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Trading Ideas - Candlesticks as Valuable Confirmation Tools

Posted May 27, 2010

Topics: Finance & Investing

If you have taken a look at candlestick charts, you probably have a good basic understanding of how it works. A few exceptionally strong candlestick formations can help you to vastly improve your entry and exit timing, and build more profits while reducing future losses.

Candlesticks tend to have interesting and descriptive names. These names usually have a lot to do with the shape and size of the sticks themselves. There are four exceptionally good patterns, all containing three consecutive sessions. They all serve as potential reversal signals. These are:

            1. Three white soldiers. This descriptive pattern has three white candles, each opening and closing higher than the day before. A white candle occurs in any session that moves upward. So each day’s high is higher than the previous, and each day’s low is also higher than the previous. This is a strong uptrend and, if it appears at the bottom of a downtrend, it is a good sign of a reversal.

            2. Three black crows. This is the opposite of the three white soldiers. It consists of three consecutive black sessions, each opening and closing lower than the one before. A black candlestick means the price movement for the day was downward. In this pattern, each day’s opening is lower than the day before; it moves downward and it closes lower as well. If you see this after a big uptrend, it means things have turned around and the price is moving down.

            3. Bull squeeze alert. This is another three-day pattern. In its strongest form it has three black candlesticks. This usually means a bearish trend. But in this case, each day is smaller than the day before. The opening is lower and the closing price is higher, so each day’s range is smaller. This is a bullish pattern because the range of decline is falling; and the declining range means things are going to turn around. The most important of the three is the first day, which sets the tone as bullish as long as the next two days are “inside days” (closing and opening in a smaller range on both sides).

            4. Bear squeeze alert. Here again, the candles seem to fly in the face of what most patterns reveal. The mood is bearish even though the candlesticks are white. (At least the first one is; the strongest indication is found when all three are white, however.) Like the bullish version, days two and three are inside days. Even though they move upward, the range between opening and closing price is declining. As a result, expect the uptrend to stop and for a downtrend to be the next move.

Candlestick interpretation is at times complex, but these revelations work best when they are confirmed by other indicators, either subsequent candlesticks or traditional technical signs like breakouts, runaway gaps, triangles, or head and shoulders formations.

In my upcoming book, Trading with Candlesticks (FT Press), I explained these and dozens of other candlestick patterns and showed how signs of change, especially reversal, can be found and acted on before most traders recognize what is going on. That’s the key, getting a jump on the crowd by smart analysis of signs that are often subtle.