Contents of this article
The Japanese candlestick chart is a technical analysis tool that packs all the price data for each period, on any timeframe, into a single candle. This makes candlesticks more useful than the traditional bar chart or the simple line chart that connects closing prices. When a candlestick pattern forms, it helps anticipate the direction of price movement; in particular, candlestick patterns are extremely useful for finding “turning points”. As early as the 18th century, Japanese rice traders chose suitable colours for different candles (bullish, bearish and so on), adding depth and colour to this technical tool.
Steve Nison brought Japanese candlestick patterns to the Western world through his hugely popular 1991 book, Japanese Candlestick Charting Techniques. Today, many traders can identify dozens of candlestick patterns with colourful, highly evocative names such as Dark Cloud Cover, Evening Star or Three Black Crows. There are also single-candle patterns such as the Doji and the Hammer, which are extremely popular and used in hundreds of buy and sell strategies.
How reliable are candlestick patterns?
Not all candlestick patterns work equally well. Their sheer popularity has reduced their reliability, because they are analysed by hedge funds and smart money. These well-capitalised players rely on lightning-fast execution to trade against retail investors and traditional fund managers who use the (technical analysis) strategies commonly found in widely shared books and materials.
In other words, hedge fund managers use sophisticated software to capture the actions of market participants looking for trend-following opportunities. Even so, when reliable candlestick patterns do appear, they create profit opportunities in both the short and long term.
The performance of candlestick patterns
This analysis is based on the work of Thomas Bulkowski, who ranked the accuracy and performance of candlestick patterns in his 2008 book, Encyclopedia of Candlestick Charts. It provides statistics for two types of candlestick patterns:
1. Reversal – reversal patterns predict a change in the price trend.
2. Continuation – continuation patterns predict that price will keep moving in the current trend.
The following examples use black-and-white candlestick charts: a white candle means the close is higher than the open (a bullish candle), while a black candle means the close is lower than the open (a bearish candle).
Three Line Strike
This is a bullish reversal pattern that appears in a downtrend, with one bullish candle overtaking the three bearish candles before it. Each of the three bearish candles makes a lower low than the one before. Then the fourth candle opens even lower but turns into a bullish Marubozu that rises above the open of the first candle in the sequence. According to Bulkowski, the Three Line Strike reversal pattern predicts higher prices with 83% accuracy.
Two Black Gapping
The Two Black Gapping bearish continuation pattern appears at the top of an uptrend. After price shows signs of topping, the pattern forms when two bearish (black) candles with lower closes appear after a downside gap. The pattern predicts that price will keep falling to lower levels and may trigger a large-scale downtrend. According to Bulkowski, this pattern predicts lower prices with 68% accuracy.
Three Black Crows
Three Black Crows is a bearish reversal pattern that begins at or near the top of an uptrend, with three bearish (black) candles, each closing lower than the previous one. The pattern predicts that price will keep falling to lower levels, which may create a larger-scale downtrend. The strongest down session, or longest bearish candle, appears after price makes a new high (point A in Figure 3), because that is where FOMO buyers are drawn into the market. According to Bulkowski, this pattern predicts lower prices with 78% accuracy.
Evening Star
The Evening Star bearish reversal pattern begins with a long bullish (white) candle that tries to make a new high. The next candle opens above the previous candle’s close, creating a gap, but no new buyers appear at this level, resulting in a narrow-range candle. Then the third candle opens below the second candle’s close, creating a downside gap that signals price will keep declining to lower levels and may trigger a larger downtrend. According to Bulkowski, this pattern predicts lower prices with 72% accuracy.
In summary
Candlestick patterns attract a lot of attention from market participants, but many of their reversal and continuation signals may no longer be effective or reliable in today’s electronic markets. Fortunately, Thomas Bulkowski’s statistics show remarkable accuracy for the small number of patterns covered in this article, giving traders reliable buy and sell signals.
Happy Trading!
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