A Japanese candle pattern is a psychological depiction of traders'mentality at the time. It vividly shows the actions of the traders astime unfolds in the market. The mere fact that humans react consis‑tently during similar situations makes candle pattern analysis work.A Japanese candle pattern can consist of a single candlestickline or be a combination of multiple lines, normally never morethan five. While most candle patterns are used to determine rever‑sal points in the market, there are a few that are used to determinetrend continuation. They are referred to as reversal and continua‑tion patterns. Whenever a reversal pattern has bullish implica‑tions, an inversely related pattern has bearish meaning. Similarly,whenever a continuation pattern has bullish implications, anopposite pattern gives bearish meaning. When there is a pair ofpatterns that work in both bullish and bearish situations, they usu‑ally have the same name. In a few cases, however, the bullish pat‑tern and its bearish counterpart have completely different names.
Reversal Patterns
A reversal candle pattern is a combination of Japanese candlesticks that normally indicate a reversal of the trend. One serious con­sideration that must be used to help identify patterns as being either bullish or bearish is the trend of the market preceding the pattern. You cannot have a bullish reversal pattern in an uptrend. You can have a series of candlesticks that resemble the bullish pat­tern, but if the trend is up, it is not a bullish Japanese candle pat­tern. Likewise, you cannot have a bearish reversal candle pattern in a downtrend.
This presents one of the age-old problems when analyzing markets: What is the trend? You must determine the trend, before you can utilize Japanese candle patterns effectively. While vol­umes have been written on the subject of trend determination, the use of a moving average will work quite well with Japanese candle patterns. Once the short term (ten periods or so) trend has been determined, Japanese candle patterns will significantly assist in identifying the reversal of that trend.
Japanese literature consistently refers to approximately forty reversal candle patterns. These vary from single candlestick lines to more complex patterns of up to five candlestick lines. There are many good references on candlesticks, so only a few of the more popular patterns will be discussed here.
Figure 12.6 Dark cloud
cover —.Dark Cloud Cover. This is a two day reversal pattern that only has bearish implications. (See Figure 12.6.) This is also one of the times when the pat­tern's counterpart exists but has a dif­ferent name (see Piercing Line). The first day of this pattern is a long white candlestick. This reflects the current trend of the market and helps confirm the uptrend to traders. The next day opens above the high price of the previous day, again adding to the bullishness. However, trading for the rest of the day is lower with a close price at least below the mid­point of the body of the first day. This is a significant blow to the bull­ish mentality and will force many to exit the market. Since the close price is below the open price on the second day, the body is black. This is the dark cloud referred to in the name.
Piercing Line. The opposite of the Dark Cloud Cover, the Piercing Line, has bullish implications. The sce­nario is quite similar, but opposite. A downtrend is in place, the forex
Figure 12.7 Piercing line +.first candlestick is a long black day which solidifies traders' confidence in the downtrend. The next day, prices open at a new low and then trade higher all day and close above the midpoint of the first candle­stick's body. This offers a significant change to the downtrend mentality and many will reverse or exit their positions.
Figure 12.9 Morning star +.Evening Star and Morning Star. The Evening Star and its cousin, the Morning Star, are two powerful rever­sal candle patterns. These are both three day patterns that work excep­tionally well. The scenario for under­standing the change in trader psychology for the Evening Star will be thoroughly discussed here since the opposite can be said for the Morning Star.The Evening Star is a bearish reversal candle pattern, as its name suggests. The first day of this pattern is a long white candle­stick which fully enforces the current uptrend. On the open of the second day, prices gap up above the body of the first day. Trading on this second day is somewhat restricted and the close price is near the open price while remaining above the body of the first day. The body for the second day is small. This type of day following a long day is referred to as a Star pattern. A Star is a small body day that gaps away from a long body day. The third and last day of this pat­tern opens with a gap below the body of the star and closes lower with the close price below the midpoint of the first day.
The previous explanation was the perfect scenario. Many references will accept as valid, an Evening Star which does not meet each detail exactly. For instance, the third day might not gap down or the close on the third day might not be quite below the midpoint of the first day's body. These details are subjective when viewing a candlestick chart, but not when using a computer pro­gram to automatically identify the patterns. That is because com­puter programs require explicit instructions to read the candle chart, and don't allow for subjective interpretation.
Continuation Patterns
Each trading day, a decision needs to be made, whether it is to exit a trade, enter a trade, or remain in a trade. A candle pattern that helps identify the fact that the current trend is going to continue is more valuable than may first appear. It helps answer the ques­tion as to whether or not you should remain in a trade. Japanese literature refers to 16 continuation candle patterns. One continu­ation pattern and its related opposite cousin are particularly good at trend continuation identification.
Rising and Falling Three Methods. The Rising Three Methods con­tinuation candle pattern is the bullish counterpart to this duo and will be the subject of this scenario building. A bullish continua­tion pattern can only occur in an uptrend and a bearish continu­ation pattern can only occur in a downtrend. This restates the required relationship to the trend that is so necessary in candle pattern analysis.
The first day of the Rising Three Methods pattern is a long white day which fully supports the uptrending market. However, over the course of the next three trading periods, small body days occur which, as a group, trend downward. They all remain with­in the range of the first day's long white body and at least two of these three small-bodied days have black bodies. This period of time when the market appears to have gone nowhere is consid­ered by the Japanese as a "period of rest." On the fifth day of this pattern, another long white day develops which closes at a new high. Prices have finally broken out of the short trading range and the uptrend will continue.
A five day pattern such as the Rising Three Methods requires a lot of detail in its definition. The above scenario is the perfect example of the Rising Three Methods pattern. Flexibility can be applied with some success and this only comes with experience. For example, the three small reaction days could remain within the first day's high-low range instead of the body's range. The small reaction days do not always have to be predominantly black. And finally, the concept of the "period of rest" could be expanded to include more than three reaction days. Don't ignore the Rising and Falling Three Methods pat­tern; it can give you a feeling of comfort when worrying about protecting profits in a trade.
Using Computers for Candle Pattern Identification
A personal computer with software designed to recognize candle patterns is a great way to remove emotion, especially during a trade. However, there are a couple of things to keep in mind when viewing candlesticks on a computer screen. A computer screen is made up of small light elements called pixels. There are only so many pixels on your computer screen, with the amount based upon the resolution of your video card/monitor combina­tion. If you are viewing price data that has a large range of prices in a short period of time, you may think that you are seeing many Doji days (open and close price are equal) when in fact, you are not. With a large range of prices on the screen, each pixel element will have a price range of its own. A computer software program that identifies patterns based on a mathemat­ical relationship will overcome this visual anomaly. Hopefully, the above explanation will keep you from thinking that your software isn't working.