Japanese Candlestick Charts (Part 2)

In part 1 of this series, we covered 11 single Japanese candlestick patterns. In this article, we look at the most important points about reading Japanese candlestick charts, the types of candlestick patterns and what they mean. The article is about as long as part 1, so make sure you have the patience to get started.

The candlestick patterns covered in this part are:

• Two-candle patterns: Engulfing, Piercing Pattern and Dark Cloud Cover.
• Three-candle patterns, including the Morning Star and Evening Star.

The Bullish Engulfing pattern

The Bullish Engulfing pattern consists of two candles: a first red candle followed by a second, green candle whose real body completely engulfs the real body of the preceding red candle.

The Bullish Engulfing gives its strongest signal when it appears at the bottom of a downtrend, and it shows that buying pressure is increasing. The pattern often triggers a reversal of the current trend as more buyers enter the market and push price higher, beyond even the selling range of the previous candle.

Interpretation: Sellers dominate during the downtrend and during the first session of the Bullish Engulfing pattern. However, the large second bullish candle shows that buyers are actively entering the market and breaking the downward move of the first candle. 

This shows that buyers have returned, offering an opportunity to enter a buy order, with a stop-loss at the lowest price of the pattern. The entry point can be adjusted to each trader’s risk appetite.

• Aggressive traders: enter once the pattern is confirmed (at the close of the second candle).
• More cautious traders can wait for a green candle in the following session to confirm that the trend has truly reversed before entering. 

Entering early gives you a lower purchase price and therefore a higher return. Entering later, however, can help limit losses if price reverses in the very next session.

The Bearish Engulfing pattern 

The Bearish Engulfing pattern consists of two candles: a first green candle followed by a second, red candle whose real body completely engulfs the real body of the preceding green candle.

In contrast to the bullish version above, the Bearish Engulfing gives its strongest signal when it appears at the end of an uptrend, and it shows that selling pressure is returning. The pattern often triggers a reversal of the current trend as more sellers enter the market and push price lower still. 

Interpretation: Buyers dominate during the uptrend and during the first session of the Bearish Engulfing pattern. However, the large second bearish candle shows that sellers are actively entering the market and breaking the upward move of the first candle. 

This shows that sellers have returned once the Bearish Engulfing pattern is confirmed, offering an opportunity to enter a sell order. The entry point should be adjusted to each trader’s risk appetite, with a stop-loss above the highest price of the pattern.

• Aggressive traders: enter once the pattern is confirmed (at the close of the second candle).
• More cautious traders can wait for a red candle in the following session to confirm that the trend has truly reversed before entering. 

The Piercing Pattern

The Piercing Pattern consists of two candles: a first red candle followed by a second, green candle that opens lower than the red candle and covers more than 50% of the previous red candle, but not all of it.

The price action behind the Piercing Pattern is similar to the Bullish Engulfing, so you can use it to enter a buy order if the pattern appears at the end of a downtrend, with the same setup as the Bullish Engulfing. However, because the second candle does not rise as high as in the Bullish Engulfing, the probability of a reversal with this pattern is lower.

The Dark Cloud Cover pattern

The Dark Cloud Cover pattern consists of two candles: a first green candle followed by a second, red candle that opens higher than the green candle and covers more than 50% of the previous green candle, but not all of it. This pattern is the mirror image of the Piercing Pattern.

The price action behind the Dark Cloud Cover is similar to the Bearish Engulfing, so you can use it to enter a sell order if the pattern appears at the end of an uptrend, with the same setup as the Bearish Engulfing. However, because the second candle does not fall as far as in the Bearish Engulfing, the probability of a reversal with this pattern is lower.

The Morning Star pattern

The Morning Star is a three-candle pattern, as shown below. The first candle is a long-bodied bearish candle, the second is a Spinning Top below the first candle, and the third is a long-bodied bullish candle. The pattern appears after a downtrend and is usually a bottoming signal.

The Morning Star signals that a downtrend may be ending and reversing. The price action behind the pattern can be explained as follows:

• First candle: The large bearish real body is the result of selling pressure and the current downtrend.
• Second candle: A small-bodied candle – sometimes a Doji – shows the first sign that the downtrend is weakening. The market has started to hesitate after a long downtrend.
• Third candle: A large bullish real body – the first real sign of demand after the market’s hesitation. This shows that sellers have lost momentum and buyers are back.

This makes it one of the most reliable candlestick reversal patterns, and traders can place a buy order as soon as the pattern is complete, with a stop-loss at the bottom of the pattern.

However, as with other technical analysis methods, there is also a chance that price continues to fall. More cautious traders can therefore wait for one more bullish candle to confirm that the uptrend has really formed.

The Evening Star pattern

The Evening Star consists of three candles, as shown below. The first candle is a long-bodied bullish candle, the second is a Spinning Top above the first candle, and the third is a long-bodied bearish candle. The pattern appears after an uptrend and is usually a topping signal.

The Evening Star signals that an uptrend may be ending and reversing. The price action behind the pattern can be explained as follows:

• First candle: A large bullish real body continues the current uptrend.
• Second candle: A small-bodied candle – sometimes a Doji – shows the first sign that the uptrend is weakening. The market has started to hesitate after a long uptrend.
• Third candle: A large bearish real body – the first real sign of supply after the market’s hesitation. This shows that buyers have lost momentum and sellers are back.

This makes it a highly reliable candlestick reversal pattern, and traders should place a sell order when the pattern is complete. In markets that allow short selling, the setup mirrors the Morning Star: enter when the pattern is complete, with a stop-loss at the top of the pattern. The take-profit target can be a support zone.

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Happy trading !