Let’s examine how technical traders use the patterns created by candlesticks on a chart to understand and predict market movements.
What are patterns?
Patterns are recognizable motifs created on charts. Technical traders use them to quickly analyze market behaviour and gain crucial insight into what might happen next – so they can trade accordingly.
Technical analysis is based on the principle that chart patterns will repeat themselves, resulting in the same price action most of the time.
Say that 90% of the time in the past, a strong rally followed by a period of consolidation has led to a bear run. If a market rallies but then tapers off, a technical trader would see it as likely that another reversal may be on the cards.
Trading with patterns
While they can be useful for predicting price action when a pattern emerges there’s no guarantee of what will happen next. So, most traders will wait to confirm their anticipated move – whether it’s a new trend, a reversal or a continuation – before opening a position.
What this means in practice is that they’ll wait for a few periods to check that the market is behaving in the way they predicted.
As ever, careful trading and strong risk management are also key.
Patterns made of one or more candlesticks offer a quick way to spot price action that offers a `strong indication of a potential future move. Here are a few key examples.
Candlestick patterns are created by one or more individual sticks on a chart.
The Doji pattern is formed when a market’s opening and closing prices in a period are equal – or very close to equal. So, whatever happened within the candlestick itself, by the end of the session neither buyers nor sellers had the upper hand.
Example of a Doji pattern
It is considered a neutral formation, suggesting indecision between bears and bulls.
Doji can come in three main types: long-legged, gravestone and dragonfly.
In a long-legged doji, there was a significant amount of indecision as buyers and sellers took the market higher and lower before eventually cancel each other out
Gravestone doji indicate that buyers initially pushed prices higher, but sellers took back control and drove them back down again
In a dragonfly doji, the opposite occurred – sellers drove the market down, then buyers took over and brought it back up again
The doji is a single-session pattern, which means it is only comprised of one candlestick. However, they become much more useful when taken as part of a wider context.
For example, a red gravestone doji after a long uptrend may be a sign that a reversal is on the cards.
Let’s take a look at what might happen within a four-hour gravestone doji to see how.
Initially in the session, the rally continued. But then sellers took over, driving the price down back to the open. If that sentiment continues, then it might be a good time for a short trade.
A wide-ranging bar looks exactly like it sounds. A long bar that is at least two to three times longer than the sticks that surround it on the chart.
Wide-ranging bars signal strong momentum in the direction of the bar. There is overwhelming buying or selling sentiment, often the result of a major news announcement – although this is not always the case.
Trading a wide-ranging bar may seem tempting due to the clear volatility and sentiment. But more often than not, it’s a better idea to take a step back. They can indicate that any pattern present before the wide-ranging bar will no longer hold. Previous support and resistance, too, can be overridden when sentiment is this strong.
A hammer has a small body, a long lower wick and a small or absent upper wick. It can be red or green, and forms after a downtrend. Hammers are taken as a sign that a bear trend may be about to reverse.
As well as having the appearance of a hammer, they get their name from how they form – in this formation, the market is ‘hammering’ out its low before bouncing up again. Like a dragonfly doji, a hammer signifies that strong selling sentiment was beaten out by buyers before the end of the session
Pay attention to the length of the lower wick when looking for hammers, as it can tell you about the strength of the formation. Ideally, the wick should be two or three times longer than the body.
But what if a hammer appears at the end of a bull run instead of a bear one?
This is also a reversal pattern, but in this case, it signals the potential end of the uptrend. And it isn’t called a hammer – it’s called a hanging man.
In a hanging man, sellers took over during the session to postpone a rally. Buyers then pushed the price back up but weren’t able to send it much past the open. This means buying sentiment may no longer be strong enough to sustain the uptrend.
Did you know? There are a few other single-session patterns that can be useful. Spinning tops, for instance, are similar to long-legged doji but with a little bit more width on their body. Marubozu, on the other hand, are all body, with no wicks whatsoever.
Inverted hammer and shooting star
You can also look for upside-down, or ‘inverted’ hammers. These are also reversal patterns, appearing at the end of bear runs and signalling a potential end to the downtrend.
If an inverted hammer appears after a rally, it is known as a shooting star. Again, it is often taken as a sign that the uptrend may be nearing its end.
It isn’t wise to jump into a trade the moment you see a hammer. Instead, you’ll want to wait to confirm the move. The simplest method of confirming a hammer is to see whether the previous trend continues in the next session. If it does, then the hammer has failed.
Morning stars are a commonly used triple-session candlestick pattern. Like hammers, they offer an indication that a downtrend might be about to end with an impending reversal.
A morning star consists of three candlesticks:
A long red candle
A small red or green candle that gaps below the close of the previous session
A long green candle
If the second candle is a doji, then the chances of a reversal increase. The trend is also seen as being stronger if the final candle gaps above the close of the second one.
A morning star begins with the downtrend intact, as shown by the long red candle and the gap to the next session. However, the second candle indicates indecision, which could signify a reversal of the cards. Then, the long green candle confirms that the reversal is underway.
Chart patterns present themselves over lots of trading sessions, so they tend to be longer than candlestick patterns.
One of the easiest chart patterns to spot is the triangle.
There are three types of the triangle to watch out for: ascending, descending and symmetrical.
In an ascending triangle, the bottoms hit by a market get successively higher – indicating a rising trend line. However, the trend pauses as the market fails to hit new highs on the upside. Instead, it keeps bouncing off a strong resistance level.
Often occurring after significant uptrends, ascending triangles are continuation patterns. So, if the market breaks through the resistance level, then a new rally may form.
However, if the market drops below the lower trend line, the pattern is voided.
Descending triangles, meanwhile, are the exact opposite. After a downtrend, a market hits a strong support level, but with ever-lower resistance. If the support is broken, a new bear run may appear.
The simplest way to trade a triangle is to place an entry order just beyond the level of resistance (on an ascending triangle) or support (descending). Then, you can trade the result price action.
It’s often a good idea to place a stop just beyond the opposite trend line. Then, if the pattern fails, your position will close automatically.
Symmetrical triangles, flags, and wedges
These three patterns all look a little bit different but are similar in how they work. Symmetrical triangles, flags and wedges are all formed by two trend lines that indicate indecision in the market. Then, if either trend line is broken, they may lead to a new rally in that direction.
In a symmetrical triangle, two trend lines point towards each other. The first connects a series of lower peaks, while the second connects a series of higher troughs
In a wedge, two trend lines point towards each other while sloping in the same general direction. In a rising wedge, the upper and lower trend lines both point up. In a falling wedge, they slope down
In a flag, two trend lines run in parallel, sloping either down (a bullish flag) or up (a bearish flag). Bullish flags appear after a significant move up, while bearish ones appear after a downtrend
In all of these patterns, the market is in a period of consolidation that is often accompanied by falling volatility and volume.
During the pattern, the market cannot decide whether to break up or down. Once either trend line is broken, there may be a substantial move in the direction of the break.
If the market breaks up, then it may start a rally. If it breaks down, it may signal a bear run.
You can trade any of them by entering a position once the market moves beyond either trend line. Again, it is often a good plan to set a stop just beyond the opposite line, in case the move fails.
Technical analysis is based on the principle that chart patterns will repeat themselves, resulting in the same price action most of the time