Taking the time to learn candlestick patterns is one of the best first steps for any trader. Once you learn the patterns, they will stay with you forever. However, before you go out and spend a lot of time memorizing them, understand some patterns that provide little useful information because the signals they indicate are inconsistent at best.
Harami, in Japanese, means "pregnant," and it is the shape the candle reflects on a chart because the second candle of the pattern is completely inside the first day's candle. The Harami pattern is listed as a reversal formation and suggests the preceding trend is reversing and trading in the opposite direction.
A bullish Harami will appear at support and supposedly indicates the trade is moving bullish, whereas a bearish Harami will appear at resistance and indicate the trade is moving bearish.
Technically these are considered reversal patterns; however, they often turn into a sideways move rather than a reversal.
Although many people like this pattern, and it is well published and documented for recognition, it's a bit of a bust. So, if you see a Harami, maybe tighten up your stops just a little bit, but do not expect a massive windfall.
This one will surprise you as the Hangman is one of the most popular candlestick patterns. The Hangman is considered a bearish reversal signal but only breaks that way some of the time. According to Thomas Bulkowski, it breaks bullish 59% of the time, which means it's a reversal pattern that doesn't reverse. The Hangman is a small spinning top that occurs at or near a resistance, with a long lower shadow.
The reason it's considered bearish is that the spinning top at resistance is considered bearish. However, it is the long lower shadow that plays out as bullish. As a bearish reversal, it is a bust and one of the worst candlestick patterns out there to identify and trade with any reasonable predictability.
If you see a hangman, our suggestion is to pause and take note of it and keep trading.
As a stock reaches up into the resistance range, selling pressure is inevitably going to show up. However, selling pressure will only show up after the bulls seem to have exhausted themselves. We often refer to this as an exhaustion move, which is defined as a big surge of buying pressure that occurs right before the end.
The exhaustion move is often accompanied by a significant volume push, sometimes a break above resistance, and usually a large white candle. The problem is bullish traders get excited and double down at precisely the wrong time. The exhaustion move is evidence market sentiment has reached an extreme, and all of the available money has flowed into the trade, which makes this surge the last of the money.
So who makes up the exhaustion move? It is the late adopters to the trade. People who have been sitting on the sidelines and not believing in the move. When those traders finally jump on board, an exhaustion move occurs.
This chart image looks very appetizing for a bullish trader but look at how it played out.
Big white candles at resistance are often nothing more than an exhaustion move, and they are frequently followed with a similar-sized black candle, which signals a bearish reversal. Consider this, almost every two or more candle reversal signal starts with a large white candle at resistance.
Dark Cloud Cover
Bearish counter attack
Evening Star Reversal
The only high-performance reversal not on the list is the bearish engulfing, and that's only because, with the engulfing pattern, the second candle is always more prominent than the first. The bottom line is large white candles at resistance look bullish, but they are often the last surge of bullishness before the reversal. Thus, if you see a large white candle at resistance, do a lot of additional analysis to determine if there is reasonable room for the trade to continue bullish. You should check for overbought indication and wait to see if the next couple of days will continue bullish or if it's just an exhaustion move looking to suck you into a trade.
The Bearish Three Line Strike is supposed to signal a continuation of a bearish trend, and many of the top candlestick researchers list it as a bearish pattern. However, it is bearish in name only and maybe one of the worst-performing patterns to ever grace a chart. The pattern is formed when three average to long day bearish candles are followed by one long white candle, which erases the previous three candles' bearish move.
In theory, it is supposed to represent a single-day retracement of the previous three days, but in function, it behaves differently. Consider this; the Three Line Strike is a bullish engulfing pattern where instead of engulfing the previous day, it engulfs the previous three days.
Thomas Bulkowski's research suggests this pattern trades bullish 84% of the time, making this pattern a horrible bearish pattern but a darn good bullish signal. Unfortunately, though, the likelihood of this pattern appearing is rare as examples are hard to find, and the frequency of occurrence is pretty low.
It has been said when it comes to real estate, the three most important factors regarding property values are location, location, and location. The same thing can be said when it comes to identifying and interpreting candlestick patterns properly. Location is essential as the same candlestick formation occurring in the wrong location will mean something different as when it appears in the correct location.
This innocent little spinning top with a long upper shadow can be a death blow to a bullish trend if it occurs at resistance, but that same candlestick formation is not even called a shooting star if it occurs at support. It is called an inverted hammer.
The incredibly powerful Evening Star Reversal is one of the most predictive formations you will find when it comes to ending a bullish trend.
But if you see it at support, it means nothing as anything can happen in the following days.
Our main takeaway is location has meaning, and learning to interpret candles in the right location is one of the most important factors when learning to understand candlestick patterns overall. Candlestick patterns in the wrong location are worthless and completely unreliable. Candlestick patterns are only the pattern we name them if they happen in the right location because anything else will lead you astray.
In closing, candlestick patterns are potent analysis tools that add to your ability to trade the stock market for a profit. These five tips can help you avoid some of the common mistakes of interpreting candles and help you avoid chasing after weak signals. So, take them to heart and Trade Smart.