Candlestick Rules
1. Volume is a very important component in identifying reversal patterns. When buying a stock, it is NECESSARY for the volume to be heavier on the reversal day than the previous day. It takes a large amount of buyers to stop a downtrend. Volume is not as crucial on short sales; a stock can fall simply from a lack of enthusiasm from buyers; it is almost always necessary to see the heavier volume on the reversal day though. Also, if the volume is well above average on both days, this makes the pattern more meaningful. (On November 3rd, EBIX completed a 2-day bearish engulfing reversal pattern. The stock had above average volume on the 1st day of the pattern, and had the highest volume in 2 years on the reversal day, more than 3 times the average daily volume. The volume confirmed the bearish pattern, and the stock lost 5% the next day on an earnings report that beat expectations, and the DOW up 200 points. Poor fundamentals don’t cause stocks to lose value, fearful investors willing to sell at any price do.)
2. Reversal patterns need a trend to reverse. The longer the trend, the greater the potential when a reversal pattern appears. A 1-year downtrend with a reversal pattern has more upside potential than a 3-month downturn. However, the longer the trend, the more volume that is needed to change the direction of the current trend. A bearish reversal pattern at a 1-year high is the tip off of a possible correction. Likewise, a bullish reversal pattern at a 1-year low is the 1st tip off to an emerging rally. A reversal pattern in congestion or within a tight trading range does not offer enough potential for a strong reversal, and therefore is considered weak. Look for long-range reversals with a minimum of a 3-week trend. Long-range trends are desired, but not a slow & steady one. Sudden trends are better than long, slow moving trends.
[AIG was in an absolute free-fall from October 2007 until it finally bottomed in March 2009. A large green candlestick on March 12 signals the trend could be ending. The gap up the next day confirms that the downtrend is over. However, an 18-month downtrend can’t end in a week, and after going up 400% in 5 days, there was a lot more selling left in AIG. After a choppy 3-month consolidation, the volume really kicked in on this sell-off. After losing nearly 70% of its value in 8 days, things were different this time. The heaviest volume in the stock’s history came on a down day of 25%. It then gapped down on July 10th to what everyone thought would be to test the March’s low. But something unexpected happened. The heavy-volume gap was not only completely closed, but AIG nearly retraced the entire loss from the day before. This created a piercing line reversal pattern, a very powerful reversal signal since it was created on the heaviest volume in the stock’s history, even more than the previous day. It takes massive volume to reverse a trend, and that is exactly what happened. Once climbing 15%, the stock went into a very tight 2-week consolidation period. It was more than justifiable to hold this position through the consolidation, with a tight stop-loss below the lower rim of the gap up after the reversal day. If sold sooner, it certainly could have been bought again at a retest of the gap for a low-risk trade. AIG never looked back as it went on to go up nearly 250% in 8 days after this consolidation, for a total of 380% if bought after this reversal pattern up and sold after a gap down on August 30th.]
3. Therefore, while candlestick patterns are very effective at showing the reversal of a trend, all reversal patterns are not created equal. A reversal pattern at a 1-year high or low is powerful, but not as powerful as a reversal pattern at a 2-year high or low, etc. The most powerful of all signals occurs at all-time highs or lows.
4. Candlestick patterns are also much more successful when combined with the slow stochastic. When the stochastic meter is below 20 and sloping up, on a 13,3,3 or 15,5,5 setting and a reversal pattern appears, this makes the pattern MUCH more powerful. Because the stock is oversold, relative to the last 14 days, the move after the reversal pattern will be much more powerful then if the stock is overbought or above 80 sloping down.
5. Once a candlestick pattern has been found, the volume is heavier on the reversal day, and the stochastic meter is oversold, there is one more confirmation that helps to confirm the reversal of the old trend, and the start of a new one. This is when the stock gaps in the opposite direction of the prior trend. This was the case of AIG, when it gapped up well above the high of July 10th after a Piercing Line reversal pattern; this gives the final confirmation that the reversal is complete. What this shows is that the weak holders have been fully flushed out, and then replaced with a base of strong new owners, anxious to buy before the open, usually on excellent news that often times is completely unexpected. With the downtrend being in serious doubt, a gap up after the 2-day reversal pattern confirms the start of a new uptrend.
A “gap” is when a stock either moves above the open of the previous day before the open of the market, or below the previous day’s open before the market open. What this shows is that so many people are so anxious to either buy or sell before the market opened, that the price “gapped” up or down. On the chart, it is an empty space between the range of 2 days. A gap signifies a change in sentiment and perception. When a stock has been in a prolonged downtrend and suddenly gaps up, it is usually the result of a shocking and unexpected piece of news. A company that has lost money for years may suddenly post a large profit, which actually happened to AIG on August 5th. This change in perception not only shows that there aren’t enough panicked sellers left to drive down price, but that people are anxious to buy at any cost, before the market opens. When these types of moves occur, hop on board immediately, as it is usually the start of a new trend that could last weeks or even months.
6. As is the case with most stocks, a tight consolidation shows support among institutions. Although candlestick reversals work extremely well after major sell-offs, it is still more desirable to trade stocks that don’t go up and down 20% while looking for support. There should be a sort of ebb and flow to it; a steady trend with slight breaks with a rounded consolidation. However, in the case of AIG, some reversal patterns are so powerful that they have to be taken.
7. If a perfect candlestick reversal pattern doesn’t work, or even goes in the opposite direction, this could be a Hound of Baskervilles sign. If the stock gaps up in the opposite direction of the way that it should, reversing course and buying could be profitable. When a perfectly set up reversal pattern does the opposite, it is showing that all is not as it appears. The underlying fundamentals must be extremely powerful for such a pattern to be aborted. (WIN 12-01) & (LDK 11-27)
8. On certain reversal patterns like the engulfing pattern, the reversal day only technically needs to engulf the real body of the previous day. Although this is the rule for identifying these patterns, an engulfing pattern that engulfs the shadows is much more powerful of a pattern, and therefore much more favorable. Also, any pattern with a large real body and no shadows is more favorable. The more days engulfed enhances the signal as well. 8 days engulfed is better than 5, etc.
9. The larger the body, the larger the reversal. However when a bar is too large, it is too obvious. For a bearish engulfing, the reversal day could have a drop of 7%. However, 30% is too much and shows way too much emotional selling, which is unsustainable for a few days. (CFSG 12-07)
10. Setting the stop-loss to break even could result in being stopped out if the stop-loss is set to break-even within 3%; trail stops by setting it $.07 more than the previous day. Also, gaps provide logical points to set stop-losses. When buying, a gap up is a good place to set a stop-loss. Likewise with short-sales, trailing stop-losses on gap downs helps lock in profit, but stay with the stock as long as possible. Always look for large volume spikes on the daily chart for a logical stop-loss point.
11. The use of the 20-day moving average in relation to the 50-day moving average is important in finding good signals. The mystery of why some signals with mediocre volume can do just as well as huge volume reversals has to do with the moving averages. When the “dead cross” has occurred, the 20-day moving average crossing below the 50-day moving average, it’s going to take massive volume to reverse that downtrend. However, when a reversal pattern occurs at the 20 or 50 day moving average, it has found clear support and doesn’t need the huge volume; a good reversal signal will do. A stock that finds resistance at the 50-day moving average doesn’t need the massive volume to show that a reversal has taken place and is ready to short. A stock in a sustained uptrend that pulls back & has a reversal pattern is a good buy, & the same in reverse for short sales.
12. The use of Bollinger Bands is very helpful in determining the bottom when trying to buy a reversal pattern. When a stock makes a low but tags the lower band, this is often a continuation signal that lower lows are to come. However, when a new low is made inside the Bollinger Bands and a reversal pattern appears with heavy volume, this is a powerful signal. All of the best buy reversals exhibit this tendency. Not necessarily on short sales, because momentum can fade instantly. More often than not, buy reversals need time until all of the selling has been worked out of the stock. (CXW 2-10-10)
13. Using technical indicators in addition to Candlestick patterns provides excellent clues as to which reversal patterns will truly work out into the start of a new trend, rather than simply a dead cat bounce. Divergences on the Stochastic, MACD, Money Flow Index, Force Index, & R.S.I are very powerful when combined with a perfect reversal pattern.
14. Always check the chart to see where the reversal pattern has appeared. When short selling a stock, if the reversal pattern appears near a previous high, this enhances the signal. (ESI 01-28-10)
Also, if the reversal pattern appears at a prior gap, this also enhances the signal.
15. When the ADX meter is above 30 a stock is at an extreme, & there is a Candlestick Reversal pattern, this makes the signal extremely powerful. This shows that not only is a reversal being traded, but that it is a reversal in the direction of the dominant trend. The trade is being made after a counter-trend move that deviates from the dominant trend.