making a new higher high for an uptrend, and a new lower low for a downtrend.
Three Inside Up Candlestick Reversal
This is our three candlestick pattern and is an extension of the bullish harami we just discussed but with added confirmation.
The first candlestick is a black (red) body in a correction or down trending market.
The second candlestick is a white (green) candlestick where the body is completely engulfed by the body of the first candlestick.
The third candlestick in this series is a candle where the closing price is above the previous close.
Here is your checklist:
- Open of the first candlestick is greater than it’s close
- Open of the first candlestick is greater than or equal to the open of the second which is greater than the close of the second candlestick
- Open of the first candlestick is greater than the close of the second which is equal to or greater than the close of the first candle
- Close of third is greater than the open
- Close of third is greater than the open of the first
I wanted to show this pattern where it fails to produce a reversal even when it coincides with a complex correction (pullback) and a support zone. This failure would also include the bullish harami.
While this particular pattern, if you traded at the completion of the pattern, went against you, the double bottom did serve as a launchpad for a $3000 run in Bitcoin.
These are the top three bullish reversal candlestick formations that are shown in studies to outperform most others.
Bearish Candlestick Patterns
What goes up, must come down and that is where we will look for a bearish pattern in the price action.
In essence, we are looking to grab the top of an uptrend for a short trade or to find an entry into the corrective rally that occurs during the down trend.
Opening Black Marubozu
The exact opposite of its cousin, white marubozu, the OBM signifies bearish conditions and showing in the middle of a downtrend, shows acceleration to the downside. You can see there is no upper shadow and the shorter the bottom shadow, the more significant this reversal candlestick can be.
- High equals the opening price
- The open is greater than the close
- Close is greater than the low
This chart highlights several OBM and shows that location matters.
- The first OBM occurs at a resistance level off to the left side of this chart. This is a good place to look for a reversal candlestick
- This happens in a somewhat range environment and more importantly, this location sets up a complex correction in this stock
- The bottom two happen at previous support and is not the place we’d be looking for a bearish reversal unless we had a breakout/pullback scenario
You will find man OBM candlesticks so ensure that you are only taking action in places where we may expect a market reaction.
This 2 candlestick reversal pattern is similar to the harami pattern we have discussed.
- Looking for an uptrend or corrective rally
- White body candle appears
- Second candle has its body fully engulfed by the previous body
I want to show one that doesn’t work out even when faced with a structure we can trade against.
Price has come up to a potential turning point where traders look to position. There are signs that resistance won’t hold and I cover that in my article about breakouts.
You can see this pattern fits the definition and while price does break down, it does so a few weeks after the reversal pattern. I highly doubt this pattern had any influence on the breakdown.
3 Outside Down
This pattern is part of the bearish engulfing pattern and bullish engulfing pattern with the third candlestick acting as a confirmation.
- White candle forms in an uptrend
- Second candle is black and engulfs the body of the first candlestick
- Last candlestick is also black and closes below the previous close
Thought we’d look at futures and this is a daily gold chart. This current top price zone was actually acting as support from Sept 2011 to April 2013 before it broke. Price is currently testing the underside of previous support and so far has found a resistance level.
As usual, context matters when looking for these candlestick patterns.
What About Doji Candles?
Doji candles are reportedly to be about indecision.
From all the testing I have read, they don’t perform well in quantitative testing. They can appear in certain patterns such as the 3 outside down reversal.
What About Long Shadows?
With some reversal candlesticks, a long lower wick for a move up or long upper shadow for a potential move down, can be an important thing to look for in a potential trend reversal pattern.
Do Time Frames Matter?
Yes. You may see a pattern on one time frame and not on another. For example, an outside bar on a daily chart probably won’t exist on a lower time frame. Experienced traders can often combine lower time frame candles to make up a candle like an outside bar.
How To Trade Reversal Candlestick Patterns
As with any pattern, including the many chart patterns, you may want to consider entering a trade when:
- The formation of the reversal pattern is taking place at or near a potential turning point such as support and resistance
- The bullish confirmation or bearish confirmation is confirmed via follow thru on the next candlestick
- An oversold or overbought reading is taking place on an oscillator such as the RSI
A protective stop loss is an essential part of your trading plan and while I prefer an ATR – average true range – stop placement, you may consider placing your stop where the pattern is violated.
Profit taking can be as simple as scaling out at 1R (1 times your risk) and trailing your stop loss.
Keep in mind that reversal candlestick patterns are not a holy grail, but a technical analysis tool to signify a potential reversal and you should be prepared to actively manage your trades.
Keep aware of changing market conditions, log all your trades, use tested trading strategies, and ensure proper risk management that allows you a string of losing trades without damaging your trading account.