Candlestick Patterns and the Way They Should be Taught

Image

If you search on google for the keyword Candlestick Patterns, I am quite certain that you will find a plethora of posts and videos talking about hundreds of different candlestick patterns with very complex names. From spinning tops to shooting stars, every single type of candlestick will have a pattern associated with it. I have never personally understood the reasoning behind giving such complex names to these patterns. After having read about 20 books on technical analysis and price action, I have an unpopular opinion that these names do not matter, and same is the case with a vast majority of candlestick patterns. I spend most of my time in a day reading charts and I can assure you that I don't remember more than 2 or 3 candlestick patterns by their names. The reason I wanted to write this blog post is to change this culture of drilling these patterns into retail traders without explaining why they work. There so many charlatans that claim of being technical analysis experts and charge thousands of dollars. Having done thousands of backtests over the last 20 years, I can assure you with 100% confidence that relying on any single technical indicator or candlestick pattern will never work in the long run. Despite that, these patterns are still good to have in your arsenal because they can sometimes help infer and predict price action. Let us go over some candlestick patterns and try to understand why they work. But before that, for new traders, we need to define what a candlestick is.

A Candlestick

Looking at investopedia, this is the definition of a candlestick that we find.

A candlestick is a type of price chart used in technical analysis that displays the high, low, open, and closing prices of a security for a specific period.

Candlesticks are important because they show us the battle of bulls and bears. If a price opens lower and ends up higher (green candle), that depicts that bulls are in control. Similarly, if the price opens lower, goes up very high but eventually closes lower as well, that means bulls tries to take control but bears defeated them. This is how I believe everyone should think about candlestick patterns. You will realize that having this type of thinking will help you understand these patterns instead of simply cramming their names and looking for them everywhere. Now that we have created a simple framework that we are going to use, let us go over some examples to drill this deep into your minds. Before we go to the section, it is pertinent that you always remember the importance of risk management when you are learning technical analysis and candlestick patterns. In your trading career, you will find out that most of these patterns only work about half the time or less. When they don't work, you need to have good risk management to get out of bad positions. Risk management is the holy grail of trading. Please do not forget that.

Battles of Bulls and Bears

TSLA Daily Chart

Instead of naming different candlestick patterns, we are going to do something different here. We are going to look at a few charts and see if there are any patterns that can illustrate how the battle between bulls and bears worked out.

There are four instances in this chart where a good battle took place between bears and bulls. In the first instance, we can see that the price was rallying for a few days. However, on November 27th, 2020, the price started low, went up very high but ended up very low as well. That tells us that bulls were in control at one point in the day but bears took control and defeated bulls thus closing the price close to the low of the day. In the next few days, we can see a reversal happen. On the next three instances, we observed a very similar pattern. Digressing a bit here, there's a great quotation, "Price has memory" that you need to remember. If a certain patter/type of battle keeps appearing on a chart, it has a much higher probability of panning out as compared to one-time battle.

On points 2, 3, and 4, we can see that we had a short term downtrend and the bears tried to make the trend continue. However, bulls took over and brought the price from a very low to either a middle ground or close to the high of the day. In the following days, we can see reversals happening

HD Daily Chart

So many things to learn from this chart. Let us start with point number 1 where we saw what folks call a "Bearish Engulfing Candle". In layman terms, that simply means that the bears were able to get the price down to ever lower the low of the previous day all the way from the top. People call this an engulfing candle because it sort of engulfs the previous candle. Sometimes, these candles can start a new short term trend as we can see here. After the engulfing by bears, the price went down.

The second point is actually very interesting and one of the higher probability setups you will find. When price continues to go in a trend for a long period of time before we see a candle where the opposite party completely defeats the trending party, we usually see a reversal from there. That is exactly what you see after point number 2. The reason this happened was because bulls had tried their hard to get the price up but bears were dominating and made the price go to the very low of the candle. I do not want to name these candles a lot but people usually call this an inverted hammer. Again, as you can now see, no one should really remember the names as there are so many. Once you understand what happens, it's easy to spot patterns.

Points 3, 4, and 5 are very similar and goes back to finding similar setups on a chart to increase probabilities. There were three times when the price was going in a downtrend before we got an indecision candle or a candle where bears were exhausted and bulls took over. After all such candles, we saw a reversal.

MRNA Daily Chart

With Moderna, we again see two bearish candles that engulfed the previous bullish candles. After the first candle, we immediately had an indecision candle where bulls and bears could not decide what to do. However, we had another engulfing candle at point 2 that started a downtrend. One thing to note here is that on a larger timeframe such as a weekly chart, the first engulfing candle would be enough to see that it started a longer term downtrend. After that candle, the price has never gone above the high of the candle. This is how we can gauge bullish and bearish pressure based on different candles to see if we should go long or short on a stock.

QQQ Daily Chart

Indices are slightly hard to trade solely based on candlestick patterns. However, we can see some pretty clear ones here that I wanted to discuss. The first two patterns were candles where bulls wanted to continue their run but bears defeated them getting the price close to the low of the candles. That initiated a short term downtrend.

The third is an interesting point where we again saw a bearish engulfing which started a slightly longer term downtrend. There are many small patterns after this candle such as an indecision green candle that started an uptrend, a hammer like candle that was a fake candlestick because the uptrend continued. Hammer like candlesticks are usually thought of as reversal patterns but they can also be thought of as bulls defeating the bears and price can potentially continue higher, which it did here.

Finally, the fourth point is again a hammer like candlestick that led to a big reversal. As I said previously, hammer like candles are mostly used to find reversals. But since the price went down and eventually came back, it also sometimes shows that bullish pressure is still there. The reason most people use them as reversal signals is that it gives us a sign of caution because there was a time when bears were able to get the price to the very low of the candle. Although bulls defeated bears for that particular candle, just the indication of bearish pressure is sometimes enough to infer a reversal.

BA Daily Chart

When you start finding candlestick patterns on charts, one thing you will realize is that there are many fakeouts i.e patterns that don't pan out immediately or don't pan out at all. There are many theories behind why this happens. One reason is that since most people know that retail traders are going to follow these patterns, they fake them to create liquidity in the market because people immediately start buying and selling on these patterns. Another reason is that these patterns are just not universal. They can show the battle between bulls and bears but new events, news, and other things come up that can affect that pressure.

In Boeing's chart, we can see that we had a huge indecision candle where bulls and bears could not decide which way to go. After a good up or downtrend, an indecision is a sign of reversal because the trending party is losing momentum. That is what we would have expected there but look at the large green candle the next day, which was a fake candle. After that, the price indeed started to go in a downtrend.

Final Thoughts

That is it. This was a short introduction to how retail traders should go about looking at candlesticks to gauge bullish and bearish pressure. I personally learned this way of looking at candlesticks from this amazing book by Alexander Elder called The New Trading for a Living. The book goes into length on many things we have discussed in this post. Please note that I have no affiliation with the author.

Finally, I would like to urge retail traders to spend time learning to read price action because it is an important skill to have in your arsenal. People forget that almost all technical indicators are simply extensions of price action since they are calculated based on the price and volume. Therefore, if you understand the tension between bulls and bears well, you will not need any technical indicators. Most of the examples we see in this post are also on daily charts. The same principles hold for weekly charts, intraday charts, or any other time period.