Chapter 5 - Candlestick Chart Formations

Question 1

What is dark cloud cover?

Answer 1

A candlestick formation that takes two time
periods to develop in an uptrend; the first
period’s real body is strong and white; the
second period’s price opens above the first
period’s high, but closes in the lower half of
the first period’s real body.

Question 2

What is a doji?

Answer 2

A candlestick formation in which the open
and close of a time period are exactly, or
very close to, equal; a doji has no (or a very
little) real body.

Question 3

What is a doji star?

Answer 3

A candlestick formation in which a doji
gaps above a real body in an uptrend, or
gaps under a real body in a downtrend.

Question 4

What is an engulfing pattern?

Answer 4

A candlestick formation that takes two time
periods to develop in either an uptrend or
downtrend; the second period’s real body is
larger and has a different colour than the
first period’s real body.

Question 5

What is an evening star?

Answer 5

A candlestick formation in a rising market
that takes three time periods to develop;
the second period’s real body gaps above
the first period’s real body the third period’s
real body gaps below the second period’s
real body; the third period must have a
dark real body.

Question 6

What is a gravestone doji?

Answer 6

A candlestick formation in which the
opening and closing prices for the time
period occur at, or very close to, the low for
the time period.

Question 7

What is a hammer?

Answer 7

A candlestick with a small real body and a
long lower shadow; the formation tends to
occur at market lows.

Question 8

What is a hanging man?

Answer 8

A candlestick with a small real body and a
long lower shadow; the formation tends to
occur at market highs.

Question 9

What is a harami?

Answer 9

A candlestick formation that takes two time
periods, (days), to develop. The second day’s real body is contained within the real
body from the first day.

Question 10

What is a morning star?

Answer 10

A candlestick formation in a falling market
that takes three time periods to develop;
the second period’s real body gaps below
the first period’s real body; the third
period’s real body gaps above the second period’s real body; the third period must
have a white real body.

Question 11

What is a piercing pattern?

Answer 11

A candlestick formation that takes two time
periods to develop in a downtrend; the first
period has a strong black real body; the
second period’s prices open below the first
period’s low, but close in the upper half of
the first period’s real body.

Question 12

What is a tweezer?

Answer 12

A candlestick formation in which two or
more candlesticks have matching highs or
lows.

Question 13

What is a window?

Answer 13

The candlestick chart equivalent of a bar
chart gap; a rising window has the bottom
of the current time period’s lower shadow
above the top of the previous time period’s
upper shadow; a falling window has the top
of the current time period’s upper shadow
below the bottom of the previous time
period’s lower shadow.

Question 14

What are the benefits of candlestick charting?

Answer 14

Candlestick charts are beneficial because they:

– Provide signals that are not available on bar charts, particularly in reversal situations
– Provide some insight into how Japanese participants analyze markets
– Have gone through a lot of scrutiny and, therefore, tend to be more reliable.

Question 15

How can one read, interpret, and trade a doji candlestick reversal pattern?

Answer 15

• Dojis are candlesticks that represent periods with an opening and closing price at the
  same (or very close to the same) level and, as a result, have no (or a very small) real
  body.
• In a trending market, dojis with certain characteristics signify a reversal; in a non-
  trending market, dojis are neutral.
• The length of the candlestick’s shadow plays an important role in interpreting a doji.
  A period where the market opens and closes at the low of the day is called a gravestone
  doji.
• Dojis that gap above (below) a previous period’s real body in an uptrend (downtrend)
  are called doji stars.
• Positions can be established at the end of the formation period with stop close only
  orders. Alternatively, orders can be placed at the close of the following period.
  Morning and evening stars
• A morning star occurs when prices gap below a real body in a falling market. An
  evening star occurs when prices gap above a real body in a rising market.
• For the reversal signal to be valid, it is important that the period following a morning
  star (evening star) has a white (dark) real body.
• Positions should be established only at the close of the period following the star.
• Protective stops should be placed at the high (low) of the evening star (morning star).

Question 16

How can one read, interpret, and trade a dark cloud cover and engulfing reversal patterns?

Answer 16

• A dark cloud cover formation is a two-candlestick pattern, where the first period’s
  candlestick has a large white real body. The second period’s candlestick has an open
  that is higher than the first period’s high, and a close within the lower half of the first
  period’s real body.
• Dark cloud covers occur at market peaks after an established uptrend. The further
  the second period’s real body penetrates the first period’s real body, the greater the
  likelihood of a reversal.
• Orders can be established at the close of the second period.
• An engulfing pattern is much like a dark cloud cover formation, but with a couple of
  differences: first, the entire second period’s real body must engulf the first period’s real
  body; second, engulfing patterns can be found at both market tops and bottoms.
• As with dark cloud cover formations, orders should be established at the close of the
  second period.

Question 17

How can one read, interpret, and trade a piercing candlestick reversal pattern?

Answer 17

• A piercing pattern is a two-candlestick formation and the opposite of a dark cloud cover
  formation, occurring at market bottoms after an established downtrend.
• The first period’s candlestick has a dark real body. The second period has an open lower
  than the first period’s low, and a close within the upper half of the first period’s real
  body.
• Positions should be established at the close of the second period, with protective stops
  being placed just below the second period’s low.
  Hammer and hanging man
• Hammer and hanging man candlesticks have long lower shadows, which are at least
  twice the length of their small real bodies.
• The real body of the candlestick must be located at the top of the daily range, and there
  must be no (or a very small) upper shadow.
• Hammers appear at market lows; hanging man candlesticks occur at market highs.
• Because they are single-day formations, orders based on the appearance of hammers or
  hanging man candlesticks should be aligned in the direction of the current trend, and
  should be confirmed with other forms of analysis.
• Once the decision to act on a hammer or hanging man candlestick has been made,
  protective stops should be placed below the low of the hammer period, or above the
  high of the hanging man period.

Question 18

How can one read, interpret, and trade a harami candlestick reversal pattern?

Answer 18

• A harami pattern is a two-day formation characterized by the second period’s real body
  contained within the first period’s real body.
• Although not as strong a reversal signal as hammers or engulfing patterns, harami
  patterns can forecast a pending change in direction.

Question 19

How can one read, interpret, and trade a tweezer candlestick reversal pattern?

Answer 19

• Tweezers are two or more relatively long candlesticks with either matching highs or
  matching lows. They can occur at either market tops or bottoms.
• Unlike most other multi-period candlestick patterns, the candlesticks that make up a
  tweezer pattern do not have to appear next to each other; they should be close, but may
  not occur consecutively.
• Once a tweezer pattern has been identified, orders can be placed at the close of the
  confirmation day, or at the open of the day following the confirmation day. Protective
  stops should be placed below the supportive low (for bottom tweezers) or above the
  resistance high (for top tweezers).

Question 20

How can one read, interpret, and trade a window (gap) candlestick continuation pattern?

Answer 20

• A price gap on a candlestick chart is known as a window.
• A rising window in an uptrend is considered bullish, whereas a falling window in a
  downtrend is considered bearish.
• Markets will occasionally retreat from the current trend to try to penetrate a previously
  established window.
• If a window is not completely penetrated, it is a good signal that the market will
  continue in the direction of the major trend.
• If a window is penetrated, it could be a potential reversal signal, unless the market
  resumes its trend quickly.
• A position can be established following a failed penetration of a window.

Question 21

How can one read, interpret, and trade a rising and falling three method candlestick continuation pattern?

Answer 21

• The rising and falling three methods are similar to flags and wedges on bar charts.
• They usually signal a pause in the market after a strong one-day move.
• The first period in a falling (rising) three method is characterized by a long black (white)
  real body. This is followed by a group (two or more) of candlesticks with small real
  bodies that fall within the first period’s range. The price range is the distance between the top and bottom of the REAL BODY (FOR THIS SCENARIO)!
• The last period’s candlestick should have a strong black (white) real body, and its close
  should be below (above) the first period’s low (high). The last period’s open should be
  below (above) the close of the candlestick immediately preceding it.
• Positions can be established at the close on the confirmation candlestick, with initial
  stops placed at the high (low) of the first period’s candlestick.

Question 22

In detail, describe the benefits of candlestick charting.

Answer 22

Candlestick charts offer the following benefits:

1. In addition to being used the same way that bar charts are (i.e., to look for the same
   formations), candlestick charts can provide signals that are not available on bar charts,
   particularly in identifying reversal situations.
2. Since most Japanese financial market participants use candlesticks, and they are a major
   player in global financial markets, it is useful, if not necessary, to understand the methods
   they are using.
3. Candlestick charts have existed for centuries and have undergone much scrutiny and
   refinement, thereby offering potentially more accurate signals.
4. Th e formations and patterns themselves provide a more graphic and visually appealing
   portrait of price action than bar charts.

Question 23

Candlestick reversal patterns usually consist of three days’ worth of price action. Explain this concept.

Answer 23

1. The set-up day or period: The day or days prior to the key signal day. Most reversal
   patterns require that a trending market precede the signal day.
2. The signal day: The first day that alerts us that a potential reversal pattern may be
   developing.
3. The confirmation day: The day that confirms the reversal pattern, either by closing in the
   opposite direction of the previous trend or by completing a three-day pattern.

Question 24

Explain what it means to “hammer out a bottom” in the markets.

Answer 24

It reaches a low point and then begins to recover. Eventually, it closes near its previous mark or higher. In this case, the market may be seen as “hammering out a bottom.” To technical analysts, a hammer candlestick pattern indicates that a stock should reverse course and begin to rise in price.

Question 25

What is meant by the term “retracement?”

Answer 25

A retracement refers to the temporary reversal of an overarching trend in a stock’s price. Distinct from a reversal, retracements are short-term periods of movement against a trend, followed by a return to the previous trend.

Question 26

TRUE or FALSE: The hammer and hanging man candlesticks have a much higher probability of working out when they are aligned in the direction of the major trend.

Answer 26

TRUE!

Question 27

What is a false doji?

Answer 27

Doji patterns occasionally produce false signals. Market indecision, which the Doji represents, may not always lead to a reversal or significant price movement. Sometimes, it could simply indicate a temporary pause in the trend.