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Aditya Goela, CFA

Aditya Goela, CFA

Co-Founder and Trainer at Goela School of Finance LLP | Chartered Financial Analyst® | Proprietary Trader | JoshTalk Speaker
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Magic of Reversal Candlestick Pattern

Aditya Goela, CFA

Aditya Goela, CFA

Co-Founder and Trainer at Goela School of Finance LLP | Chartered Financial Analyst® | Proprietary Trader | JoshTalk Speaker
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Have you ever been fascinated by the red and green sticks on screens of traders in stock markets? Those sticks, called candlesticks, continuously form in live markets, leaving beginners mesmerized. With price plotted onto the right-hand side of the screen, the entire setup with these red and green sticks is referred to as a candlestick chart in technical analysis taken up in our stock market classes. These charts are either filled up with numerous candles at different time intervals, often moving and changing colour in live markets. Through analyzing a group of them, a futuristic movement can be predicted. But wait, let us first understand what a candlestick is?

What does a candlestick mean?

A candlestick is a type of chart style that reflects the movement of price in terms of the size of the stick. The bigger the candlestick is, the more the change the stock/ underlying instrument has gone through. Their colour represents the type of movement in price that has occurred. A red one signifies that people have sold the underlying asset during that period of the candlestick while a green one represents buying by the people during that period.

Structure of the Candlestick:

Open: The value or the price at which the particular instrument’s first trade occurs in that duration.

High: The highest value of the instrument at which a transaction has taken place.

Low: The lowest value of the instrument at which a transaction has taken place.

Close: The value or the price at which the particular instrument’s last trade occurs in that duration.

Body: The difference between the open and close of a candle is the body.

Wick: The extremes of the candle i.e. High and Low concerning the body, constitute the wicks of the candle. They are often known as shadows in different stock market training institutes.

Types of Candles:

Depending upon the structure of the candle, they are classified into numerous types. Some of them are discussed here:

  1. Marubozu: Sometimes, High and/ or Low coincides with the Open and/ or close of the candle, forming no wicks in the candle. Such candlesticks are called Marubozu candles, and they generally are bigger in size.
  2. Doji: Such candles have a negligible or a horizontal line for the body with wicks. The location of the body determines the market sentiment in that particular duration. If it is in the middle of the Doji candle, it denotes indecisiveness. If the body is towards the bottom of the candle, it means that sellers have dominated for the period in the tussle, while if the body is in the upper side, then it means buyers have emerged victorious for the duration.
  3. Spinning top: All other kinds of candles except the Doji and the Marubozu are categorized under the spinning top type of candles.

What is a pattern?

A collection of continuous candlesticks that indicates a strong sentiment for a probable movement is known as a candlestick pattern. There are numerous patterns covered across different stock market technical analysis courses, but they are broadly classified into two categories- Bullish and Bearish. A Bullish pattern indicates that the underlying instrument, i.e. a stock, etc. has a strong affinity to move up in the coming time, while a bearish pattern indicates a probable downfall in the price of the instrument in the coming time. These patterns are of several types- Engulfing, Cloud, Reversals, etc.

What is a reversal pattern?

A reversal pattern, as the name suggests, signifies an ongoing trend getting reversed with movement in the opposite direction commencing. This is a very strong pattern and is an integral part of the Modern Price Action theory as additional confirmation covered in stock market courses for beginners. The profitability percentage is very high in this type of pattern when tested in the currency, commodity, and equity markets for decades. So let’s get entangled into the magic of reversal patterns:

  1. Hammer: It indicates the sentiment reversal in the instrument from bearish to bullish. Although the price went down, buyers have become dominant and have taken control. The distinctive feature of the hammer is a downtrend followed by a long wick candle with the upside body almost half or lesser in size than the wick. It is then continued by an uptrend. An additional confirmation to a more profitable hammer pattern can be observed, if the colour of the hammer is green and the uptrend closes above the opening of the last downtrend candle left to the hammer.
  2. Inverted Hammer: Often mistakenly thought as the opposite of hammer, this pattern is also bullish. The distinguishing feature of an inverted hammer is a downtrend, followed by a long wick candle with the downside body almost half or lesser in size than the wick, and then an uptrend. A more reliable inverted hammer pattern can be observed if the colour is green and it is followed by a bullish confirmation.
  3. Shooting star: Being the counterpart of Hammer, this pattern indicates the trend reversal from bullish to bearish. Although the price went up, sellers have now become dominant, due to being heavily overpriced. It can be identified by an uptrend, followed by a long wick candle with a downside body almost half or lesser in size than the shadow, and then a downtrend. A more confident shooting star can be observed if the colour of the intermediate candle is red. Such a phenomenon represents price rejection and the presence of strong resistance.
  4. Morning Star: A morning star pattern is a bullish pattern, which can be identified through a downtrend, followed by a bearish candle and then a small candle (any colour), in turn, followed by a bullish candle which has a body almost to the size of the bearish one.
  5. Evening Star: An evening star pattern is a bearish pattern, which can be identified through an uptrend, followed by a bullish candle and then a small candle (any colour), in turn, followed by a bearish candle which has a body almost to the size of the bullish one.

Risk-Reward and SL:

The key factor with trading through candlestick patterns is not the accuracy of the pattern, rather the risk reward. People often blame the pattern when they face difficulty in delivery mode, due to gap ups and downs in a volatile market. But if they have their SL placed at the nearest support with the risk-reward at least being 1:2, they will see a huge improvement in their trading ledger. A share market learning course which covers this aspect too, instead of only patterns, is best and recommended for a beginner.

Problems with Candlestick patterns:

Once being an indispensable tool for trading, these patterns have now become a little inefficient. Retailers getting trapped by the hedge fund managers by their advanced tools in high-risk-reward scenarios is the main reason behind the loss in popularity. However, this doesn’t mean that these patterns have become ineffective and they are of no use. Some of these patterns remain to be the finest tools for additional confirmations for price action strategies or support and resistance. These patterns work reliably well on daily and hourly charts, while the performance on other timeframes may vary quite a lot.

If you love our content and want to learn more about technical analysis or stock market technical analysis courses, feel free to reach out to us at info@goelasf.in. 

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