Japanese Candlesticks Theory

 Hammer and Hanging Man
 Engulfing Pattern
 Dark Cloud Cover
 Piercing Pattern
 Morning and Evening Stars and Doji Stars
 Shooting Star and Inverted Hammer
 Harami
 Continuation Patterns
 Doji

 Hammer and Hanging Man
o Candlestick Reversal Patterns
Reversal signal indicates that prevailing trend may change. This means that market may become flat, or
may move in the opposite direction. Any reversal signal should be treated only as a sign of the fact that
the prevailing trend may change, not as a signal of a new trend or the reason to initiate a new position
in the opposite direction. To consider the opening of a new position global tendency should be analyzed
more carefully but in order to offset position reversal signals may be and should be used.

Let’s begin with the most strong reversal signals, which more often than not produce opposite to the
main trend price behavior.

The Hammer and the Hanging Man

The Hammer is a candle with a short real body and a long lower shadow, which appears after a
downtrend. The Hammer is a strong reversal signal that a bearish trend is weakening:

The Hanging man is a candle with a short real body and a long lower shadow. which appears during a rally indicating forthcoming reversal: .

The longer the lower shadow the shorter the upper one. and the smaller the real body the higher hammer’s or hanging man’s potential.How to define the hammer and the hanging man:  Real body of any color is in the upper price range. but hanging man’s black body is more bearish signal and hammer’s white body is more bullish signal:  Hammer’s white body signifies that despite the fact that the prices at the opening were falling. The more the price gap between the hanging man’s real body and the next bar open price. the more probability that hanging man will form the high. .  Close price of the next bar’s black candle is under the hanging man’s close price.  Lower shadow as the bottom more than twice longer than a real body. Hanging man’s confirmation signals:  The next bar opens under hanging man’s real body. Real body of such a candle can be both white and black.  Candle does not have an upper shadow or has a very short one. at the end of the period bulls were able to drive the closing price to the maximum. Therefore we can assume that bulls have become more aggressive.  Hanging man’s black body signifies that closing price could not rebound to the opening level so it assumes bears’ potential gathers momentum.

It is worth mentioning that the hanging man is formed close to the prior candle high. and the hammer is formed close to the prior candle bottom. if before the formation of the pattern there has been downtrend or uptrend respectively.  The second real body should be of the opposite color and be white if the bullish engulfing pattern is formed and be black in case of the bearish engulfing pattern. Bullish and Bearish Engulfing Patterns .  The second real body engulfs the body of the first candle (shadows may be not engulfed).Confirmation signals for the hammer are diametrically opposite. Important: The hammer and/or the hanging man behaves in accordance with the theory.  Engulfing Pattern The Engulfing pattern is formed when:  There is a distinct tendency on the market either down or up (even a short- term).

and after the long term uptrend tiny black real body is engulfed by a tall black real body of the second candle. This means that after a long-term downtrend tiny white real body is engulfed by a tall white next candle's real body. Bearish Engulfing Pattern .There is an exception for the third point when the real body of the first candle is too short so it is considered to be a doji.

Bullish Engulfing Pattern Factors that increase the importance of Bullish and Bearish Engulfing Patterns:  The first candle has a tiny real body and the second candle has relatively longer one.  The second candle engulfs several real bodies.  The second candle is associated with a large volume trading. . This means that the prevailing trend is blowing off. This means that the trend has come to the end. If trend is a long- term then all buyers (sellers) have taken their decisions and no more buyers (sellers) are expected to initiate positions. Fast price movements “spread” the market and make traders to fix quick profits/losses by closing positions.  The pattern appears after a long-term or impetuous tendency. The previous trend is being swept away by the opposite forces.

The lower the close price of the black candle the more chances to form the high.  Dark Cloud Cover The Dark Cloud Cover pattern appears after an uptrend (or near upper price ranges) and has two candles: Dark Cloud Cover The first candle is white with a strong real body. It is considered that close price of the black candle should cover more than 50% of the prior white candle's real body. covering most of the white candle. Then the next candle opens above the high of the prior white candle – a bullish signal. . Bulls may think that they control the situation but then price rising stops. but the bar closes near the low and covers most of the prior candle’s white real body. Bullish positions become unprofitable. Now Bears have the target for Stop Loss orders (the high of the second (black) candle of the pattern). In another words. at the first stage we see that the market is rising (white candle). The next bar open price is above the high of the previous bar. Bears become more aggressive and the candle closes near its lows.

 If during a long-term uptrend white candle with a long real body and no shadows are formed and next day a black candle with a long real body and no shadows are formed then they say that there is “a black day with cut high and bottom”.  The second bar is associated with a large volume trading and it means that the uptrend is blowing off. This means that bullish tendency is weakening and chances are that the high will be formed. .Dark Cloud Cover Factors that increase the importance of the Dark Cloud Cover pattern:  The more the black candle's real body covers the white candle’s real body the stronger the pattern. Piercing Pattern The Piercing Pattern is the opposite of the Dark Cloud Cover.  If the second candle in the pattern opens above the important resistance level but then the price falls below this level.

Example of the Piercing Pattern The Piercing Pattern appears after a downtrend and is formed with two candles:  the first candle has a black real body and the second one has a white long body. which forms the price gap with the prior candle with the bigger real body: .  the white candle opens under the black candle bottom and closes above the prior black candle center.  Morning and Evening Stars and Doji Stars Star is a candle with a small real body.

Any star. Sometimes the pattern has more than one star. and it has a bearish character: . which real body covers most of the prior black candle's real body: The Morning Star A tall black candle is a strong bearish signal. The Evening Star is an opposite pattern to the Morning Star. after a gap. The main factor of importance is how deep the third candle pierces the first candle. Stars reversal patterns:  Morning Star. It is formed as a candle with a long black body which is followed by a candle with a small body (a star). The color of the star does not matter. especially a doji one. indicates that the trend may reverse.  Evening Star. Bulls become more aggressive as strong white body is being formed. Morning and Evening Stars The Morning Star pattern is a bottom reversal signal.Morning and evening stars It is required to have a gap between candle bodies (shadows may intersect). A small real body assumes that the fight between bulls and bears has reached a deadlock. Then we see that a candle with a small body is formed - this means that bearish trend weakens. In the ideal pattern the gaps between real bodies should be both before and after the middle candle (a star).  Shooting Star In all the patterns star’s real body can be of any color. If the opening price of the star is at the same level as the closing price it is called a doji star. Although the second gap is a rare thing it does not make the pattern less effective.  Doji Star. The third bar is a white candle.

The Evening Star Intensifying factors for the Morning / Evening Star pattern:  the second gap. Doji star In case of a doji star (a star with no real body.  the more the third candle’s real body covers the real body of the first candle the stronger the pattern.  lower volume on the first candle and higher volume on the third candle. This means that there is a strong signal for reversal: . open price at the same level as close price) Morning Doji and Evening Doji stars are formed.

Morning and Evening Doji stars  Shooting Star and Inverted Hammer The Shooting Star and the Inverted Hammer are the next reversal signals but not so strong as the previous ones: The Shooting Star and The Inverted Hammer Their characteristics:  A small real body of any color is at the bottom of a candle. A real body of the ideal Shooting Star / Inverted Hammer and a prior candle's real body have a gap between them but it is not required.  Upper shadow is very long. .  Lower shadow is very small or missing.

The long candle is a "mother" and the short candle is her "baby": Harami If in the engulfing patterns candles should be of different colors for Harami it is not a requirement.The Shooting Star  Harami Previously described patterns have quite strong reversal characteristics. The second candle with a short real body is placed inside relatively long real body of the prior candle. Size and relative position of the shadows do not matter. and Harami pattern is used for predicting a flat market. Harami (in Japanese means "pregnant") is a pattern formed with two candles. The smaller the second real body the . The second candle’s real body must be completely inside the first candle. The only requirement for Harami is that its second candle’s real body must be short and the first candle’s real body must be long.

If prices rebound and gapping disappears but opposite to the prevailing trend market participants are still aggressive then wait for the reversal. As a rule once the gap is formed price moves back so it is a good time to initiate a position. when it is time to rest – rest". Such a pattern is more significant as it is comprised of an "almighty" doji. As in the Japan saying: "Stomach is 80% full".better the signal. In the future gaps will be support or resistance levels. . Most of the continuation patterns signal that the market has resumed the trend taken before the continuation pattern emerged. An example of the Harami pattern  Continuation Patterns As the Japanese say: "When it is time to sell – sell. Place Stop Loss orders under (above) the gap when opening a buy (sell) position. If the second candle is a Doji then Harami is called a Harami Cross (or a Petrifying Patten). or when bar high is below the prior bar low we see the formation of a price gap. when it is time to buy – buy. Analysis rules:  If once a gap has appeared and you have register from eight to ten rising highs (falling lows) then wait for the correction. Gaps When bar low is above the prior bar high.

Three Stars is a rare but significant reversal pattern.  If gap is not closed within next three bars then wait that the market will move in the gap direction. Rickshaw man and Gravestone Doji leave no chance for the upward momentum. When doji appears after a tall white candle it is time for the bulls to keep a bright lookout as it is the most meaningful signal. Three stars are formed by three doji. Once doji appears on the chart its open/close prices will be support/resistance levels. and the middle is a Doji star: The Three Stars pattern . 15 minutes charts are useless for analyzing this pattern as there are lots of them there. If doji is formed at the high this is the strongest signal of all as at the bottom doji’s magical abilities to reverse the market may disappear. Doji is important only on the markets where it appears rarely. Once the third gap has formed and you see the reversal pattern the prevailing trend is about to change.  Doji Doji is a candle which is formed when the bar open and close prices are at the same levels or have several pips difference: Examples of Doji Once doji has appeared on the chart you must consider that it is a strong reversal signal.  Once three gaps have been formed upward (downward) wait for the high (bottom).