Candlestick Formations

Candlestick formations are the way the market portrays its emotions. Below, I would like to present the most significant of such formations and how they can be interpreted by investors to undertake decisions on the market.

Hammer

What are the characteristics of the hammer formation?

• Formation is made up of one candlestick.
• Small upper body with long bottom shadow. The body should not represent more than 1/3 of the entire formation. Little or no upper shadow.
• The color of the body makes no difference.
• Appears on bottoms and signals trend reversal.

The long bottom shadow depicts the power of the bulls who are not willing to fall beneath a certain market level. What this means is that the low of the hammer formation could be a significant support level.

Shooting Star

What are the characteristics of the shooting star formation?

• Formation is made up of one candlestick.
• Small bottom body with long upper shadow. The body should not represent more than 1/3 of the entire formation. Little or no bottom shadow.
• The color of the body makes no difference.
• Appears on tops and signals trend reversal.

The long upper shadow depicts the power of the bears who are not willing to rise above a certain market level. What this means is that the high of the shooting star formation could be a significant resistance level.

Examples:

On this EURUSD chart we can see many hammer or shooting star formations. Some of them were followed by a trend reversal (pink rectangles), whilst others were not (yellow rectangles). What you have to keep in mind is that all the characteristics should be remembered, especially the information about where these formations should be forged, and secondly and most importantly investors should keep in mind that candlestick formations should not be the only source of information when making decisions on the market. They should be treated only as confirmation to our analysis. Therefore, if with accordance to our analysis we are awaiting a trend change at some level a candlestick formation will be a confirmation to that. Personally, I believe transactions should seldom be opened without confirmation from candlestick formations. Candlestick formations are also a very good source of information to where a stop loss could be assigned. This matter will be discussed in further materials.

Morning Star

What are the characteristics of the morning star formation?

• Formation is made up of three candlesticks.
• The first candle is a big black candlestick which continues the decrease trend.
• The second candle is situated below the first one and has a small body. The color is not important. This candle shows the uncertainty on the market and the fight between the bulls and the bears.
• The third candle, which is a white candle is situated above the second candle and breaks through around 50% of the first candle.
• Appears on bottoms and signals trend reversal.

Although not mentioned in books, I have come to realize that the market tends to draw more than one candle in between the first and last one. The effect is the same and the formation is a signal to trend change.

Evening Star

What are the characteristics of the evening star formation?

• Formation is made up of three candlesticks.
• The first candle is a big white candlestick which continues the increase trend.
• The second candle is situated above the first one and has a small body. The color is not important. This candle shows the uncertainty on the market and the fight between the bulls and the bears.
• The third candle, which is a black candle is situated under the second candle and breaks through around 50% of the first candle.
• Appears on tops and signals trend reversal.

As in the previous formation the market tends to draw more than one candle in between the first and last candle.

Examples:

• This is a typical morning star formation.
• Morning star formation where the white candle did not exceed 50% of the black candle signaling that the decrease trend may still not be over.
• Morning star formation where the first candle has long shadows on the top and bottom.
• Typical morning star formation.
• Morning star formation with three candles in between.

What you should keep in mind is that not all formations will be bookish like. Investors should try to evaluate what the market is trying to show. On many occasions investors discuss which formation they are encountering. Remember that this is not important. It is not important to know how to call a certain formation, but how to interpret what we are seeing. This will take you some time and the best way to do this is actually observing the market live and evaluating your emotions at the time of the forging of any such formation.

Piercing Line

What are the characteristics of the piercing line formation?

• Formation is made up of two candlesticks.
• The first candle is a black candlestick which continues the decrease trend.
• The second candle, which is a white candle has an opening price under the previous candlestick closing price, but breaks through around 50% of the first candle and does not exceed its body.

Appears on bottoms and signals trend reversal.

Dark Cloud Cover

What are the characteristics of the dark cloud cover formation?

• Formation is made up of two candlesticks.
• The first candle is a white candlestick which continues the increase trend.
• The second candle, which is a black candle has an opening price above the previous candlestick closing price, but breaks through around 50% of the first candle and does not exceed its body.
• Appears on tops and signals trend reversal.

Examples:

Which formations are found in the pink rectangles?

• This is not a black cloud cover because the opening of the second candle is not above the closing price of the first candle.

This is not a piercing line formation because the opening price of the second candle is not below the closing price of the first candle.

Bullish Engulfing

What are the characteristics of the bullish engulfing formation?

• Formation is made up of two candlesticks.
• The first candle is a black candlestick which continues the decrease trend.
• The second candle, which is a white candle has an opening price under the previous candlestick closing price, and a closing price above the previous candlestick opening price; i.e. the white candlestick covers the whole previous candlesticks body.

Appears on bottoms and signals trend reversal.

Bearish Engulfing

What are the characteristics of the bearish engulfing formation?

• Formation is made up of two candlesticks.
• The first candle is a white candlestick which continues the increase trend.
• The second candle, which is a black candle has an opening price above the previous candlestick closing price, and a closing price under the previous candlestick opening price; i.e. the black candlestick covers the whole previous candlesticks body.
• Appears on bottoms and signals trend reversal.

Examples:

As with all candlestick formations, these also provide us with significant support (bullish engulfing) and resistance (bearish engulfing) levels. What should be kept in mind is that support and resistance levels are also met at the 50% level of the second candlestick. Many successful investors build their stop loss strategy depending on the candlestick formation they encounter. If it is a pro increase formation than the stop loss is set one pip beneath the formation, whilst if it is a pro decrease formation than the stop loss is set one pip above the formation. Sometimes setting the stop loss may seem too far, and the risk undertaken would just be too big. What could be done in such situations? One method is to move the stop loss if possible to a closer support or resistance level, which is possible after the engulfing formations. Another possible outcome, is not opening a position at all.

Lets, take a look at two examples:

• This is a major bullish engulfing, but there could be a problem with setting the stop loss. What investors should remember is that, as long as their expected profit is a few times higher than the possible risk than there is no problem in opening a position.
• Typical bearish engulfing.

Which formations are found in the pink rectangles?

• This is not a black cloud cover because the second candle does not break through 50% of the first candle.
• This is not a black cloud cover due to the fact that the whole first candle is covered. This formation also signals the power of the bears and will be discussed in the next presentation.

This is also not a piercing line formation due to the fact that the whole first candle is covered.