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Candlestick Charts

Candlestick charts can be extremely helpful in spotting stock or market reversals. Developed in Japan, they are now in frequent and increasing use in the United States and elsewhere. Their power lies in their ability to not only depict the price action of the underlying security or index, but also the emotional context in which it took place. Below are a few examples of typical candlestick charts. This is by no means an exhaustive list, as the use of candlestick chart patterns techniques is a study in itself.

Candlestick charts have individual lines that look like candles, hence their name. Candlestick lines consist of a rectangular "real body," which defines the closing and opening prices for the session. When the close is higher than the open, the real body is white. A black real body forms when the close is lower than the opening.

Candlestick Chart 1
The thin lines above and below the real body are called "shadows." They represent the extreme highs and lows of the session. The bottom of the lower shadow underneath the real body is the low of the session. The top of the upper shadow is the high of the session.

The interpretation of any candlestick chart is, of course, subjective, and depends upon its context. For example, whether it is occurring during an uptrend or downtrend, whether there other patterns confirming its validity, whether the pattern is confirming previous support or resistance areas, where it occurs in relation to certain moving averages, whether it is accompanied by above average volume, etc..

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One Candlestick Chart Patterns

The simplest form of candlesticks are called "umbrella lines." They are the simplest lines because they do not necessarily have to be spotted in combination with other candles to have some validity. Their shadows should be at least twice the length of their real bodies and their real bodies should be small. The two forms of umbrella lines are the "hanging man" and the "hammer."

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The hanging man appears during an uptrend, and its real body can be either black or white. While it signifies a potential top reversal, it requires confirmation during the next trading session. The hanging man usually has little or no upper shadow.

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The hammer appears during a downtrend, and can be either black or white. It signifies a potential bottom reversal and, like the hanging man, has little, if any, upper shadow.

Other candlesticks similar to the hanging man and hammer are the "shooting star," and the "inverted hammer." Both have small real bodies and can be either black or white but they both have long upper shadows, and have very little or no lower shadows.

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The shooting star is a bearish candle and appears in an uptrend.

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The inverted hammer is a bullish candle and appears in a downtrend.

Two Candlestick Chart Patterns

"Engulfing patterns" are two-candle chart patterns which are either bullish or bearish, depending upon whether they occur during an uptrend or downtrend.

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A "bullish engulfing pattern" signifies that the buyers are overwhelming the sellers, and consists of a large white real body that engulfs a small black real body during a downtrend.

A "bearish engulfing pattern," on the other hand, occurs when the sellers are overwhelming the buyers. It consists of a long black body real body engulfing a small white real body.

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A "dark cloud cover" is a bearish reversal signal that occurs during an uptrend. It consists of a long white candlestick that is followed by a black candlestick that opens higher than the prior white candlestick's high, and that closes at least half-way into the white candlestick's real body.

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The bullish counterpart to the dark cloud cover is the "bullish piercing pattern." It occurs during a downtrend, and consists of a long black candlestick followed by a gap lower open during the next session, but which closes at least halfway into the prior black candlestick's real body.

Another two-candle reversal pattern is the "harami."

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In uptrends, the harami consists of a large white candle followed by a small white or black candle (usually black) that is within the previous session's large real body.

In downtrends, the harami consists of a large black candle followed by a small white or black candle (usually white) that is within the previous session's large real body. This pattern signifies that the immediately preceding trend may be concluding, and that the bulls and bears have called a truce.

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When the second candlestick is a doji, which is a candle with an almost non-existent real body, these patterns are called "harami crosses."

Three Candlestick Chart Patterns

There are also three candlestick charts. Two of these are the "evening star" and the "morning star."

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The evening star is a top reversal pattern formed by a tall white body candle, a second candle with a small real body that gaps above the first real body to form a "star," and a third black candle that closes well into the first session's white real body.

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The morning star is the reverse of the evening star, and is a bottom reversal pattern formed by a tall black body candle, a second candle with a small real body that gaps below the first real body to form a star, and a third white candle that closes well into the first session's black real body.

If the middle candle of either of these two patterns is a doji, these two patterns are called evening star or morning star dojis.

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How Candlestick Charts Are Used To Spot Reversals

Leading stocks suffer from bouts of selling just like other stocks. This selling pressure can be created by market downturns, analyst downgrades, negative news about the stock, or a sector temporarily falling out of favor, etc. At Stock Confidential, we examine these downturns for signs that the stock is ready to head back up again.

We look for several things in our featured reversal stocks. These include 1) A stock with solid fundamentals or leadership potential, 2) A stock that is reaching an area of price support, such as its 20, 50, or 200-day moving average, 3) Recent climactic volume, and 4) A stock that is forming one or more reversal candlestick charts.

Solid Fundamentals or Leadership Potential

Most of the reversal stocks we feature rank in the 80's or 90's in EPS (earnings per share) and RS (relative price strength) as ranked by Investors Business Daily. These are generally considered the market's best-performing stocks. But we also occasionally consider past winners that are trying to regain their dominance.

Varian Medical Systems (symbol: VAR) sported a 94 EPS (earnings per share) rating and a 92 RS (relative price strength) reading when we saw its shares plummet for some unknown reason. Moreover, the stock was in one of the market's strongest industry groups with an "A" rating in this category, and it had a solid "B" accumulation rating, so there was no lack of potential buyers for the stock.

Reaching An Area of Price Support

VAR slashed below its 50-day moving average (the bright green line), an area of support for the stock in the past. Large institutional investors (mutual funds, investment houses, etc.) typically buy quality stocks at or near their 50-day moving averages.

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Recent Climatic Volume

In addition to hitting a traditional support area, the stock experienced huge, climactic volume (see the "up" arrow in the volume portion of the above chart). Seeing this in the absence of any news or other factual reason for the stock's decline, we featured VAR at a buy point slightly above its close at $49.15.

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Since reversal stocks are riskier to trade than breakout stocks, and can take longer to turn around and head back up again than expected, VAR dropped another $1.55 the day after we featured it. But the day after that, the stock gapped up $4.84, tacked on another .92 the day after that and another .78 after that. Had you sold the stock four days after we featured it, you would have pocketed a $4.89 gain!

Candlestick Chart Reversal Patterns

Sometimes, a stock will flash one or more candlestic reversal patterns in addition to the other technical criteria discussed above, just before it potentially turns and heads back up again. Here's Avocent (Symbol: AVCT), descending below its 50-day moving average support area (bright green line). There is no climactic volume, but the stock has formed an inverted hammer/doji after several big down days.

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Having exhausted its downward momentum, Avocent was now free to head back up above its 50-day moving average in a big way. From its $21.89 close on the day it formed the inverted hammer/doji, to its close just seven days later, it notched a $5.52 price move, which would have given you a nice profit, thanks to candlestick charts.

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