TRADING TECHNICAL ANALYSIS

GUIDE TO TECHNICAL ANALYSIS

The 5 Most Powerful Candlestick

Patterns
By ALAN FARLEY Updated April 28, 2021
Reviewed by CHARLES POTTERS

Fact checked by KIRSTEN ROHRS SCHMITT

Candlestick charts are a technical tool that packs data for multiple time frames
into single price bars. This makes them more useful than traditional open-high,
low-close bars or simple lines that connect the dots of closing prices.
Candlesticks build patterns that predict price direction once completed. Proper
color coding adds depth to this colorful technical tool, which dates back to
18th-century Japanese rice traders.

Steve Nison brought candlestick patterns to the Western world in his popular
1991 book, "Japanese Candlestick Charting Techniques." [1] Many traders can
now identify dozens of these formations, which have colorful names like
bearish dark cloud cover, evening star, and three black crows. In addition,
single bar patterns including the doji and hammer have been incorporated into
dozens of long- and short-side trading strategies.

KEY TAKEAWAYS
Candlestick patterns, which are technical trading tools, have been used
for centuries to predict price direction.
There are various candlestick patterns used to determine price
direction and momentum, including three line strike, two black
gapping, three black crows, evening star, and abandoned baby.
However, it’s worth noting that many signals emitted by these
candlestick patterns might not work reliably in the modern electronic
environment.
 01:42 / 01:42

Understanding Basic Candlestick Charts

Candlestick Pattern Reliability

Not all candlestick patterns work equally well. Their huge popularity has
lowered reliability because they've been analyzed by hedge funds and their
algorithms. These well-funded players rely on lightning-speed execution to
trade against retail investors and traditional fund managers who execute
technical analysis strategies found in popular texts.

In other words, hedge fund managers use software to trap participants looking
for high-odds bullish or bearish outcomes. However, reliable patterns continue
to appear, allowing for short- and long-term profit opportunities.

Here are five candlestick patterns that perform exceptionally well as precursors
of price direction and momentum. Each works within the context of
surrounding price bars in predicting higher or lower prices. They are also time-
sensitive in two ways:

1. They only work within the limitations of the chart being reviewed, whether
intraday, daily, weekly or monthly.
2. Their potency decreases rapidly three to five bars after the pattern has
completed.

Candlestick Performance
This analysis relies on the work of Thomas Bulkowski, who built performance
rankings for candlestick patterns in his 2008 book, "Encyclopedia of Candlestick
Charts." [2] He offers statistics for two kinds of expected pattern outcomes:

1. reversal - Candlestick reversal patterns predict a change in price direction

2. continuation - Continuation patterns predict an extension in the
current price direction.

In the following examples, the hollow white candlestick denotes a closing print
higher than the opening print, while the black candlestick denotes a closing
print lower than the opening print.

Three Line Strike

The bullish three line strike reversal pattern carves out three black candles
within a downtrend. Each bar posts a lower low and closes near the intrabar
low. The fourth bar opens even lower but reverses in a wide-range outside bar
that closes above the high of the first candle in the series. The opening print
also marks the low of the fourth bar. According to Bulkowski, this reversal
predicts higher prices with an 83% accuracy rate.

Two Black Gapping

Image by Julie Bang © Investopedia 2020

The bearish two black gapping continuation pattern appears after a notable top
in an uptrend, with a gap down that yields two black bars posting lower lows.
This pattern predicts that the decline will continue to even lower lows, perhaps
triggering a broader-scale downtrend. According to Bulkowski, this pattern
predicts lower prices with a 68% accuracy rate.

Three Black Crows

Image by Julie Bang © Investopedia 2020

The bearish three black crows reversal pattern starts at or near the high of an
uptrend, with three black bars posting lower lows that close near intrabar lows.
This pattern predicts that the decline will continue to even lower lows, perhaps
triggering a broader-scale downtrend. The most bearish version starts at a new
high (point A on the chart) because it traps buyers entering momentum plays.
According to Bulkowski, this pattern predicts lower prices with a 78% accuracy
rate.

Evening Star

Image by Julie Bang © Investopedia 2020

The bearish evening star reversal pattern starts with a tall white bar that carries
an uptrend to a new high. The market gaps higher on the next bar, but fresh
buyers fail to appear, yielding a narrow range candlestick. A gap down on the
third bar completes the pattern, which predicts that the decline will continue to
even lower lows, perhaps triggering a broader-scale downtrend. According to
Bulkowski, this pattern predicts lower prices with a 72% accuracy rate.

Abandoned Baby
Image by Julie Bang © Investopedia 2020

The bullish abandoned baby reversal pattern appears at the low of a

downtrend, after a series of black candles print lower lows. The market gaps
lower on the next bar, but fresh sellers fail to appear, yielding a narrow range
doji candlestick with opening and closing prints at the same price. A bullish gap
on the third bar completes the pattern, which predicts that the recovery will
continue to even higher highs, perhaps triggering a broader-scale uptrend.
According to Bulkowski, this pattern predicts higher prices with a 49.73%
accuracy rate.

The Bottom Line

Candlestick patterns capture the attention of market players, but many reversal
and continuation signals emitted by these patterns don't work reliably in the
modern electronic environment. Fortunately, statistics by Thomas Bulkowski
show unusual accuracy for a narrow selection of these patterns, offering traders
actionable buy and sell signals.

Putting the insights gained from looking at candlestick patterns to use and
investing in an asset based on them would require a brokerage account. To save
some research time, Investopedia has put together a list of the best online
brokers so you can find the right broker for your investment needs.

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Related Terms
Stick Sandwich Definition
A stick sandwich is a technical trading pattern in which three candlesticks form what
appears to be a sandwich on a trader's screen. more

What Is a Doji Candle Pattern?

A doji is a name for a session in which the candlestick for a security has an open and close
that are virtually equal and are often components in patterns. more

What Is a Bearish Abandoned Baby?

A bearish abandoned baby is a type of candlestick pattern identified by traders to signal a
reversal in the current uptrend. more

Unique Three River Definition and Example

The unique three river is a candlestick pattern composed of three specific candles, and it
may lead to a bullish reversal or a bearish continuation. more

White Candlestick Definition

A white candlestick depicts a period where the security's price has closed at a higher level
than where it had opened. more

Up/Down Gap Side-by-Side White Lines

The up/down gap side-by-side white lines is a rare three-candle continuation pattern that
occurs on candlestick charts. more

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