Reversal Patterns

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jcocrat
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191893
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Reversal Patterns
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2013-01-10 15:58:03
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Reversals
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Reversal Patterns
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    • Hammer
    •  
    • • Direction: Bullish  • Type: Reversal  • Reliability: Moderate 
    • After an established downtrend  • Hammer candles have a small real body that forms at the upper end of the days trading range  • The candle can be either blue or red, analyst usually do not differentiate.  • Lower wick at least twice as long as the real body  • No (or almost no) upper wickAfter a bearish sell-off a significant rally brings price back up creating a long bottom wick. By day end buyers are able to push prices back to the upper range creating a short body. The Hammer pattern signifies a weakening in bearish sentiment. The long lower wick signifies an initial continuation of the downtrend. However, renewed buying sentiment acts as support and drives the price higher to close near its opening price.   • Strength and ConfirmationThe strength of a Hammer formation depends on where it appears. If a hammer forms near support levels, then the likelihood of a strong bullish reversal is high. However, if the hammer forms in the middle of a trading range it tends to have little significance. In ideal conditions traders want the wick length to be several times longer than the body of the candle. The longer the candle, the more buyers were able to drive price back up and the stronger the bullish signal this candle provides. Although above we state that most analysts do not care if the small candle is red or blue, traders will actually take a blue candle to suggest a stronger bullish signal. Buyers being unable to bring the close price above the open price suggest additional bullish strength. Generally the difference between blue and red candles is minimal. The bullish Dragonfly Doji serves as a stronger buy signal than the Hanging Man pattern. Since a Dragonfly candle (where open and close are identical, but we see a low similar in length to the Hanging Man) reflects more uncertainly and lack of direction, candlestick analysts will usually take it as a stronger buy signal.   • Hammer vs Hanging Man.Alone, Hammer and Hanging Man candles look identical. Their difference lies in what type of trend the candle follows. If the market had been trending up for a while the formation is a Hanging Man. In fact the name, Hanging Man, suggest price is hanging over a precipice, ready for a fall. Hammers follow a bearish trending market and its name suggest price has already been weighted down. Although traders will usually wait for confirmation the next day, look for buying opportunities to come.
    • Hanging Man  • Direction: Bearish  • Type: Reversal  • Reliability: Moderate to Weak
    • • In a uptrend a red or blue day occurs with a body in the upper part of the sessions range, a long lower wick, and little to no upper wick  • Analysts do not care of the small candle is red or blueThe Hanging Man formation indicates trend exhaustion, and suggests a bearish reversal. After a bullish rally the day opens with a significant sell-off, creating a long bottom wick. However, buyers are able to push prices back to the upper range, creating a short body. The meaning of the candle is a bit ambiguous. Even though sellers brought the market to low lows, in the end buyers brought the close price back up near the market open price. Overall this candlestick serves as an early indication that buyers are losing control and bearish traders are gaining strength. Since the signal alone is fairly weak, traders look for a number of characteristics to reinforce the bearish signal. In ideal conditions traders want the wick length to be several times longer than the body of the candle. The longer the candle, the stronger sellers were able to drive price down and the stronger the bearish signal this candle provides. Although above we state that most analysts do not care if the small candle is red or blue, traders will actually take a red candle to suggest a slightly stronger bearish signal. Sellers being unable to bring the close price below the open price suggest stronger bearish control. The bearish Dragonfly Doji serves as a stronger sell signal than the Hanging Man pattern. Since a Dragonfly candle (where open and close are identical, but we see a low similar in length to the Hanging Man) reflects more uncertainly and lack of direction, candlestick analysts will usually take it as a stronger bear signal.   • Hammer vs Hanging Man.Alone, Hammer and Hanging Man candles look identical. Their difference lies in what type of trend the candle follows. If the market had been trending up for a while the formation is a Hanging Man. In fact the name, Hanging Man, suggest price is hanging over a precipice, ready for a fall. Hammers follow a bearish trending market and its name suggests price has already been weighted down. Although traders will usually wait for confirmation the next day, look for selling opportunities to come.
    • Bullish Engulfing  • Direction: Bullish  • Type: Reversal  • Reliability: Moderate
    •   • After an established downtrend, day-one continues the trend with a red candle  • Day-two is a long blue day that engulfs the body of the first day, closing well above the previous dayÃ?¢??s open.The Bullish Engulfing is one of the more clear-cut two day bullish reversal patterns. The formation reflects buyers overtaking selling strength, and often precedes a continued rally in price.   • Day-One: Characteristics for Signal StrengthThe first day may even appear as a Doji, and the smaller day-one is and larger the second day is, the stronger the reversal signal. Dojis and small candles reflect uncertainty in the markets trend, thus the smaller the first days candle the better the signal of an end to the established bear trend.   • Day-Two: Characteristics for Signal StrengthThe second day bull move acts to confirm the death to the bear trend. The bigger the blue candle reflects the stronger the rally and the better the reversal signal.   • Overall Characteristics for Signal StrengthThis pattern is also more meaningful if it follows a lengthy downtrend, or a recent fast move down. Both these cases suggest the market may be oversold and more apt for a reversal.   • Support Level CreatedBullish Engulfing patterns also provide resistance levels for where the lowest level of price action reached. In the future this level tends to offer good support.
    • Bearish Engulfing  • Direction: Bearish  • Type: Reversal  • Reliability: Moderate
    • • In an established uptrend, an average to small sized blue candle occurs on day-one.  • In the second day a longer red candle forms  • Ideally with a red candles high is above the previous days high.  • The strength of the signal is additionally increased by the further the red candle closes below the low of the blue day.The Bearish Engulfing is one of the more clear-cut two day bearish reversal patterns. The formation reflects sellers overtaking buying strength, and often precedes a fall in price.   • Day-One Characteristics for Signal StrengthThe first day may even appear as a Doji, and the smaller day-one is and larger the second day is, the stronger the reversal signal. Dojis and small candles reflect uncertainty in the markets trend, thus the smaller the first days candle the better the signal of an end to the established bull trend.   • Day-Two Characteristics for Signal StrengthThe second day bear move acts to confirm the death to the bull trend. The bigger the red candle reflects the deeper the bear move and the better the reversal signal.   • Overall Characteristics for Signal StrengthThis pattern is also more meaningful if it follows a lengthy bull trend, or a recent fast move up. Both these cases suggest the market may be overbought and more apt for a reversal. Bearish Engulfing patterns also provide resistance levels for where the highest level of price action reached. In the future this level may be difficult to break.
  1. Dark-Cloud Cover Chart Pattern


    • Type: Bearish Reversal Pattern
    • Appearance:The dark-cloud cover pattern consists of a long body white (up) candle, followed by a black (down) candle which opens above the first candle's high. This means there is a gap between the first candle's close and second candle's open. The second candle then penetrates deep into the body of the first candle.
    • Typical Duration: 2 candles
    • Description: The dark-cloud cover pattern occurs mostly in up-trends, but may also be seen in an up move within a consolidation. It is a reversal signal that predicts lower prices coming up. The reasoning behind it is similar to that of other reversal patterns. The bulls make a strong run with a long white candle, followed by an upward gap on the next candle's opening. Normally these types of rallies are caused by investor exuberance. The gap is then quickly closed and price action never looks back, making a strong move downward. According to most investors, the black candle should penetrate to at least 50% of the previous white candle's body. The further it penetrates, the more confident we can be of the pattern's success. So let's sum up the requirements:

    • Long body white candle in an up-trendnding or consolidating market.
    • The following candle gaps up and opens above the first candle's high, meaning above it's shadow.
    • That same second candle then goes to move downward strongly, closing at least 50% into the previous candle's body.
    • In addition to these requirements, there are several factors which can improve the pattern's performance in real trading.

    • The further the second candle's close penetrates into the previous candle's white body, the more likely it is that the pattern is in fact forming a significant top in price, and the more likely therefore, that trades based on the dark-cloud cover will succeed. Please note that if it penetrates so far as to engulf the entire white candle, then we have a bearish engulfing pattern.
    • The shorter the shadows are on both candles, the better chance of success. It follows that the best performance comes with "shaved bottom" and "shaved head" candles, meaning no shadows at all, only bodies.
    • If the pattern occurs near a previous resistance level, we have further confirmation of a bounce, again increasing our probability of success. A text-book pattern would have the first candle close near the resistance level, then gap up above it, only to be taken down by strong selling pressure.
    • In markets where volume data is available, heavy volume on the second candle's open could indicate a last gasp by the bulls, very likely signalling an imminent strong "long squeeze" and sharp downward move. Unfortunately, this information is not available to us in the retail forex market, at least not in any reliable form.
    • Strengths: When traded on weekly charts, the dark-cloud cover pattern can be a fairly reliable reversal signal. It is similar to the engulfing pattern, with the added advantage that somewhat tighter stop losses can be placed due to the reduced average distance to the top of the formation. This can significantly improve the reward:risk ratio, in some cases overcoming the disadvantage of the reduced reliability of the signal as compared to the engulfing pattern (more on this in the next section).
    • Weaknesses: Picture-perfect dark-cloud cover patterns are not very common in the forex, due to the requirement that there be a gap between the first candle's close and the second candle's open. Gaps in the forex rarely occur except over the weekend when the market is inactive. This means that the probability of finding a gap during the week is quite low, so we can either ignore that requirement, or deal with a significantly reduced pool of signals. This is not the case on weekly charts, however. As has already been noted, the dark-cloud cover is very similar to the bearish engulfing pattern, with a lesser degree of penetration of the bear candle into the bull candle. According to our rules, this makes the pattern inherently less reliable than the engulfing pattern.
    • How to Trade It: Without an inherent take profit target, we have to turn to other analyses to get that resolved. Besides that drawback however, the dark-cloud cover pattern is easy to trade and can even be discovered by automated pattern recognition software. Simply wait for the pattern to close, enter a short position according to your money management rules, set your stop loss above the dark-cloud cover's high in case the pattern fails, and enter your take profit target according to your other analysis.
    • Bullish Piercing Line Pattern is a bottom reversal pattern. A long black candlestick is followed by a gap lower during the next day while the market is in downtrend. The day ends up as a strong white candlestick, which closes more than halfway into the prior black candlestick’s real body.
    • Recognition Criteria:1. Market is characterized by downtrend.2. We see a long black candlestick.3. Then we see a long white candlestick whose opening price is below previous day’s low on the second day.4. The second day’s close is contained within the first day body and it is also above the midpoint of the first day’s body.5. The second day however fails to close above the body of the first day.
    • Explanation:
    • The market moves down in a downtrend. The first black real body reinforces this view. The next day the market opens lower via a gap. Everything now goes, as bears want it. However suddenly the market surges toward the close, leading the prices to close sharply above the previous day close. Now the bears are losing their confidence and reevaluating their short positions. The potential buyers start thinking that new lows may not hold and perhaps it is time to take long positions.
    • Important Factors:
    • In the Bullish Piercing Pattern, the greater the degree of penetration into the black real body, the more likely it will be a bottom reversal. An ideal piercing pattern will have a real white body that pushes more than half way into the prior session’s black real body.
    • A confirmation of the trend reversal by a white candlestick, a large gap up or by a higher close on the next trading day is suggested.

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