Stock Trading through Candlestick Technical Analysis

by Vinaya HS on June 1, 2017

in Finance

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Traders in the stock and other financial markets use technical analysis to make their trading decisions. Candlesticks patterns offer an excellent visual aid to the price movements in a certain period of time.

These patterns are formed through candle bodies, which are solid areas between the opening and closing prices and wicks representing the highs and lows. A solid candle may be formed when opening price is equal to the low and closing price is equal to the high. Thin candles, i.e. candles that have a small body and long wicks result due to price volatility that fluctuates a lot in a single trading session.

Candlestick charts include data for several timeframes in single pricing bars. That includes the opening price, the closing price, the high of the session, and the low of the session. Therefore, they are more beneficial for technical analysis of stocks in comparison to traditional line chart which just shows the closing prices.

With his book “Japanese Candlestick Charting Techniques”, Steve Nison introduced candlestick patterns to the Western countries in 1991. Several formations having colorful names, such as evening star, bearish dark cloud cover, and three black crows are identified by traders. Additionally, hammer and Doji patterns are used for long and short side trading strategies.

Reliability of candlestick patterns

Although there are a large number of such patterns, not all work well. Greater popularity of candlestick patterns has reduced their reliability because these have been deconstructed by the algorithms of the hedge funds. Such stock market players rely on quick executions when compared to traditional fund managers and small individual traders. Often individual traders and fund managers use complex strategies based on multiple technical charts and indicators that are found in popular texts.

Here are five patterns that perform well to help predict price momentum and direction. Each pattern works within surrounding price bars to predict high or low prices. In addition, these patterns are time-sensitive in two ways. Firstly, these perform within the limitations of charts under review, such as daily, weekly, or monthly. Secondly, the effectiveness quickly reduces by three to five bars after the completion of the pattern.

Five popular candlestick patterns

Candlestick patterns predict reversal and continuation. The reversal patterns predict modification in price direction. On the other hand, continuation patterns predict the extension in the current price movements.

1. Three line strike



This is a bullish reversal pattern that carves three black candles within a downward trend. Each bar shows a lower low and closes near to the intrabar low. The fourth bar shows an even lower opening but reverses in a wider range outer bar that closes higher than the first candle within the series. The opening print also marks the fourth bar low. According to the well-known investor Thomas Bulkowski, this reversal pattern is able to predict higher prices with an accuracy rate of almost 84%.

2. Two black gapping



This bearish two black gapping pattern is a continuation trend appearing post a notable top in an uptrend. It also shows a gap down yielding two black bars that post lower lows. This candlestick pattern is predictive of a decline that will continue to further lower lows and may trigger a broad scale downward trend. This pattern is able to predict lower prices with 68% accuracy.

3. Three black crows



Three black crows is a bearish reversal pattern beginning at or near the high during an upward trend. It shows three black bars that post lower lows that close near to the intrabar low. This candlestick pattern predicts a continued decline in the price reaching lower lows that may even result in broad scale downward trend. The most bearish pattern often begins at a new high because it often catches buyers that enter momentum plays. The accuracy of this pattern to predict low price trends is 78%.

4. Evening star



The bearish evening star trend is a reversal pattern beginning with a tall white bar carrying an upward trend to a new high. The market gaps higher on the next bars but fails to bring in new buyers. As a result, narrow range candlestick formations are created. A gap below the third bar completes the pattern and indicates a further decline to continue towards even lower lows. This may result in broader scale downward trend. This candlestick pattern is able to predict reduced prices with 72% accuracy.

5. Abandoned baby



This abandoned baby is a bullish reversal pattern appearing at the low of a downward trend. It is formed post a series of black candles print lower lows. The market gaps lower on the next bar but new buyers do not enter the market resulting in a narrow range Doji candlestick that opens and closes prints at the same price. The pattern is completed with a bullish gap on the third bar and predicts continued recovery to reach higher highs. This may result in a broader scale upward trend. Higher prices can be predicted using 70% accuracy using this pattern.

Candlestick patterns are used by market players as these provide continuation and reversal trend predictions. These patterns are beneficial as they offer early signals. Traders and investors who are able to understand these patterns may earn higher profits through stock market investing.




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