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TECHNICAL ANALYSIS TECHNICAL ANALYSIS BASIC EDUCATION

Technical The 5 Most Powerful

Analysis
Candlestick Patterns
TECHNICAL ANALYSIS BASIC
EDUCATION

ADVANCED TECHNICAL
ANALYSIS CONCEPTS By ALAN FARLEY | Updated Feb 18, 2020

Candlestick charts are a technical tool that packs data for multiple time frames
into single price bars. This makes them more useful than traditional open-high,
low-close bars or simple lines that connect the dots of closing prices. Candlesticks
build patterns that predict price direction once completed. Proper color coding
adds depth to this colorful technical tool, which dates back to 18th-century
Japanese rice traders.

Steve Nison brought candlestick patterns to the Western world in his popular 1991
book, "Japanese Candlestick Charting Techniques." Many traders can now identify
dozens of these formations, which have colorful names like bearish dark cloud
cover, evening star and three black crows. In addition, single bar patterns
including the doji and hammer have been incorporated into dozens of long- and
short-side trading strategies. 

KEY TAKEAWAYS
Candlestick patterns, which are technical trading tools, have been used
for centuries to predict price direction. 
There are various candlestick patterns used to determine price direction
and momentum, including three line strike, two black gapping, three
black crows, evening star, and abandoned baby. 
However, it’s worth noting that many signals emitted by these candlestick
patterns might not work reliably in the modern electronic environment.

Candlestick Pattern Reliability

Not all candlestick patterns work equally well. Their huge popularity has lowered
reliability because they've been deconstructed by hedge funds and their
algorithms. These well-funded players rely on lightning-speed execution to trade
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against retail investors and traditional fund managers who execute technical
analysis strategies found in popular texts.

In other words, hedge fund managers use software to trap participants looking for
high-odds bullish or bearish outcomes. However, reliable patterns continue to
appear, allowing for short- and long-term profit opportunities.

Here are five candlestick patterns that perform exceptionally well as precursors of
price direction and momentum. Each works within the context of surrounding
price bars in predicting higher or lower prices. They are also time sensitive in two
ways. First, they only work within the limitations of the chart being reviewed,
whether intraday, daily, weekly or monthly. Second, their potency decreases
rapidly three to five bars after the pattern has completed.

Top 5 Candlestick Patterns

This analysis relies on the work of Thomas Bulkowski, who built performance
rankings for candlestick patterns in his 2008 book, "Encyclopedia of Candlestick
Charts." He offers statistics for two kinds of expected pattern outcomes: reversal
and continuation. Candlestick reversal patterns predict a change in price direction,
while continuation patterns predict an extension in the current price direction. 

In the following examples, the hollow white candlestick denotes a closing print
higher than the opening print, while the black candlestick denotes a closing print
lower than the opening print.

Three Line Strike

Three Line Strike

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The bullish three line strike reversal pattern carves out three black candles within
a downtrend. Each bar posts a lower low and closes near the intrabar low. The
fourth bar opens even lower but reverses in a wide-range outside bar that closes
above the high of the first candle in the series. The opening print also marks the
low of the fourth bar. According to Bulkowski, this reversal predicts higher prices
with an 84% accuracy rate.

Two Black Gapping

Two Black Gapping

Image by Julie Bang © Investopedia 2020

The bearish two black gapping continuation pattern appears after a notable top in
an uptrend, with a gap down that yields two black bars posting lower lows. This
pattern predicts that the decline will continue to even lower lows, perhaps
triggering a broader-scale downtrend. According to Bulkowski, this pattern
predicts lower prices with a 68% accuracy rate.

Three Black Crows

Three Black Crows

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 Image by Julie Bang © Investopedia 2020

The bearish three black crows reversal pattern starts at or near the high of an
uptrend, with three black bars posting lower lows that close near intrabar lows.
This pattern predicts that the decline will continue to even lower lows, perhaps
triggering a broader-scale downtrend. The most bearish version starts at a new
high (point A on the chart) because it traps buyers entering momentum plays.
According to Bulkowski, this pattern predicts lower prices with a 78% accuracy
rate.

Evening Star

Evening Star

Image by Julie Bang © Investopedia 2020

The bearish evening star reversal pattern starts with a tall white bar that carries an
uptrend to a new high. The market gaps higher on the next bar, but fresh buyers
fail to appear, yielding a narrow range candlestick. A gap down on the third bar
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completes the pattern, which predicts that the decline will continue to even lower
lows, perhaps triggering a broader-scale downtrend. According to Bulkowski, this
pattern predicts lower prices with a 72% accuracy rate.

Abandoned Baby

Abandoned Baby

Image by Julie Bang © Investopedia 2020

The bullish abandoned baby reversal pattern appears at the low of a downtrend,

after a series of black candles print lower lows. The market gaps lower on the next
bar, but fresh sellers fail to appear, yielding a narrow range doji candlestick with
opening and closing prints at the same price. A bullish gap on the third bar
completes the pattern, which predicts that the recovery will continue to even
higher highs, perhaps triggering a broader-scale uptrend. According to Bulkowski,
this pattern predicts higher prices with a 70% accuracy rate. 

The Bottom Line

Candlestick patterns capture the attention of market players, but many reversal
and continuation signals emitted by these patterns don't work reliably in the
modern electronic environment. Fortunately, statistics by Thomas Bulkowski show
unusual accuracy for a narrow selection of these patterns, offering traders
actionable buy and sell signals.

Putting the insights gained from looking at candlestick patterns to use and
investing in an asset based on them would require a brokerage account. To save
some research time, Investopedia has put together a list of the best online brokers
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so you can find the right broker for your investment needs.

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Related Terms
Stick Sandwich Definition
 A stick sandwich is a technical trading pattern in which three candlesticks form what
appears to beEDUCATION MARKETS
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Harami Cross Definition and Example

A harami cross is a candlestick pattern that consists of a large candlestick followed by a
doji. Sometimes it signals the start of a trend reversal. more

Piercing Pattern Definition

The piercing pattern is a two-day candle pattern that implies a potential reversal from a
downward trend to an upward trend. more

Doji
A doji is a name for a session in which the candlestick for a security has an open and close
that are virtually equal and are often components in patterns more

Outside Reversal Definition

Outside reversal is a chart pattern that shows when a security’s high and low price for the
day exceed those achieved in the prior day’s trading session. more

Bullish Engulfing Pattern

A bullish engulfing pattern is a white candlestick that closes higher than the previous day's
opening after opening lower than the previous day's close. more

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