Basics part 1: Candlestick patterns

Technical analysis at its core is all about understanding the shifting balance of supply and demand for a given stock or exchange traded fund (ETF). Over many years, traders have come to rely on technical analysis as a tool to help identify trends, possible reversals of trends, support and resistance levels as well as provide an indication of possible target prices. There are a variety of technical patterns and indicators in common use today. In this article, we will highlight three types of candlestick patterns that should be understood by technical traders.

Candlestick patterns are the oldest type of technical indicators in use today, some dating back to the Japanese rice markets of the 1700s. These types of patterns get their name from the fact that they're identified using candlestick charts. These patterns typically have very short-term influence over the price; normally lasting no more than 10 candlesticks. This would be about two weeks when using daily charts or about 2 ½ months when using weekly charts.

The hammer is a bullish pattern indicating that the previous downtrend in the price of a stock is likely to reverse. The hammer pattern always occurs at the end of an established downtrend. The hammer is characterized by a small real candlestick body near the top of the price range. This pattern indicates a sharp a change in the sentiment of traders on the day that it occurs. In Figure 1, the candlestick indicates that the price opened near the highs of the day, then sold off sharply as the trading day progressed. At some point, the sentiment changed and the price began to move higher, closing the day near the session highs. This pattern indicates bullish sentiment in the minds of traders has emerged and that the stock is likely to rally over the subsequent days. An example of a hammer is shown in Figure 1.

The hanging man pattern is the bearish counterpart of the hammer. A hanging man always occurs at the end of an established market uptrend. The name hanging man is used because it has a gloomy connotation. The hanging man pattern is characterized by a small real body near the top of the price range. The hanging man has a long lower shadow that should be at least twice the length of the real body. The hanging man indicates to the trader that the uptrend is nearing exhaustion and that there is significant bearishness in the mind of traders. An example of a hanging man pattern is shown in Figure 2.

The engulfing pattern, sometimes called an engulfing line, is a pattern which can be either bullish or bearish depending on the context. An engulfing line is characterized by a candlestick with a real body, which completely engulfs the preceding candlestick. In the bullish example, the engulfing line comes at the end of an established downtrend and must consist of a white candlestick which completely engulfs the preceding black candlestick. For the bearish case, the pattern comes at the end of an established uptrend and must consist of a black candlestick which completely engulfs the preceding white one.