Robert Steinadler, 2 months ago

What are reverse candle patterns, and how do you read them?

Traders use different tools to get an idea of where the market is heading. Reversal candle patterns are one of these tools. They have become important, particularly when trading the crypto market since it is highly volatile. One aspect of volatility is that the market turns its direction violently. Reversal candle patterns can indicate when the time for a change has come. In this article, we will explore how they work, how to read them, and how they differ from retracements.

What is a reversal candle pattern?

Reversal candle patterns are formations in candlestick charts. They are indicating that the current trend has come to an end and that the trend will soon switch directions. Candlesticks charts are one of the most common tools in trading. Most traders use Japanese candlesticks, to which this article refers when discussing specific patterns.

There are two types of reversal candle patterns, and each represents a trend. A bullish reversal pattern occurs when the market switches from a downtrend to an uptrend. The other one is bearish reversal patterns that occur when a market changes from an uptrend to a downtrend.

Reversal patterns are distinguished in shape and their location within the trend. Each detail contributes to the interpretation of the pattern in question. Some have long wicks that indicate that the price met support or resistance, while others produce large candle bodies that indicate strong growth or decline in price. The location is also important since a bullish pattern needs to occur in a downtrend, where it marks a turning point, while a bearish pattern appears at the top of an uptrend.

What is the difference between a reversal and a retracement pattern?

A retracement pattern is very similar to a reversal, but it indicates something different. Reversals indicate a change in the larger trend, while retracements indicate a change in the short term.

Most retracements are connected to steep price movements. After a rally, buyers are exhausted, and some investors start to sell to cash in profits. The price drops to a certain level only to pick up again and continue the original bullish trend. An opposite scenario is when sellers are exhausted, and buyers are willing to scoop up as many coins for a cheap price. In effect, the price rises, but after reaching a certain level, buyers are exhausted again, and the bearish trend will continue.

Bullish reversal candlestick patterns

These patterns are used to predict when the market sentiment will change, and the current downtrend is coming to an end. Once the pattern is confirmed, it indicates the possibility that the market will rally. However, it does not indicate for how long the bullish trend will continue. When looking at a weekly time frame, it becomes apparent that bullish trends can last very long in crypto. Most bull markets have rallied for more than a year. Bullish reversal patterns can help to spot the beginning of a bull market on higher time frames as early as possible.

The three white soldiers

This pattern consists of three consecutive candlesticks. Each opens within the previous candle's body and closes above the previous high. It indicates strong intraday volatility with an increasing demand that effectively pushes the price higher with each new candle. The bodies of the candles are long, and there are no wicks or at least very short ones. The wicks are important because they indicate that the rally only saw minimal setbacks on each candle. The three white soldiers are indicating that the bulls are taking over. Should the trading volume expand together with each candle, the signal is considered to be even stronger.

The dragonfly doji

This is a very particular doji pattern that occurs when the market closes and opens at the same price. The candle has no body. Instead, there is a long wick to the downside called shadow or lower tail. This gives the dragonfly doji its typical t-shaped form that resembles a dragonfly. It indicates a powerful bullish shift because the bears failed to push the price down further. Instead, buyers stepped in and took the opportunity to scoop up the coins, effectively pushing the price to the same level as the opening.

The morning star pattern

The morning star consists of three candlesticks, with the first candle having a large body and a bearish direction. The second candle is pushing the price even lower only to rebound a little bit, leaving it with a small body and often time two wicks attached to it. The third candle, on the other hand, has a large body and a bullish direction. This indicates that a strong reversal is occurring, which is underlined by the fact that the price almost fully recovered with the third candle.

Three-line strike

The three-line strike pattern consists of four candlesticks, with the first three candles being bullish. Each of them is closing higher than the previous candle, followed by a strike down at the fourth candle, effectively pushing the price back to where it started. While the last candle creates a bearish signal, the three-line strike pattern is often interpreted as a signal that a dip has occurred. Meaning that the fourth candle is a signal to enter the trade since it is assumed that the uptrend will continue after the pattern is completed.

The morning doji star

This pattern is very similar to the morning star described above. Both are in fact cousins, and the morning doji star also consists of three candlesticks. The only difference between the two patterns is that in this case, the second candle forms a doji.

Bullish engulfing

The bullish engulfing pattern consists of two candlesticks, with the first candle being bearish. It often forms a long body with no or short wicks at both ends. The second candle, on the other hand, is bullish. Its body is fully engulfing the first candle, meaning that it forms a lower low but also closes with a higher high than the first one. Hence, the name bullish engulfing. This pattern is creating a powerful signal because after the market touches a new low, it almost immediately rebounds and rallies to a new high.

Bullish abandoned baby

This formation is a three-candlestick pattern. Its first candle is large and bearish, and the second has a rather small body. The third one, however, is bullish again. The bullish abandoned baby is a variation of the morning star pattern. The difference between both formations is that the abandoned baby is that the second candle gaps below the lower wick of the first one and the third candle gaps above the second.

The piercing line

This formation consists of two candlesticks, with the first candle being bearish. It has a mid to large-sized body. The second candle indicates the trend reversal by being bullish. It forms a new low but pierces back to the upper half of the first candle, where it closes. This indicates that the market found a new low, but right after that happened, the market started to rally.

Hammer candlestick

The hammer is a pattern with a single candlestick, which makes it particularly easy to spot. Its body is relatively short, with a long wick to the bottom of the candle. The colour of the candle is not relevant, and there might be a very short wick attached to the top of the body, but it doesn’t have to. The hammer indicates that incoming sell pressure was caught up by buyers, which pushed the price back up above or near the opening. This formation is even more powerful if the hammer marks the exact bottom candle of a downtrend, which requires the second candle that follows to confirm the trend reversal.

The bullish harami

A bullish harami is made of two candlesticks. The first candle is large and red, while the second is a small green candle. With the first candle being bearish and the second moving higher but with a small body, the pattern indicates that the sentiment is about to change. What seems to be a consolidation, at first glance, turns out to be a shifting trend.

Inverse head and shoulders

The head and shoulders pattern indicates the upstart of a bearish trend. However, the inverted version is signalling a bullish reversal. The pattern consists of multiple candles and is, therefore, a chart formation that takes time to complete. The left shoulder creates a low, the head is forming a new low, while the right shoulder forms a higher low again. Both shoulders can find their respective lows on the same level, but they don’t necessarily have to. Between each shoulder and the head, a relief rally happens, and the local top can be connected with a straight line.

This is the so-called neckline. Should the price rally after the right shoulder is completed AND the neckline is broken, only then the inverse head and shoulders pattern is considered to be confirmed.

Bearish reversal patterns

These patterns indicate when an uptrend is ending, and a reversal is about to happen. A reversal pattern suggests that traders act accordingly and close long positions, liquidate crypto assets on the spot market or open a short position in the derivatives markets to hedge their bets.

The shooting star

This is a single candle pattern that appears at the very top of an uptrend. Its body is small, and a long wick is formed to the upside, indicating that the bulls are exhausted and that selling pressure occurred when reaching a higher price range.

Dark cloud cover

This is the bearish variant of the piercing line pattern described above. The first candle is bullish, while the second turns bearish after reaching a higher high.

The evening star

The evening star consists of candlesticks and is the bearish variant of the morning star pattern described above. It indicates a downtrend, with the second candle failing to continue upwards and the third one falling back to the opening of the first.

The hanging man

Again, this is a single candle pattern that forms a small body and a long wick at the bottom of the candle. The candle can either be green or red and resembles the same features as the hammer candlestick. The crucial point is the location of the candle. If it occurs at an uptrend, it indicates a strong reversal.

Bearish abandoned baby

This is the bearish version of the bullish abandoned baby pattern and a variation of the evening star. Again, the pattern suggests that the rally has come to an end or failed, with the third candle turning bearish. It retraces all or almost all the gains that were made during the first candle.

Bearish engulfing

This is the bearish version of the bullish engulfing. Therefore, this is a two-candle pattern, with the first candle being bullish. However, the second candle is bearish and engulfs the first one fully by reaching a new high and a new low.

Evening star doji

This is a variation of the evening star pattern. The second candle is a doji that indicates that there is an indecision at the top of the uptrend. The third candle confirms this and completes the pattern by turning bearish, suggesting that a stronger correction might follow completion of the pattern.

The three black crows

This is a three-candlestick pattern, with each candle being red. It indicates a strong downtrend as the decline continues with each candle. The body of those candles is large and they have no or small wicks.

How to trade reversal patterns?

When spotting a reversal pattern, there are some things that a trader might want to consider:

  • If a position is already in profit, a bearish reversal pattern can indicate that it is time to realize profit by closing the trade. On the flip side, if no position is open, a bullish reversal might create a buying signal.
  • Other factors like the trading volume or fundamental news can influence how strong or weak the signal is that has been given by the reversal pattern. When trading with a stop loss and receiving a weak signal, it might be as well an option to adjust stops rather than selling.
  • When no position has been entered, a bearish reversal pattern might create a signal to stay flat in the spot market rather than to buy and hope for the uptrend to continue.

Are reversal patterns reliable?

A pattern by itself is just creating a signal that a trend could potentially reverse. That being said, it doesn’t have to form a reversal necessarily. Analyzing candlestick patterns is just one of many tools that help to make decisions when trading. It is the confluence of using pattern analysis along with other market data that creates an edge for traders. The same can be said about all other tools in trading, such as oscillators.

When using this particular tool, one should always consider other data and take current events into account. For instance, if there is an evening star pattern forming for Bitcoin in the daily chart and a few hours later, the U.S. confirms that it will adopt BTC as its national currency, it is easy to see that the pattern would fail to play out.

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