5 Most Powerful Candlestick Chart Patterns

Candlestick charting is considered one of the most useful charting methods to detect the underlying trends across time horizons. There are numerous candlestick patterns that traders use for different market conditions and trade setups. Karan Bhojwani identifies the top five candlestick patterns that are easy to use and have a better probability of success ratio

Technical analysis is a great way to decode market trends. Quality technical analysis can give the traders and investors a bird’s eye view of market trends which can prove to be extremely profitable in the long term. However, conducting technical analysis is no mean task as there are numerous chart types (Bar, Line etc.) and even more chart patterns to deal with. It goes without saying that no chartist can follow all the chart types and bet on all the chart patterns to make consistent money in the markets. Focus and developing expertise in specific charting techniques are the key attributes when it comes to success in technical analysis.

Often it is seen that a combination of two or more studies provides optimal results while executing trades using technical analysis, as for example, the use of candlestick charting techniques and oscillators. A combination of both can refine the stock selection and market timing, pushing the success ratio higher for any trader. One may add trend line to the study on a regular basis along with various chart patterns such as candlesticks and momentum oscillators to provide more authenticity to the trade setup.

Candlestick charting techniques is one of the most popular methods adopted by chartists. One of the most important reasons for the popularity of candlestick charting is the pictorial representations of stock prices and the way the market information is displayed so that traders can use this information to their maximum advantage. Candlestick charts are easy to read and are one of the oldest studies in technical analysis. They originated in Japan over 100 years before the bar and point-andfigure charts were developed in the western markets.

Candlestick charts capture not only the link between the price and supply and demand but also the emotions of traders. The investors’ emotion is highlighted by visually representing the size of price movements with different colours. These charts display the high, low, open and close prices for the time period chosen by the trader. The candlestick charts can be for as low as one minute (one minute price action) to as long as a monthly chart (one month price action). Each candlestick on a chart is composed of a top shadow or wick, a real body and a bottom shadow or wick.

A green candle is considered bullish as for that timeframe buyers are in control while a red candle is considered bearish as for that timeframe the bears or sellers are in control. Wicks or shadows are indicators of where the price is traded during the time period of the candle. A green candle with a bottom shadow is considered bullish as the prices at lower levels see buyers coming in and the market rejecting the lower price levels. Similarly, a top shadow indicates that the bulls could not sustain at higher levels and the prices were pushed lower, thus indicating bearishness.

Candlestick Chart Patterns

Chart patterns are the shapes in a price chart that can help suggest what the price might do next. These can be classified into two major categories – continuation chart patterns and trend reversal chart patterns. The trend reversal patterns or those patterns that help us identify the change in trend are most valued by traders and investors alike. Following are the five most powerful candlestick chart patterns that we believe can help traders make money in the markets if interpreted and implemented accurately. 

1. Spinning Top

While trading in equity markets or any other liquid risky asset class, profits can be maximised by identifying a change in trend and then betting in the right direction. A spinning top candlestick pattern does exactly that. It helps identify change in trend for the underlying. Spinning tops are simple candlestick lines that have small real bodies with upper and lower bodies that are greater in length than the real bodies. Overall, it is a small candlestick pattern (single candle) where the stock prices open and close near each other. The pattern is formed at the peak of an uptrend or at the bottom of a downtrend.

Unlike many other candles, a spinning top can be a bearish or bullish candle i.e. the colour of the candle does not matter and hence should not be given undue importance. It is important that the trader must wait once the spinning top pattern is formed and see the next price movement to take a bet on market direction.

Assuming an uptrend is prevalent and a trader sees a bearish candle form after the spinning top pattern at a resistance level, the exit point would lie there. The interpretation, structure and logic of spinning tops and doji are more or less the same. However, a spinning top displays a wider candle body, highlighting the fact that there was substantial movement in price during the candle period. As indicated in the image alongside, the stock of Tasty Bite Eatables Ltd. formed a spinning top pattern and thereafter witnessed nearly 41 per cent correction in 19 trading sessions.

2. Last Engulfing Pattern

A last engulfing pattern can be classified into last engulfing top and last engulfing bottom pattern.

A) Last Engulfing Bottom: The price trend leading to a last engulfing bottom is downward. Usually the first bar is a green candle followed by a red candle whose body engulfs the prior candle’s body. It should be noted that the red candle need not engulf the shadows of the green candle. One would expect the last engulfing bottom to be a bullish reversal pattern but at times the pattern is followed by bearish continuation for some time. For example, the stock of Maruti Suzuki India formed a last engulfing bottom candlestick pattern on October 19, 2018 and thereafter witnessed nearly 18 per cent upside in nine weeks.

B) Last Engulfing Top: It is a two-line pattern with the first candle being red followed by a green candle and the green candle’s body overlapping or engulfing the prior candle’s body, not including the shadows. This pattern formation at times leads to bullish continuation but is more of a bearish reversal pattern. For example, the stock of Ajanta Pharmaceuticals Limited formed a last engulfing top candlestick pattern on January 19, 2018 and thereafter witnessed almost 43 per cent downside in 20 weeks.

3. Record Session Count

Whenever the market makes new lows with each following session making a higher high, it is known as a record session high. A record session high is believed to have occurred when we get eight or more previous candles that have higher closes. Similarly, a record session low is established when we get eight or more previous candles that have lower closes. For example, the stock of Maruti Suzuki India witnessed almost 25 per cent upside in nine trading sessions and thereafter witnessed correction.

4. Hammer

A bullish hammer is one of the most popular and frequently used single candlestick patterns that occur at the bottom of the trend. The prior trend should be a downtrend. A hammer consists of a small real body and that too at the upper end of the trading range with a long lower shadow. The longer the lower shadow more bullish the pattern can be. The colour of the hammer should not matter much as long as it qualifies ‘the shadow to real body ratio’. However, a green real body can be viewed more favourably when compared to a red real body. What a bullish hammer signifies is that the bulls are coming back and not allowing the underlying asset to fall further. For example, the stock of Havells India Ltd. formed a hammer candlestick pattern on February 18, 2019 and thereafter the stock surged over 13 per cent in 16 trading sessions.

5. Engulfing Pattern

A bullish engulfing pattern occurs in a downtrend and is essentially a two-candle pattern. The first candle has to be a red candle, suggesting a bear trend. The next day i.e. after the red candle, the market will open below the closing of the previous day and slide down only to gain by the end of the trading session. The gains should be big enough to engulf the red candle. The second day candle is essentially a green one. Here the logic is that at lower levels, bearishness wanes and bulls start dominating the trade. It should be noted that the engulfing of the real body should be enough even though some traders feel that the shadow needs to be engulfed. For example, considering the daily timeframe, the stock of Escorts Ltd. formed a bullish engulfing candle on August 23, 2019 and thereafter witnessed almost 50 per cent upside in 19 trading sessions. 

The bearish engulfing pattern, contrary to the bullish engulfing pattern, occurs in an uptrend. It is a two-candle pattern with the first candle being a green candle and the second one being a red one whose real body engulfs the previous day’s green candle real body. Again, the engulfing of the real body should confirm the pattern and one need not look for engulfing of the shadows as well. A bearish engulfing pattern suggests a short trade and points to bears being in control. For example, the stock of State Bank of India formed a bearish engulfing candle on November 12, 2010 and thereafter witnessed a corrective phase for nearly one year.

Conclusion

One would argue that candlestick charting is just another tool as it does not provide any extra information about market action, in the sense that all other chart types also provide similar market information in real time. However, candlestick charting stands out in its visual appeal and its ability to offer data relationships in an easier way. Candlesticks provide a quick insight into current trading psychology. They offer a quick picture into the psychology of short-term trading, studying the effect. This makes it an effective tool for anyone practicing technical analysis. Candlesticks show the interaction between buyers and sellers and provide a complete picture that other chart types do not.

The human mind does not handle large numbers of macro ideas well. Hence, focus is required when one is dealing in risky assets. Mere sound analysis (technical analysis) will not suffice to yield results; the analysis needs to be transformed into best trading practices. One of the best trading practices is to focus on the ‘top chart patterns’ in technical analysis that are understood by the trader and have a good success ratio. Whenever markets are volatile and investors’ portfolios begin to plunge, fears dominate investors’ mind and people tend to think of negative outcomes such as in the case of recession, war, debt, bank failures, the ongoing viral crisis, US-China trade war, etc.

In such volatile times, something is needed to keep us from falling victim to everyday emotion and delusions – that something being candlestick patterns and technical analysis. Investors and traders should develop a deeper understanding of candlestick patterns or any other chart pattern before implementing them. Focus on a few select few chart patterns as mentioned in the article, which is essential in order to improve the success ratio in trading and investing bets.