Thursday, April 3, 2008

Candlestick Trend Reversal Patterns: Chart Examples

Yesterday I introduced the concept of using certain candlestick patterns to identify potential reversals in price trends. These patterns included shooting stars and hanging men which occur at the end of an extended rise in price and signal a bearish reversal. Scanning the charts this morning, I found one example that contains both of these patterns. It is the VIX, the volatility index. It's customary for these candlestick patterns to occur on heavier than normal volume, but since the VIX is an index, there's no volume associated with it, alas. I'm showing it anyway because it is just such a textbook example of these two patterns. Here it is.

You can see from the chart that both patterns are confirmed by the next day's follow-through where the price (volatility) gapped lower. (As a note, hammers and shooting stars occur much more frequently that the hanging man which is why I used the VIX.)

The chart of Freeport-McMoran (FCX) provides not one but two classic examples of a hammer. A hammer will appear at the end of an extended decline, again on heavy volume. The pattern is confirmed if the next day is up, preferably gapping up at the open. In this scenario, the bulls are gaining the upper-hand and many times the follow-through day occurs on heavy volume as well because of short-covering. These criteria are all met in the following chart.

You should note that these patterns are formed after an extended price trend; if you see them in the middle of a trend, they usually aren't very significant. Also, the charts of highly volatile stocks can produce false candlestick patterns, so be skeptical if you see a chart with a lot of topping and bottoming tails. As with all charting techniques, candlesticks aren't one hundred percent accurate. With practice, you'll be able to spot when a pattern is more likely to be valid than not.

I tried to find some charts today that looked like they might be setting up in one of these patterns. The only stock I found was that of X-Rite (XRIT) which looks like it formed a hammer today. The hammer isn't exactly a textbook example since it has a bit of a top wick, but it did trade on five times normal volume. We won't know for sure if the bulls are gaining control until tomorrow. Here's the chart.

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