A comprehensive guide to reversal candlestick patterns

In the ever-evolving landscape of financial markets, to trade successfully requires a keen understanding of various tools and strategies. Among these, technical analysis stands tall as a cornerstone strategy, offering you invaluable insights into price movements and potential reversals. 

At the heart of technical analysis lie reversal candlestick patterns, a set of visual cues that help you identify significant shifts in market sentiment and trend direction. When you start to understand how to spot these patterns and what they mean, you can start to anticipate potential trend changes that could act as great trading opportunities. 

In this article, we delve into the fascinating world of reversal candlestick patterns, shedding light on their importance and demonstrating how they serve as invaluable tools for traders in their quest for consistent profitability.

You may also like: DII: The power players of India’s economy

Introduction to reversal candlestick patterns

Candlestick reversal patterns are what the name suggests – patterns that identify reversals in the market sentiment. This could be in either direction, bullish or bearish. Typically, patterns that signal a turn from a bullish to a bearish market are called ‘bearish reversal patterns’ and vice versa.

There are several candlestick patterns, each with its own distinct characteristics and implications. Here are some of them.

Also read: Deciphering the rising wedge pattern in stock trading

The Hammer and Hanging Man patterns

The Hammer

This is a bullish reversal pattern, which means it forms typically after a downtrend to signal an upcoming uptrend. It is named for its resemblance to a hammer, with a short body near the top of the candlestick and a long lower shadow that is at least twice the length of the body. The long lower shadow signifies that sellers pushed prices significantly lower during the session, only for buyers to regain control and push the prices back up by the end.

When traders see the Hammer, they interpret it as a potential signal that the downtrend might be losing momentum and that a bullish run could be imminent.

The Hanging Man

The Hanging Man pattern, on the other hand, is a bearish reversal pattern that forms after an uptrend. Like the Hammer, it has a small body and a long lower shadow. The important difference here is that the Hanging Man appears at the top of an uptrend, signalling potential reversal from a bullish movement to a bearish one.

The Hanging Man suggests that despite an initial attempt by buyers to continue the uptrend, selling pressure intensified, causing prices to retreat significantly from their highs.

Also read: How does arbitrage trading work?

Engulfing patterns

Engulfing patterns are reversal indicators on either side. Generally, they involve two candles with the latter candle ‘engulfing’ the entire body of the candle right before it. The engulfing candle can be bullish or bearish, depending on where it forms with respect to the continuing trend.

Bullish engulfing

A bullish engulfing provides the strongest signal when it is seen at the bottom of a downtrend. This is characterised by a larger green candle engulfing a smaller red candle. This shows that buyers are piling into the market with aggression and provides a bias for reversed upward momentum.

Bearish engulfing

This is simply the opposite of a bullish engulfing. Typically occurring at the top of a bull run, it looks like a large red candle engulfing a smaller red one. A pattern like this signals a reversal of an existing upward trend that could potentially reverse.

Engulfing patterns are usually used for spotting trend reversals. They could also be used to identify trend continuations. For example, a bullish engulfing during an uptrend could provide more confidence that the trend will continue. Reversal patterns are usually great indicators of opportunities to either enter or exit the market.

Doji

The word Doji comes from a Japanese phrase that means ‘the same thing.’ This candlestick, hence, indicates that the price closed where it opened during the candle’s time period. While they may not seem like much, they’re important additions to your trading arsenal.

Doji candlesticks usually also help traders identify reversals, or market tops and bottoms. For instance, a Doji candlestick that forms during an uptrend could indicate bullish exhaustion – that is, the market’s shifting towards the sellers from the buyers.

There are several kinds of Doji patterns and they all have their own meanings depending on the position and length of the shadow.

• Neutral Doji – This is a Doji with an almost invisible body located in the middle of the candlestick, with the upper and lower wicks of similar lengths. This pattern appears when bullish and bearish sentiments are balanced.
  
• Long-legged Doji – The long-legged Doji has longer wicks, suggesting that buyers and sellers have tried to take control of the price action aggressively at some point during the candle’s timeframe. Depending on where the next candle closes (and other indicators like RSI), this Doji could both indicate a reversal or a continuation.
  
• Dragonfly Doji – The Dragonfly Doji appears like a T-shaped candle with a long lower wick and almost no upper wick. It means that the open, the close, and the high price are almost at the same level. When seen at the bottom of a downtrend, the Dragonfly is seen as a strong buy signal.
  
• Gravestone Doji – A Gravestone Doji represents an inverted T-shaped candlestick, with the open and close coinciding with the low. The candlestick indicates that the buyers tried to push the market price up but couldn’t hold it long enough for the candle to close.

Conclusion

Reversal candlestick patterns like the one discussed above are for traders who want to visualise when a market’s trend might be changing. They can be used as reliable metrics not by themselves, but in conjunction with other factors of technical analysis like volume changes, RSI, trend lines, etc. Using these patterns solely at their merit is calling for trouble since technical analysis is a very complicated science. Here is an example analysis. Good luck!