Basics of Technical Analysis

Part 1 Candlestick Patterns 

By Peter Ashton

In this news article published by CIBC Investor's Edge Exchange, Peter Ashton writes about the most commonly used candlestick patterns found in classic candlestick patterns.

“Over many years, traders have come to rely on technical analysis as a tool to help identify trends, possible reversals of trends, support and resistance levels as well as provide an indication of possible target prices.”

Technical analysis at its core is all about understanding the shifting balance of supply and demand for a given stock or ETF in the market. Over many years, traders have come to rely on technical analysis as a tool to help identify trends, possible reversals of trends, support and resistance levels as well as provide an indication of possible target prices. There are a variety of technical patterns and indicators in common use today. In this article, we will highlight three types of candlestick patterns that should be understood by technical traders.

Candlestick patterns are the oldest type of technical indicators in use today, some dating back to the Japanese rice markets of the 1700's. These types of patterns get their name from the fact that they are identified using candlestick charts. These patterns typically have very short-term influence over the price; normally lasting no more than 10 candlesticks. This would be about two weeks when using daily charts or about 2 ½ months when using weekly charts.

Hammer

The “Hammer” is a bullish pattern indicating that the previous downtrend in the price of a stock is likely to reverse. The Hammer pattern always occurs at the end of an established downtrend. The Hammer is characterized by a small real candlestick body near the top of the price range. This pattern indicates a sharp a change in the sentiment of traders on the day that it occurs. This candlestick indicates that the price opened near the highs of the day, then sold off sharply as the trading day progressed. At some point, the sentiment changed and the price began to move higher, closing the day near the session highs. This pattern indicates bullish sentiment in the minds of traders has emerged and that the stock is likely to rally over the subsequent days. An example of a Hammer is shown in Figure 1 below.

Figure 1: Hammer Candlestick Pattern

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Hanging Man

The “Hanging Man” pattern is the bearish counterpart of the Hammer. A Hanging Man always occurs at the end of an established market uptrend. The name "Hanging Man" is used because it has a gloomy connotation and because the candlestick that defines this pattern looks like a hanging man with dangling legs. The Hanging Man pattern is characterized by a small real body near the top of the price range. The Hanging Man has a long lower shadow that should be at least twice the length of the real body. The Hanging Man indicates to the trader that the uptrend is nearing exhaustion and that there is significant bearishness in the mind of traders. An example of a Hanging Man pattern is shown in Figure 2 below.

Figure 2: Hanging Man Candlestick Pattern

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Engulfing Pattern

The “Engulfing Pattern”, sometime called an Engulfing Line, is a pattern which can be either bullish or bearish depending on the context. An Engulfing Pattern is characterized by a candlestick with a real body which completely engulfs the preceding candlestick. In the bullish example, the Engulfing Line comes at the end of an established downtrend and must consist of a white candlestick which completely engulfs the preceding black candlestick. For the bearish case, the pattern comes at the end of an established uptrend and must consist of a black candlestick which completely engulfs the preceding white one.

Figure 3: Bullish Engulfing Pattern

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Technical traders use a variety of other types of candlestick and short-term patterns beyond the three that are highlighted here. Other common short-term patterns include Gravestones, Exhaustion Bars, Two Bar Reversals, Outside Bars and Key Reversal Bars. Identifying and using these types of events in your trading can be a daunting task – fortunately, there are online tools available to aid the investor in this process. Recognia offers Trading Central Technical Insight that is available free of charge to CIBC Investor’s Edge account holders. Technical Insight automates the standard practices of technical analysis, thereby making it easy to identify new trade ideas or evaluate the technical perspective for a given stock or ETF. All the candlestick patterns described in this article are automatically detected by Technical Insight on an end-of-day basis.

Technical Insight users can “lookup” a stock or ETF of interest and see all the active technical patterns and indicators which are currently active. The Featured Ideas module highlights ten trade ideas per day based on what is poised to move from a technical perspective. Users can also search for trade ideas in a given sector or based on a specific technical pattern (like a Hammer or Hanging Man) using the Technical Event screener. Finally, users can stay on top of their positions and tune in to signs of weakness using the email alerts functionality. For access to more educational content, visit the Investor’s Edge Knowledge Bank.

The investment ideas presented here are for information only. They do not constitute advice or a recommendation by Trading Central in respect of the investment in financial instruments. Investors should conduct further research before investing.

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