Based on content from the Market Whisperer - day trading book
Chairman & Head Trader
Reversal patterns are chart formations (represented by a group of candles) that help us identify high and low points. We use reversal patterns to understand when we should buy or sell stocks that are about to change (reverse) direction. For example: when we buy a stock, we want to sell as close as possible to its high, but if we are shorting a stock, we want to buy it back as close as possible to its low, just at the point where it begins to go up.
Reversal patterns are usually formed after a significant rise or fall in price. They are subdivided into bullish (implying an upward direction) or bearish (implying a downward direction) formations.
A reversal pattern should be looked for only within the stock’s trend. In an uptrending stock, we will look for the bullish pattern to buy, and in a downtrending stock, we will look for the bearish pattern to short.
The reversal patterns in the table below are common and accepted by professional traders. All of these patterns are valid for any time frame. They can be implemented for a group of weekly candles, daily candles, or intraday candles, depending on your purposes and the time period over which you plan to hold the stock.
Doji – A bullish pattern formed at the base of movement when, after several downtrending candles, a candle appears showing that the open and closing prices are identical. Doji indicates perfect balance between buyers and sellers (in other words, indecisiveness), and it usually indicates possible pattern reversal.
Dragonfly Doji – A bullish pattern created at the base of movement, similar to the doji, but with the addition of a wide-range bottoming tail indicating that control has been taken by buyers.
Gravestone Doji – A bearish pattern created at the peak of movement, similar to the doji, but with the addition of a wide-range topping tail indicating that control has been taken by sellers.
Abandoned Baby – A “daily” bullish pattern at the base of movement. The uniqueness of this pattern is that the closing price of the day prior to this doji is higher than the highest price of the doji’s tail, and the open price of the next day’s trade is higher than the doji tail’s highest price.
Dark Cloud Cove – A bearish pattern in which the black candle covers more than half of the clear candle’s movement, in the opposite direction of the stock’s overall movement.
Engulfing – A bullish pattern in which the clear candle covers more than the entire length of the black candle, in the opposite direction of the stock’s overall trend (the black candle is fully shadowed by the clear candle).
Evening Doji Star – A bearish pattern in which the doji heading the trend indicates pattern reversal, and the black candle following it falls at least halfway below the body of the clear candle preceding the doji.
Evening Star – A bearish pattern. At the trend’s peak is a narrow-range candle indicating pattern reversal. The black candle following it falls at least halfway below the body of the clear candle that precedes the narrow-range candle. The-narrow range candle could be clear or black.
Morning Doji Star – A bullish pattern opposite to that of the Evening Doji Star. Here the doji indicates pattern reversal after the black candle. The clear candle following the doji rises at least halfway above the body of the black candle preceding the doji.
Morning Star – A bullish pattern opposite to that of the Evening Star. At its base is a narrow-range candle indicating pattern reversal, followed by a clear candle rising at least halfway above the body of the black candle preceding the narrow-range candle. The narrow-range candle could be clear or black.
Long Lower Shadow – A bullish pattern. At its base is a candle with a long bottoming tail, followed by a clear candle rising to at least halfway above the body of the black candle preceding the bottoming-tail candle.
Long Upper Shadow – A bearish pattern. Its movement peaks with a candle having a long topping tail, followed by a black candle dropping at least halfway below the body of the clear candle preceding the topping-tail candle.
Piercing Line – A bullish pattern. After a black wide-range candle, a clear candle follows and penetrates beyond the halfway point of the black candle’s body.
Hammer – A bullish pattern, formed within a short-term downtrend, in which the price of a stock drops significantly, but recovers during the candle’s time interval and closes with a significantly higher price than the low price.
Hanging Man -A bearish pattern, formed within a short-term uptrend, in which the stock price drops at the start of the candle’s time interval, but recovers and closes with a high price. The strong sales at the outset indicate the beginning of the end for buyer control.
Inverted Hammer – A bullish pattern created when a dropping stock reverses its pattern briefly and rises, but returns to the bottom at the end of the candle’s time interval, leaving a topping tail. The strong buying pressure at the outset indicates the beginning of the end of seller control.
Spinning Top – A bearish pattern. At the pattern’s peak is a narrow-range candle with two tails, followed by a black candle that falls at least halfway below the body of the clear candle preceding the narrow-range candle.
There is little point in learning patterns if you do not know when to press the Buy or Short button. In the chart below, we have marked the long and short entries in the accepted reversal formations.
Of course, you need to remember that this is not an exact science. The entry point is more a feeling composed of many facets tied, among other things, to the general market direction, the trend’s strength, and the stock’s behavior. When you know your entry point and are ready to press the button, you will need to quickly assess all of these factors to determine whether to press early or late, relative to what you see and sense.
As will you note in the chart, in most cases we have marked entry points that precede the complete development of the classic patterns. However, entering a trade early is not something we recommend for those who are just starting out. Our advice to the novice trader is to wait until a clear reversal develops. Only later will you acquire the “artistic” component in trading. The novice trader should consider early entry only when guided by an experienced trader (e.g., in a trading room).
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