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Candlestick Formations

By Russ Horn

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Candlestick Formations
We use Japanese Candlesticks when we trade. The advantage to using these is
they have a way of hinting to us what the market will do almost right away. There
are certain formations that candles make that tell us what the market consensus
is.

Candlestick formations can be a red flag to a trade we are in. Often we might get
a reversal formation halfway to our target, this is an instance when you would
consider closing the trade early and keeping your hard earned profits.

There are books written on the subject, and some go into it at length. Steve
Nison is the guy who introduced the Western world to Japanese Candlesticks, and
he has written volumes on the subject. Here I am going to explain the few of the
more popular ones that I pay attention to.

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Engulfing
One of the more popular candlestick formations is the Engulfing. It’s a 2 candle
formation and will appear at the top or bottom of a larger market movement.
There is a small body candle followed by a big body candle the opposite color.
The larger candle’s body will be larger than the body of the previous candle.
The Bullish Engulfing formation appears at the bottom of a trend.
The Bearish Engulfing shows up at the top of a trend.

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Bearish Engulfing pattern at Outer and Channel.

Bullish Engulfing pattern at Inner Channel.

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Inside Bar / Harami

This is a 2 candle formation that occurs at the top or bottom of a market move.
The first candle has a larger candle body which is followed by a second candle
with a smaller candle body (in Japanese, Harami means pregnant). The body of
the second candle will be contained within the body of the larger candle to the
left and be of the opposite color.

Personal note:
The Harami is generally only considered when comparing bodies of the candles,
but I prefer to see the Harami candle contained inside of the range of the
previous candle. This means that the high and low of the Harami is inside of the
high and low of the previous candle, I find this gives the Harami a more powerful
signal.

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Bullish Harami at the Inner Channel.

Bearish Harami at the Outer Channel.

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Doji
Doji is a one candle formation. The key feature of a Doji is that the open and
close price is the same or very close to being the same. The body of a Doji will be
very narrow as the candle opens in the same place it closes. The length of the
upper and lower shadows will remain fairly small as the market has lost the
momentum it recently had. A change in direction often follows this reduction in
momentum. A Doji is only a valid candle formation when it appears at the top or
bottom of a market move.

Long Legged Doji: The open and close are at the same price, but the upper and
lower wicks are very long. The creation of the long Legged Doji has the market
frantically looking for a direction. This is a period of indecision, but at the top or
bottom of a trend, the temptation for the market to reverse is very strong.

Gravestone Doji: With a long wick, the open and close of this Doji are at the
bottom of the candle. It is a great formation denoting the end of an upward
trend, but can, on rare occasions, also be found at the bottom of a trend. (also
referred to as Pin Bar).

Dragonfly Doji: The opposite of a Gravestone Doji, the Dragonfly Doji has it’s
open and close at the top of the candle formation. This is a formation that will
clearly determine the bottom of a trend, but will occasionally appear at the top of
a trend. (also referred to as Pin Bar).

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Doji at Inner Channel

Long Legged Doji at Middle /Outer Channel.

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Gravestone Doji at Middle / Outer Channel.

Dragonfly Doji at Middle / Outer Channel.

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Hammer / Hanging Man

The same candlestick formation as one another, the Hammer appears at the
bottom of a move and the Hanging Man appears at the top. This candlestick has a
small body and a longer lower wick. There will be either no upper wick or a very
small one. The length of the lower wick will be approximately 2 times the length
of the body. The color of the body doesn’t much matter, but it’s been said that
the effectiveness if the formation is better if the Hammer’s body is white and the
Hanging Man’s body is black.

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Hammer at Middle Channel.

Hanging Man at the Middle Channel.

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Inverted Hammer / Shooting Star

The same description as the Hammer and Hanging man, the Inverted Hammer
appears at the bottom of a move and the Shooting Star appears at the top. This
time the Upper wick is double the length of the candle’s body and either no or
very small lower wick.

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Inverted Hammer at Middle Channel.

Shooting Star at the Outer Channel.

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Railroad Tracks
This is an instance of a quick change of mind. Railroad tracks are 2 similarly
lengthy candles that are longer than the average surrounding candles. They stick
out like a sore thumb when you see them. In an upward market movement, there
will be a strong surge upward and then the next candle will be an almost
complete undoing of the initial candle. This would be the same in a downtrend.
They are good reversal candles in moving markets.

Railroad tracks don’t always have to happen in a moving market, you can find
them in times or relative quiet. In these cases, it’s almost like a glitch in the
works, there is very little in the way of an increase in momentum. Railroad tracks
in a quiet market should not be traded, or traded with extreme caution.

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Bullish Railroad Tracks at the Outer Channel.

Bearish Railroad Tracks at the Outer Channel.

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Wicks in General
Without looking for specific candle formations, the one thing that I pay the most
attention to would be wicks. Whether or not the candle body is longer or shorter
than the average, a long wick will often point to a change in direction. A long wick
on a single candle means that during that formation of the candle there was a
more than usually aggressive battle between the bulls and the bears. Whoever
was able to push the charge back to actually form the wick will generally keep
pushing. An initial powerful surge upwards by the bulls is met with retaliation by
the bears. The bears defending their control over the market will continue to be
aggressive for a short while afterwards.

Simultaneous Wicks
A series of wicks is a heads-up to a change in market direction. As price keeps
trying to push in a direction, it is being continually met with resistance. Eventually
this resistance will take over and push price in the opposite direction. In a market
that was moving upwards, upper wicks will show pressure to the downside, and in
a downward market, several lower wicks will hint to a potential move up.

The bodies on the candles don’t have to be unusual in length, and there doesn’t
have to be an exact number of candles. 2 candles with these wicks are called
“tweezers”, but you will come across 3 or 4 candles all with longer wicks on one
side of the candle.

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Longer than average series of Lower Wicks at the Outer Channel.

Longer than average series Upper Wicks at the Middle Channel.

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Quick Reference Guide

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Candlestick formations are great to be aware of, but like the man himself, Steve
Nison warns, we must trade the formations in conjunction with other indicators.

These formations work best when they appear at the top or at the bottom of a
market move. Trying to trade these formations in a sideways market will not
yield the desired results.

Candlestick formations are best used alongside other trading elements like
moving averages or support and resistance levels. They work well with the
guidelines laid out by the Rapid Results Method.

Good trading to you!

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