The Need-to-Know Candlestick and Chart Patterns
We run down the essential day trading candlestick and chart patterns every new trader should learn to recognize
The market is a creature of repetition. Day in, day out traders spot common patterns in candlesticks and the stock chart to help decode price action. By learning to identify these candlestick patterns and chart patterns traders can pre-empt future breakouts and trend reversals.
How? Every candlestick tells a story. Every stock chart, a saga. The battle between the bulls and bears. Buyers and sellers. Supply and demand. Fear and greed. Stock charts convey so much information, it’s easy to get lost in the analysis. Identifying patterns in candlestick charts can help cut through some of the noise of price action and reveal signs of future price movements. Patterns reveal opportune moments to buy and sell stocks, options, futures, crypto, or any other financial instrument you choose to trade.
In this article, we take you through the essential candlestick and chart patterns regularly used in day trading setups. We discuss the theory behind the patterns and show you how to trade them. Learn to recognize and master these simple chart patterns to improve your day trading success.
Best Day Trading Candlestick and Chart Patterns
There are hundreds upon hundreds of different patterns traders can look for in stock charts. It’s certainly not necessary to know them all. Rather, we suggest beginner traders focus on a few different setups to see if they work with their own trading strategy. To help get you started, we’re taking you through a number of our essential day trading patterns.
For simplicity’s sake, we’ve decided to split these into ‘Candlestick Patterns’ and “Chart Patterns’. Where:
Candlestick Patterns: Look at patterns formed by less than 3 candlesticks;
Chart Patterns: Look at patterns formed in an overall chart or more than 3 candlesticks.
While we have separated them into groups, please keep in mind that candlestick patterns and chart patterns are complementary and when taken together can provide a holistic picture of price action.
Before we get started, a short word of warning. While many traders find that candlestick patterns and chart formation can help bring clarity to their charts, many others struggle with seeing patterns clearly. The difficulty is that it’s easy to be swayed by your own bias. Noticing patterns that support your position while ignoring others that go against you. Reading patterns in candlestick charts is not an exact science — it takes time to familiarise yourself and build up the skill to identify formations accurately.
Japanese Candlestick Patterns for Day Traders
Japanese Candlesticks provide a visual representation of price action. Created in the late 1700s by legendary rice trader Munehisa Homma who is largely heralded as the ‘Father of Price Action Trading’. Legendary because Homma is held to be one of the most successful traders to have lived, having made the equivalent of $10 billion in today’s money by trading the Japanese rice markets.
Each day Homma would record the open, close, high, and low of the rice market in a shape now known as the ‘candlestick’. From there he began to see repetitive patterns that we now recognize as ‘Doji’s’, ‘Hanging Man’, and ‘Stars’. These patterns helped Homma predict the future direction of the rice market. Fast forward to today and the Homma’s Candlesticks are the default chart setting for most trading and chart analysis platforms.
Why Day Traders Use Japanese Candlesticks
You will all no doubt recognize the Japanese Candlestick. For beginner traders, this is the first chart style they are introduced to. So, it may surprise some of you that the modern Japanese candlestick only rose to mainstream prominence in the late ’90s and early 2000s. Prior to this traders commonly used the American bar charts. Why did traders switch to Japanese Candlesticks? For its superior visual appeal that allows for quick and efficient technical analysis and the sheer depth of knowledge that is revealed at a single glance. In one quick look, a candlestick conveys all a trader needs to know about price action, volume, buying pressure, selling pressure, and momentum.
How to Read Japanese Candlesticks
Each Candlestick represents the price open, high, low, and close of a particular time period. I.e. a one hour candle is one hour of trade data. Candlesticks illustrate this data in an appealing and efficient drawing composed of the following parts:
Candlestick Real Body
The Candlestick Real Body represents the difference between the asset’s open and close price for the candlestick’s time period.
Where the real body is large, this means that there was a substantial difference between the opening and close prices of the stock for that time period. Where the body is very small or non-existent, this means that the open and close price was very similar or the same.
Candlestick bodies can be represented as green/red candles or white/black candles depending on the charting software color scheme. A green or white candle is used when the close price is higher than the open price, meaning that the stock price has risen during the time period. A red or black candle is used when the close price finishes lower than the open price, meaning that the stock price fell during the time period.
Candlestick Shadows or Wicks
The thin lines above and below the candlestick body are known as the wicks or shadows. They represent the range of price movements above and below the open and close prices.
The Upper Wick represents the high price for that time period with the Lower Wick representing the price low.
The visual nature of the Candlesticks allows traders to see Price Direction, Price Range, and Momentum. The power of Candlestick Chart Patterns lies in their repetition so we’re going to take you through the most powerful Candlestick Patterns for day trading.
The Hammer Candlestick Pattern
A Hammer Candle is formed when a stock trades significantly lower than the opening price but rallies to close near the open and well above the period’s low point. This forms the characteristic hammer shape — little to no upper wick, small real body, and lower wick two times the size of the real body.
The existence of a Hammer Candle tells you that there was strong selling pressure at the start of the time period that has been engulfed by strong buying pressure at the end of the time period.
Hammer Candlesticks tend to form at the end of a downtrend, signaling that the price is close to reaching the bottom. This can be a sign of a bullish reversal happening which should be confirmed by the following candle closing above the hammer low.
Shooting Star Candlestick Pattern
The opposite of the Hammer Candlestick is the Shooting Star Candlestick. They form at the end of an upward trend, signaling a bearish reversal that suggests the price has reached its peak.
A Shooting Star Candlestick is formed when a stock trades well above its open but drops as sellers step in and push the price back down toward the open. This gives the Shooting Star its characteristic long upper shadow that’s double the length of the real body, small real body, and little to no lower shadow.
Where bearish reversal is not supported by the next candlestick and price continues to rise, this price range around the shooting star may still act as an area of resistance.
The Engulfing Candlestick Pattern
The Engulfing Candlestick Pattern is a two-candle reversal pattern that can be a signal for either a bullish or bearish reversal. They are powerful patterns that provide strong indications of price reversals. We explain both ways below.
Bullish Engulfing Candlestick Pattern
A Bullish Engulfing Candlestick Pattern occurs at the end of a downward trend where the real body of the first candle is completely engulfed by the real body of the second candle. This signals a bullish trend reversal pattern so the first candle should be red and the second candle green. The larger the second candle, the more significant the signal. If a bullish engulfing candle is accompanied by an increase in volume this further increases the strength of the buy signal.
Bearish Engulfing Candlestick Pattern
A Bearish Engulfing Candlestick Pattern occurs at the end of an upward price move where the real body of the first candle is completely engulfed by the real body of the second candle. This signals a bearish trend reversal so the first candle should be green and the second candle red.
Doji Candlestick Pattern
The Doji Candlestick or the Doji Star is a signal of indecision in the market. Neither the bulls nor bears are in control so there is a price standoff. Many traders see Doji as a sign of a possible upcoming reversal of trend or that momentum is building and a breakout may be on the horizon. It has the characteristic look of a ‘cross’ or a ‘plus sign’ as the stock’s open and close prices are virtually the same. There are a number of different types of Doji’s that can be formed depending on where the open and close fall. These are:
Doji Star — Neutral signal. Wicks are of similar length.
Gravestone Doji — Bearish signal. Long upper wick shows rejection of higher prices.
Dragonfly Doji — Bullish signal. Long lower wick shows rejection of lower prices.
Chart Patterns for Day Traders
Going back to trading legend Homma, when he discovered the existence of candlesticks patterns, he went back and analyzed the price movements of the rice markets for the preceding hundred years. What he found was the same patterns forming right before the market was about the change directions. These patterns and formations repeated themselves time and time again, all the way back to the creation of the modern rice market.
Here are some of the frequent and powerful patterns and formations used by modern-day traders.
Bull Flag and Bear Flag
A strong continuation pattern that represents a brief pause in an upward trend. The formation resembles a flag on a pole where the pole forms resulting from a sharp rise in stock price. The flag can either be a horizontal rectangle or a downward channel that represents a consolidation of price and reduction of volume. When volume begins to build, traders can expect a strong price breakout resembling the length of the previous flagpole.
The psychology behind the Bull Flag formation is that after a strong rally, bears step in to try to bring the price back down but are being squeezed out of their position by bulls. The price then jumps swiftly higher and the upward trend continues.
A Bear Flag is the same formation just inverted and is a powerful signal for the continuation of a downward trend.
How to Trade the Bull Flag
- Mark the bottom and top of the upward trend (flagpole) and identify the upper and lower boundaries of the consolidation channel (flag).
- If the price retracement is greater than 50% of the flagpole, then the formation may not be a flag.
- Keep an eye on volume. If volume is rapidly building, enter a long position either at the bottom of the flag or the top of the flag in anticipation of a breakout.
- The breakout should be similar to the length of the preceding flagpole.
Bullish Pennant and Bearish Pennant
Bullish Pennants are continuation patterns very similar to Bull Flags. The difference being that the consolidation period looks like a pennant or triangle at the end of the flagpole, not a rectangular channel (Bull Flag). The converging support and resistance lines of the flag pole
A Bearish Pennant is the same formation just inverted and is a powerful signal for the continuation of a downward trend.
How to Trade the Bullish Pennant
You can trade Bullish and Bearish Pennants in a similar way to Flag patterns. Conservative traders should wait for confirmation of the direction of the breakout first as it could go either way.
The Falling Wedge is a bullish chart formation formed by two downward sloping and converging trendlines. The two trend lines slope at different angles giving the appearance of a wedge. Bears start to lose momentum as the bulls step in to slow down the rate of price decline. The formation occurs during a downward trend and is generally a strong indication of a reversal of the trend to the upside.
The opposite of the Falling Wedge is a Rising Wedge which is usually observed in downward trends.
How to Trade the Falling Wedge
- Identify the downward trend by marking the lower highs and lower lows with trendlines.
- Keep an eye on volume. If volume is rapidly building, enter a long position in anticipation of a breakout or wait for the confirmation of the breakout.
- Place your stop loss and profit targets according to the previous levels of resistance or with regard to your own risk to reward ratio.
Remember that fake breakouts occur often so trade management, including the setting of mental stop losses is always necessary.
Unfortunately, there is no trading crystal ball and no foolproof way to predict the market 100% of the time. Luckily, as traders, our job is not to be right all of the time. We just have to be right more often than not and not lose more than we gain. We do this by using technical analysis to read the charts and strict trade management.
The market is reflective of human nature. We are creatures of habit so the market is a creature of repetition. Learning to spot these repetitive patterns can assist traders to understand market sentiment and see potential breakouts.