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Wednesday, September 17, 2008

Japanese Candlesticks - Reversal Patterns

Prior Trend
For a pattern to qualify as a reversal pattern, there should be a prior trend to reverse. Bullish reversals require a preceding downtrend and bearish reversals require a prior uptrend. The direction of the trend can be determined using trendlines, moving averages, or other aspects of technical analysis.

Long Shadow Reversals
There are two pairs of single candlestick reversal patterns made up of a small real body, one long shadow and one short or non-existent shadow. The long shadow should be at least twice the length of the real body, which can be either black or white. The location of the long shadow and preceding price action determine the classification.

The first pair, hammer and hanging man, are identical with small bodies and long lower shadows. The second pair, shooting star and inverted hammer, are also identical with small bodies and long upper shadows. Only preceding price action and further confirmation determine the bullish or bearish nature of these candlesticks. The hammer and inverted hammer form after a decline and are bullish reversal patterns, while the shooting star and hanging man form after an advance and are bearish reversal patterns.

Hammer and Hanging Man
The hammer and hanging man look exactly alike, but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower shadows and short or non-existent upper shadows. As with most single and double candlestick formations, the hammer and hanging man require confirmation before action.

The hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom.

After a decline, hammers signal a bullish revival. The low of the long lower shadow implies that sellers drove prices lower during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. While this may seem enough to act on, hammers require further bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure is needed before acting. Such confirmation could come from a long white candlestick.

Recognition Criteria:
• The long shadow is about two or three times of the real body.
• Little or no upper shadow.
• The real body is at the upper end of the trading range.
• The color of the real body is not important.

The hanging man is a bearish reversal pattern that can also mark a top or resistance level. Forming after an advance, a hanging man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of selling pressure raises the yellow flag. As with the hammer, a hanging man requires bearish confirmation before action. Such confirmation can come from a long black candlestick.

Recognition Criteria:
• A long lower shadow which is about two or three times of the real body.
• Little or no upper shadow.
• The real body is at the upper end of the trading range.
• The color of the body is not important, though a black body is more bearish than a white body

Inverted Hammer and Shooting Star
The inverted hammer and shooting star look exactly alike, but have different implications based on whether you’re in a downtrend or uptrend. Both candlesticks have small real bodies (black or white), long upper shadows and small or non-existent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before trading.

The shooting star is a bearish reversal. It occurs in an upper trend which indicates that the price opens at its low, rallies and pulls back to the bottom. A shooting star can mark a potential trend reversal or resistance level. The resulting candlestick has a long upper shadow and small black or white body. After a large advance (the upper shadow), the ability of the bears to force prices down raises the yellow flag.

To indicate a substantial reversal, the upper shadow should relatively long and at least 2 times the length of the body. Bearish confirmation is required after the shooting star and can take the form of a long black candlestick.

The inverted hammer looks exactly like a shooting star, but occurs after a downtrend. Inverted hammers indicate a possibility of the reversal of the downtrend.

After a decline, the long upper shadow indicates buying pressure during the session. However, the bulls were not able to sustain this buying pressure and prices closed well off of their highs to create the long upper shadow. Because of this failure, bullish confirmation is required before trading. An inverted hammer followed by a long white candlestick could act as bullish confirmation.

“Shoot for the moon. Even if you miss,

you'll land among the stars.”
Les Brown

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