A Flicker of Light: Candlestick Reversal and Continuation Patterns

Candlestick charts trace their origins to 17th century Japanese merchants as they tracked rice futures on the Dojima Rice Exchange. Since then, they’ve become popular and are now the go-to chart type for most technical traders.

Each candlestick is made up of three components: the body of the “candle,” plus upper and lower tails (the “wicks”). Similar to a bar chart, candlesticks display the open, high, low, and close, but their slightly different presentation makes a big visual difference. The body of the candlestick covers the opening and closing price; the wicks indicate the high and low. Like bar charts, candlesticks may be color coded to indicate direction.

As prices fluctuate on a candlestick chart, patterns sometimes emerge. These patterns generally fall into two categories—those that technicians believe could signal the end of a trend (reversal candlestick patterns) and those that could indicate a trend is about to resume (continuation candlestick patterns). When speaking of the trend and candlestick patterns, technicians are usually referring to the short-term trend that may last just a week or two. Some candlestick traders estimate that a pattern is good for about 20 to 30 candles thereafter. Of course, past performance does not guarantee future results.

Before going into the specific patterns, here are a few points to keep in mind:

• Reversal and continuation patterns are not a guarantee the trend will reverse; they signal a potential change. 
• Reversal and continuation patterns that show up in a range aren’t necessarily valid, meaning they don’t indicate a breakout from the range. Reversal patterns are typically more valid when preceded by a pronounced trend, either up or down.
• Reversal patterns may be more significant at levels of support or resistance.
• Most reversal and continuation patterns have specific criteria. 

Reversal candlestick patterns

Bullish reversal doji: A doji is a candle where the opening price and closing price are the same, meaning there’s no real body—just a horizontal line indicating where price started and ended (see figure 1).

While you may see dojis at various times, a bullish reversal doji forms at the end of a downtrend. Analyzing the doji in figure 1, we see that the close was near the high of the bar, which suggest that after the stock opened, price continued lower in the direction of the previous downtrend, but then it reversed and closed near where it opened. This indicates to candlestick traders that the downtrend is running out of steam. If the next candle bar after the reversal doji closes higher, it can act as a confirmation, indicating a possible change of trend. In fact, when including the candle before and after the doji, it turns into a morning star pattern.

Reversal hammer: A reversal hammer is similar to a reversal doji, except that it has a small body giving it the appearance of a hammer (see figure 2). Some traders think the hammer is a stronger signal than the doji because the close is slightly higher than the open, suggesting a potential rebound. As with the doji, when the candle following the hammer closes positive, it validates the pattern and alerts the trader to a potential trend change.

Bearish engulfing pattern: This is a two-candle pattern indicating a reversal of the previously established uptrend. You can also find these occurring at the bottom of a downtrend, but they’re referred to as bullish engulfing patterns. Three specific criteria create a bearish engulfing reversal:

• The first candle is bullish and continues the uptrend.
• The second candle is bearish, and its opening price is higher than the closing price of the first candle.
• The second candle’s closing price is lower than the first candle’s opening price.

Figure 2 shows a bearish engulfing pattern. The second (bearish) candle “engulfs” the body of the first candle. After the pattern formed, you’ll notice the uptrend reversed. 

These are a handful of common reversal patterns you’re likely to come across. But sometimes, instead of reversing, price will pause or pull back.

Continuation candlestick patterns

When a trend is taking a breather, it may be time to look for signs of continuations. And there are candlestick patterns that may identify potential trend continuations. But just like with reversal patterns, there are a few things to keep in mind with continuation patterns:

• A continuation pattern is not a guarantee the previous trend will continue—just a signal that the pause in the trend might be temporary.
• Continuation patterns that show up in a range are not necessarily valid. They should normally be preceded by a trend—either up or down.
• Most continuation patterns have specific criteria. 

That said, let’s look at some popular candlestick continuation patterns.

Three white soldiers: This pattern takes its name from a time when charts were drawn by hand on paper. Up candles were white and down candles were black. But now that we use software for our charts, up candles are generally green and down candles are red.

As the name implies, this pattern involves three white (green) candles in a row, with the following criteria:

• All three candles are long and bullish.
• Each candle’s opening price is within the previous candle’s body.
• Each candle’s closing price is higher than that of the previous candle.

This pattern type is determined by where it occurs. For example, if it occurs after an extended downtrend, it can be a reversal pattern. However, it’s considered a continuation pattern if it occurs after a minor pause in the middle of an existing trend (see figure 3).

Rising three methods: This is a bullish continuation pattern made up of five candles. Because of this, they’re sometimes difficult to identify, but you may be able to find this pattern on a chart on the thinkorswim platform. They typically look like this:

• The first candle is long and bullish and continues the uptrend.
• The next three candles are small and form a short-term pullback, all closing within the first candle’s body.
• The fifth candle is long and bullish, and its closing price is higher than that of the first candle.

In neck: It’s an odd name, but it’s a pattern that can only be bearish (see figure 4):

• The first candle is long and bearish and appears in a downtrend.
• The second candle is bullish and opens at a new low price.
• The second candle’s close is either equal to or slightly higher than the close of the first candle.

There’s a slightly different version of this pattern called on neck. It too signals only bearish continuation, and the only difference is that the second candle’s closing price is equal to the low price of the first candle.

These are just a few of the more common continuation patterns. As with any type of pattern recognition, there are no guarantees as to which way price will go next, but these and other candlestick patterns can help alert you to possible outcomes.

Although these principles are the foundation of technical analysis, other approaches, including fundamental analysis, may assert very different views.