Candlesticks 3: Bullish Reversal Patterns
Being able to anticipate a trend shift is a basic skill for a trader. If you are able to recognise when a trend is likely to end you will increase your chances of making a succesful trade. While sometimes a trend will change without notice, most of the time it will when it's nears a resistance/support zone; but also, when a chart goes into a support/resistance zone, the stock can breakout/breakdown, so, How can we know if the trend is going to reverse or is going to continue?
That's when candlestick patterns come in. These patterns can give you a confirmation that a chart is having trouble going through resistance/support and is likely to change direction.
On this post I'm going to focus on bullish reversal patterns, that is when a downtrend shifts to an uptrend. While there are dozens of bullish reversal patterns, I'll list & explain the most common and important. These are:
Hammer
What's happening when the hammer appears?
After a decline, the hammer's intraday low indicates that selling pressure remains. However, the strong close shows that buyers are starting to become active again.
While this is a very popular pattern, it is best to wait for bullish confirmation the next day. Treat the hammer as a sign that says "Hey! This might go back up, keep watching!" instead of as a bullish confirmation.
Example:
Nike (NKE)
![[Nke]](http://stockcharts.com/images/minilink_sc.gif)
declined from the low fifties to the mid thirties before starting to
find support in late February. After a small reaction rally, the stock
declined back to support in mid March and formed a hammer. Bullish
confirmation came two days later with a sharp advance. Bullish Engulfing
The bullish engulfing pattern is another strong reversal pattern, made of 2 candlesticks, one black and the next white. The size of the black candle is not that important, as long as it's not a doji, as it would be pretty easy to engulf. The size of the white candle is what matters, as it has to engulf the previous black candle, that means, that it's open is below the previous close, and the close is above the previous open; the longer the engulfing candle, the more bullish the pattern is Remember: the shadows don't count, for it to be an engulfing pattern, it must be the white real body that engulfs the previous real body.
What's happening when the bullish engulfing pattern appears?
After a decline, the second white candlestick begins to form when selling pressure causes the security to open below the previous close. As it opened lower, buyers are seeing that price as an opportunity, and start to buy, pushing up price. Continuous buying leeps pushing up the price, making the bears nervous, some of them resign and become bulls to, elevating the price even more and the stock finishes with a strong close.
Further strength is required to provide bullish confirmation of this reversal pattern.
Example:
In Jan-00, Sun Microsystems (SUNW)
formed a pair of bullish engulfing patterns that foreshadowed two
significant advances. The first formed in early January after a sharp
decline that took the stock well below its 20-day exponential moving average (EMA). An immediate gap up confirmed the pattern as bullish and the stock raced ahead to the mid-forties. After correcting to support,
the second bullish engulfing pattern formed in late January. The stock
declined below its 20-day EMA and found support from its earlier gap up.
This also marked a 2/3 correction of the prior advance. A bullish
engulfing pattern formed and was confirmed the next day with a strong
follow-up advance.
What's happening when the bullish engulfing pattern appears?
After a decline, the second white candlestick begins to form when selling pressure causes the security to open below the previous close. As it opened lower, buyers are seeing that price as an opportunity, and start to buy, pushing up price. Continuous buying leeps pushing up the price, making the bears nervous, some of them resign and become bulls to, elevating the price even more and the stock finishes with a strong close.
Further strength is required to provide bullish confirmation of this reversal pattern.
Example:
In Jan-00, Sun Microsystems (SUNW)
formed a pair of bullish engulfing patterns that foreshadowed two
significant advances. The first formed in early January after a sharp
decline that took the stock well below its 20-day exponential moving average (EMA). An immediate gap up confirmed the pattern as bullish and the stock raced ahead to the mid-forties. After correcting to support,
the second bullish engulfing pattern formed in late January. The stock
declined below its 20-day EMA and found support from its earlier gap up.
This also marked a 2/3 correction of the prior advance. A bullish
engulfing pattern formed and was confirmed the next day with a strong
follow-up advance.
Piercing Pattern
The Piercing pattern is similar to the bullish engulfing pattern: it is formed by two candles, one black and one white, the white candle opens below the previous close and has a strong day, but instead of closeing above the previous open, it ends up closing somewhere between the real body of the previous candle. The closer the candle close is to the previous open, the more bullish the pattern is.
What's happening when the piercing pattern appears?
Just as with the bullish engulfing pattern, selling pressure forces the security to open below the previous close, indicating that sellers still have the upper hand on the open. However, buyers step in after the open to push the security higher and it closes above the midpoint of the previous black candlestick's body.
Further strength is required to provide bullish confirmation of this reversal pattern.
Example:
In late March and early April 2000, Ciena (CIEN)
declined from above 80 to around 40. The stock first touched 40 in
early April with a long lower shadow. After a bounce, the stock tested
support around 40 again in mid April and formed a piercing pattern. The
piercing pattern was confirmed the very next day with a strong advance
above 50. Even though there was a setback after confirmation, the stock
remained above support and advanced above 70. Also notice the morning doji star in late May.
Just as with the bullish engulfing pattern, selling pressure forces the security to open below the previous close, indicating that sellers still have the upper hand on the open. However, buyers step in after the open to push the security higher and it closes above the midpoint of the previous black candlestick's body.
Further strength is required to provide bullish confirmation of this reversal pattern.
Example:
In late March and early April 2000, Ciena (CIEN)
declined from above 80 to around 40. The stock first touched 40 in
early April with a long lower shadow. After a bounce, the stock tested
support around 40 again in mid April and formed a piercing pattern. The
piercing pattern was confirmed the very next day with a strong advance
above 50. Even though there was a setback after confirmation, the stock
remained above support and advanced above 70. Also notice the morning doji star in late May.
Bullish Harami
The bullish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black.
Whether they are bullish reversal or bearish reversal patterns, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bullish reversals after a decline and potential bearish reversals after an advance. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.
In his book Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but that the most bullish are those that form with a white/black or white/white combination. Because the first candlestick has a large body, it implies that the bullish reversal pattern would be stronger if this body were white.
What's happening when a Harami appears?
The long white candlestick shows a sudden and sustained resurgence of buying pressure. The small candlestick afterwards indicates consolidation. White/white and white/black bullish harami are likely to occur less often than black/black or black/white.
After a decline, a black/black or black/white combination can still be regarded as a bullish harami. The first long black candlestick signals that significant selling pressure remains and could indicate capitulation. The small candlestick immediately following forms with a gap up on the open, indicating a sudden increase in buying pressure and potential reversal.
Micromuse (MUSE)
declined to the mid sixties in Apr-00 and began to trade in a range
bound by 33 and 50 over the next few weeks. After a 6-day decline back
to support in late May, a bullish harami (red oval) formed. The first
day formed a long white candlestick, and the second a small black
candlestick that could be classified as a doji. The next day's advance
provided bullish confirmation and the stock subsequently rose to around
75.
Morning Star
Here's a pattern that involves 3 candlesticks. The candlestick that make the Morning Star pattern are:
The black candlestick confirms that the decline remains in force and selling dominates. When the second candlestick gaps down, it provides further evidence of selling pressure. However, the decline ceases or slows significantly after the gap and a small candlestick forms. The small candlestick indicates indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long white candlestick provides bullish confirmation of the reversal.
After declining from above 180 to below 120, Broadcom (BRCM)
formed a morning doji star and subsequently advanced above 160 in the
next three days. These are strong reversal patterns and do not require
further bullish confirmation, beyond the long white candlestick on the
third day. After the advance above 160, a two-week pullback followed and
the stock formed a piecing pattern (red arrow) that was confirmed with a
large gap up.
- A long black candlestick.
- A small white or black candlestick that gaps below the close of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a morning doji star.
- A long white candlestick.
The black candlestick confirms that the decline remains in force and selling dominates. When the second candlestick gaps down, it provides further evidence of selling pressure. However, the decline ceases or slows significantly after the gap and a small candlestick forms. The small candlestick indicates indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long white candlestick provides bullish confirmation of the reversal.
After declining from above 180 to below 120, Broadcom (BRCM)
formed a morning doji star and subsequently advanced above 160 in the
next three days. These are strong reversal patterns and do not require
further bullish confirmation, beyond the long white candlestick on the
third day. After the advance above 160, a two-week pullback followed and
the stock formed a piecing pattern (red arrow) that was confirmed with a
large gap up.
How to confirm a reversal pattern?
There will be times when one of these patterns form and, still, the trend won't change. So, then, how can be we confirm that a reversal pattern truly indicate a shift in trend?
The answer: VOLUME. Volume is the indicator that is going to help you confirm a reversal pattern. If a reversal pattern forms with little volume, it means that just a few traders were involved those days, but if the reversal pattern includes a lot of volume, it means that there's more buyers coming as well as sellers giving up, so both sides combine, resulting in high volume days. Always take volume into consideration.
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