Candlestick charts are frequently used in technical analysis to provide traders with a visual representation of price movements to help them identify future price directions. The candlestick reversal pattern is a common tool traders look for to create their trading strategies.
In this FXOpen guide, we explain how these patterns work and how to use them in your trading to determine when to open and close positions.
What Is a Reversal Candlestick Pattern?
Candlesticks are a type of technical chart that corresponds to the opening, closing, low, and high prices for an asset over a given period. Candlestick reversal patterns are the opposite of continuation patterns in that they indicate a potential change in the direction of the trend rather than its continuation.
Reversal patterns are formed by a group of candlesticks that denote a shift in market sentiment. Bullish reversals point to a potential shift from a downward trend to an upward trend, while bearish candlestick reversal patterns indicate a potential shift from an upward trend to a downtrend.
Reversal candlesticks indicate that the market direction seen over a certain period is changing. They are typically characterised by the market moving higher or lower after the momentum in the previous direction has been exhausted.
How to Use Reversal Candlestick Patterns
In forex, candlestick reversal patterns are particularly useful for day trading strategies as the markets are highly volatile. They are, however, also used across a range of timeframes. They are used for various assets, including stocks, commodities, and cryptocurrencies*.
Trading platforms such as TickTrader have candlestick charts you can analyse to build your trading strategy. Once you have identified a reversal, you can enter a trade after the pattern has formed.
Note: traders always look for confirmation that the trend is reversing before making any trading decisions. You could wait for the candle after the pattern to close or wait for other technical indicators to confirm the change in direction, such as a break of a key support or resistance level.
Top 5 Reversal Patterns
There are many reversal patterns, but some are more frequently used than others. We look at five common shapes to be aware of.
1) The Hammer
The hammer, also known as the pin bar, is formed by a single candlestick and indicates a potential bullish turnaround of a bearish trend, suggesting the market is attempting to find a bottom. The candle has a small body, a lower wick that is at least twice as long as the body, and little to no upper wick. The candle’s colour isn’t important, but if it’s bullish, the signal is considered to be stronger.
The shape of the hammer indicates that, while selling pressure pushed the market down, there was a strong move to the upside that brought the closing price back towards the opening price. Therefore, the downward trend could be losing momentum, and an upward trend could be starting.
Traders typically buy when the reversal is confirmed by subsequent candles and place a stop loss below the bottom of the hammer or possibly just below the candle’s body if the price moves aggressively higher in the confirmation candle.
2) Shooting Star
The shooting star is considered the opposite of the hammer formation. It is formed by a single candlestick with a small body, an upper wick that is at least twice as long as the body, and little to no lower wick.
To classify as a shooting star, the candle must be formed while the market is rising. The shape of the shooting star reflects the fact that, while buying pressure has lifted the price, the momentum has slowed, and selling activity has pushed the closing price down. This is a bearish signal to traders as it suggests the upward trend could be ending, and a downward trend could be starting.
Traders typically wait to see how the next candle forms before making a trade. If the price falls, they may sell. If the price moves higher, the shooting star may have been a false signal. Alternatively, it could indicate potential resistance around the candle’s price range. A stop-loss level can be placed above the high of the shooting star.
3) Engulfing Candlesticks
The engulfing candlestick pattern is a two-candle pattern that can indicate either a bullish or bearish change in direction. A bullish shape forms at the end of a downward movement when the body of a large green upward candle completely engulfs the body of the preceding red downward candle. The green candle opens lower than the previous one but closes higher, indicating a shift from selling to buying pressure.
When a bullish engulfing pattern confirms a trend reversal, the price does not typically fall any further than the low of the second candlestick. Therefore, traders often use it to enter a trade at the market opening price after the second candle has closed and place a stop loss underneath the second candle’s low.
Conversely, a bearish shape forms at the end of a bullish trend when a large red downward candlestick completely engulfs the previous small green upward candle. The red candle opens higher than the preceding candles but closes lower, suggesting the momentum could shift from buyers to sellers.
Traders often enter the market on the open price of the first bearish candle after the engulfing and place a stop-loss order underneath the second candle’s low.
4) Three Outside Up / Three Outside Down
The three outside up and three outside down are patterns that consist of three candlesticks. The three outside up is a bullish reversal formation in which the first candlestick has a small red body, the second is a large green candle engulfing the previous one, and the third is a bullish candle that closes above the close of the second.
This provides traders with a buy signal that is confirmed when the price moves to a new high on the third candle. They would enter a trade at the top of the third candle’s wick and place a stop loss below the second.
On the flip side, the three outside down is a bearish reversal setup formed by a small green candlestick, a large red candle that engulfs the previous one, and a red candle that closes below the close of the second one.
Traders take this as a signal to sell below the wick of the third candle, placing a stop loss at the peak of the second wick.
5) Piercing Line and Dark Cloud Cover
The piercing line and dark cloud cover are two-candle patterns. The piercing line is a bullish reversal formation at the end of a downtrend. It is formed when a long falling candlestick is followed by a long rising candle, which opens lower than the preceding candle but closes above its midpoint.
The length of the candles and the gap between them indicates how powerful the trend reversal will be: the longer the second candle, the stronger the signal; if there is a gap up after the second candle, the trend is stronger.
Traders usually wait for the price to form another bullish candle after the piercing line formation. If it’s bullish, they go long. A stop-loss order is usually placed below the pattern’s second candle.
Conversely, the dark cloud cover is a bearish pattern formed by a long rising candle followed by a long falling candle that opens higher than the prior one but closes below its midpoint. By opening higher, the second candle provides an optimistic view of the future price rise; however, it reverses more than half of the previous gain. This explains the formation's name, as it starts "sunny," but "dark cloud" cover moves in. The bearish signal is stronger if the next candlestick closes below the bottom of the first, as the price could then fall steadily for some time without a higher retracement.
As with the piercing line structure, the length of the candles and the gap between them signals the strength of the trend reversal. Traders wait for another bearish candle to be formed after the pattern. If there is one, they go short and place a stop-loss order above the pattern’s second candlestick.
When analysing candlestick patterns, reversal candles provide useful insights into potential changes in the direction of trends, helping you decide when to open or close a trade. While these patterns can be reliable, traders combine them with other technical indicators to make more informed trading decisions. You can open an FXOpen account to practise on live charts.
*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.
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