Learn how to identify trend reversal patterns using candlestick charts.
Editor’s note: This article is the second installment in a series on candlestick patterns. The first article introduced candlestick charts. This one looks at trend reversal patterns.
First developed by Japanese merchants centuries ago to track the price of rice futures, candlestick charts gained popularity in the U.S. in the early 1990s and are now the go-to chart type for most traders.
Each candlestick is made up of three components: the body of the “candle,” plus upper and lower tails (the “wicks”). Like the bar chart, candlesticks display the opening, high, low, and closing prices, 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 signal the end of a trend (“reversal patterns”) and those that indicate a trend is about to resume (“continuation patterns”).
The rest of this article is dedicated to reversal patterns. But keep in mind:
A doji is a candle where the opening price and closing price are the same, meaning there is no real body—just a horizontal line indicating where price started and ended.
FIGURE 1: REVERSAL DOJI.
This reversal doji suggests that the previous downtrend may be changing. Image source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only.
Figure 1 shows a doji with a long lower shadow that formed after a downtrend. The doji candle’s structure indicates that after the stock opened, price continued lower in the direction of the previous downtrend, but then reversed and closed right where it opened.
This price action suggests that the downtrend has run out of steam. When the next candle after the reversal doji closes higher, it acts as confirmation, indicating a possible change of trend.
A reversal hammer is similar to a reversal doji except that it has a small body (“candle”), so it looks like a hammer (figure 2).
FIGURE 2: REVERSAL HAMMER.
Similar to the reversal doji, the hammer forms a small, green real body. Image source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The price action on a reversal hammer is the same as a reversal doji, but many traders think it’s a stronger indicator of a potential reversal because it includes a rebound back above the opening price.
Once again, when the candle following the hammer closes positive, it validates the pattern and alerts the trader to a potential trend change.
A bullish engulfing reversal is a two-candle pattern that indicates a reversal of the previously established trend.
FIGURE 3: BULLISH ENGULFING REVERSAL.
A two-candle pattern indicating a possible trend change. Image source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Three specific criteria create a bullish engulfing reversal:
You may have noticed in figure 3 that the second (bullish) candle “engulfs” the real body of the first candle, though not quite its upper wick. This still qualifies as a bullish engulfing pattern, but it may be seen as slightly less definitive than if the second candle fully engulfed the first candle’s price action.
The morning star reversal is a three-candle pattern that incorporates what’s known as a “star” candle.
FIGURE 4: MORNING STAR REVERSAL.
This three-candle reversal pattern includes a “star” as the second candle. Image source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
A star is a candle with a small real body that gaps away from the large real body preceding it. In practice, the color of the star is not important. If it is a doji, it is sometimes called a “doji star.”
There are three specific criteria for a morning star reversal pattern:
Look for confirmation when the first bar after the morning star reversal closes higher than the highest point of the overall pattern.
These are just a few of the common reversal patterns you’re likely to spot with candlestick charts. Each of them has a bearish counterpart that indicates a possible reversal of an uptrend; they’re known respectively as the inverted hammer, bearish reversal doji, bearish engulfing pattern, and evening star reversal.
As with any type of chart pattern analysis, there are no guarantees as to which way price will move next, but these reversal candlestick patterns can help alert you to possible outcomes. The thinkorswim platform allows you to scan automatically for traditional candlestick patterns or create your own.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2020 TD Ameritrade.