Wednesday, April 2, 2008

Cooking Tools #2: Candlestick Trend Reversal Patterns: Hammers, Shooting Stars, and Hanging Men

If you're a beginning investor, you're probably looking at this title thinking that a candlestick is something used by Mrs. Green to off Colonel Mustard in the library. In the non-Parker Brothers world of investing (although successfully identifying chart patterns does involve a bit of detective work), candlesticks are a graphical representation of price and price patterns. Whereas a point and figure chart is represented by a series of vertical lines with horizontal handles that represent the opening and closing prices over a specified time period, a candlestick chart represents the same information but more graphically as illustrated in the diagram below.

The main portion of the candlestick is called the body. If the closing price is lower than the opening price, the body is typically shaded either black or red. In the reverse case where the closing price is higher than the opening price, the body is typically either white or green. (Some charting programs will let you select the colors for your candlesticks. I prefer the green/red schema.) The lines above and below the body are called the wick or shadow. They reflect the high and low price for that time period. Candlestick patterns are a graphical representation of investor psychology, and learning how to interpret them provides insight into market movement. Although there's an entire field of chartology devoted to candlesticks, I'm just going to touch on a few of the more useful and predictive patterns, specifically those that signal a market reversal after an established trend, so that you will be able to identify them and know what to do if these patterns crop up in your charts.

Bullish Reversal Pattern: Hammers
When a hammer is formed at the end of a long price decline, you can bet that a turnaround is imminent, especially if the next day's price action is to the upside. A hammer consists of a lower wick that is at least twice the length of the body and little to no upper wick. (A long wick is also called a tail.) The body of the hammer can be either color, but a white (or green) body is usually better. Why does this formation occur? During an extended down-trend, investors are understandably bearish. The stock opens and heads lower. Then the bulls step in and push the price of the stock back up, thus creating the long wick. The bears are now questioning whether the decline is still intact. A white body the next day would confirm that the bulls have taken control, especially if the price gaps up on the open. Note that the longer the bottoming tail, the more bullish the pattern. Here's what a hammer looks like:

Bearish Reversal Patterns: Hanging Men & Shooting Stars
Let's look first at the hanging man. A hanging man pattern looks exactly like a hammer, except that it occurs at the end of a long up-trend. The formation criteria is the same as well with the body at the upper end of the trading range. The color is not important although a black body is a stronger signal meaning that the bears are gaining control The pattern is confirmed if the next day is a black body or better yet, if it gaps down with a lower close. Again, the longer the tail, the higher the potential of a price reversal, especially if accompanied with higher than average volume. Typically, the volume on a reversal day can be quite large. Here's what a hanging man looks like:

A shooting star is just like the previous patterns except that the direction of the tail (wick) is reversed. It, too, signals the end of a bull run. The criteria for formation are just like the hanging man. The signal is enhanced if it gaps up from the previous day's close on heavier than normal volume. A lower open or a black candle the following day reinforces the fact that the bulls are losing control. Here's what a shooting star looks like:

This is just a brief introduction to candlesticks. There are many books and websites that cover candlestick interpretation for those interested in learning more. I wanted to introduce these concepts to you because I'll be mentioning these chart patterns throughout my blogs.

Tomorrow I'll see if I can find some charts that illustrate these patterns so that, unlike Colonel Mustard, you won't get clobbered by an errant candlestick should it appear in your stock charts.

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