Japanese Candlesticks Theory

Hammer and Hanging Man

Engulfing Pattern
Dark Cloud Cover
Piercing Pattern
Morning and Evening Stars and Doji Stars
Shooting Star and Inverted Hammer
Harami
Continuation Patterns
Doji

Hammer and Hanging Man

o Candlestick Reversal Patterns
Reversal signal indicates that prevailing trend may change. This means that market may become flat, or
may move in the opposite direction. Any reversal signal should be treated only as a sign of the fact that
the prevailing trend may change, not as a signal of a new trend or the reason to initiate a new position
in the opposite direction. To consider the opening of a new position global tendency should be analyzed
more carefully but in order to offset position reversal signals may be and should be used.

Lets begin with the most strong reversal signals, which more often than not produce opposite to the
main trend price behavior.

The Hammer and the Hanging Man

The Hammer is a candle with a short real body and a long lower shadow, which appears after a
downtrend. The Hammer is a strong reversal signal that a bearish trend is weakening:
The Hanging man is a candle with a short real body and a long lower shadow, which appears during a
rally indicating forthcoming reversal:
How to define the hammer and the hanging man:
Real body of any color is in the upper price range.
Lower shadow as the bottom more than twice longer than a real body.
Candle does not have an upper shadow or has a very short one.

The longer the lower shadow the shorter the upper one, and the smaller the real body the higher
hammers or hanging mans potential.

Real body of such a candle can be both white and black, but hanging mans black body is more bearish
signal and hammers white body is more bullish signal:

Hammers white body signifies that despite the fact that the prices at the
opening were falling, at the end of the period bulls were able to drive the
closing price to the maximum. Therefore we can assume that bulls have
become more aggressive.
Hanging mans black body signifies that closing price could not rebound to the
opening level so it assumes bears potential gathers momentum.

Hanging mans confirmation signals:

The next bar opens under hanging mans real body. The more the price gap
between the hanging mans real body and the next bar open price, the more
probability that hanging man will form the high.
Close price of the next bars black candle is under the hanging mans close
price.
Confirmation signals for the hammer are diametrically opposite.

Important: The hammer and/or the hanging man behaves in accordance with the theory, if before the
formation of the pattern there has been downtrend or uptrend respectively. It is worth mentioning that
the hanging man is formed close to the prior candle high, and the hammer is formed close to the prior
candle bottom.

Engulfing Pattern
The Engulfing pattern is formed when:

There is a distinct tendency on the market either down or up (even a short-

term).
The second real body engulfs the body of the first candle (shadows may be not
engulfed).
The second real body should be of the opposite color and be white if the
bullish engulfing pattern is formed and be black in case of the bearish
engulfing pattern.

Bullish and Bearish Engulfing Patterns

There is an exception for the third point when the real body of the first candle is too short so it is
considered to be a doji. This means that after a long-term downtrend tiny white real body is engulfed
by a tall white next candle's real body, and after the long term uptrend tiny black real body is engulfed
by a tall black real body of the second candle.

Bearish Engulfing Pattern

Bullish Engulfing Pattern

Factors that increase the importance of Bullish and Bearish Engulfing Patterns:

The first candle has a tiny real body and the second candle has relatively
longer one. The previous trend is being swept away by the opposite forces.
The pattern appears after a long-term or impetuous tendency. If trend is a long-
term then all buyers (sellers) have taken their decisions and no more buyers
(sellers) are expected to initiate positions. This means that the trend has come
to the end. Fast price movements spread the market and make traders to fix
quick profits/losses by closing positions.
The second candle is associated with a large volume trading. This means that
the prevailing trend is blowing off.
The second candle engulfs several real bodies.
 Dark Cloud Cover
The Dark Cloud Cover pattern appears after an uptrend (or near upper price ranges) and has two
candles:

Dark Cloud Cover

The first candle is white with a strong real body. The next bar open price is above the high of the
previous bar, but the bar closes near the low and covers most of the prior candles white real body. The
lower the close price of the black candle the more chances to form the high. It is considered that close
price of the black candle should cover more than 50% of the prior white candle's real body.

In another words, at the first stage we see that the market is rising (white candle). Then the next candle
opens above the high of the prior white candle a bullish signal. Bulls may think that they control the
situation but then price rising stops. Bears become more aggressive and the candle closes near its lows,
covering most of the white candle. Bullish positions become unprofitable. Now Bears have the target
for Stop Loss orders (the high of the second (black) candle of the pattern).
Dark Cloud Cover

Factors that increase the importance of the Dark Cloud Cover pattern:

The more the black candle's real body covers the white candles real body the
stronger the pattern.
If during a long-term uptrend white candle with a long real body and no
shadows are formed and next day a black candle with a long real body and no
shadows are formed then they say that there is a black day with cut high and
bottom.
If the second candle in the pattern opens above the important resistance level
but then the price falls below this level. This means that bullish tendency is
weakening and chances are that the high will be formed.
The second bar is associated with a large volume trading and it means that the
uptrend is blowing off.

Piercing Pattern
The Piercing Pattern is the opposite of the Dark Cloud Cover.
Example of the Piercing Pattern

The Piercing Pattern appears after a downtrend and is formed with two candles:

the first candle has a black real body and the second one has a white long
body;
the white candle opens under the black candle bottom and closes above the
prior black candle center.

Morning and Evening Stars and

Doji Stars
Star is a candle with a small real body, which forms the price gap with the prior candle with the bigger
real body:
Morning and evening stars

It is required to have a gap between candle bodies (shadows may intersect). The color of the star does
not matter. If the opening price of the star is at the same level as the closing price it is called a doji
star.

Any star, especially a doji one, indicates that the trend may reverse. A small real body assumes that the
fight between bulls and bears has reached a deadlock.

Stars reversal patterns:

Morning Star,
Evening Star,
Doji Star,
Shooting Star

In all the patterns stars real body can be of any color.

Morning and Evening Stars

The Morning Star pattern is a bottom reversal signal. It is formed as a candle with a long black body
which is followed by a candle with a small body (a star), after a gap. The third bar is a white candle,
which real body covers most of the prior black candle's real body:

The Morning Star

A tall black candle is a strong bearish signal. Then we see that a candle with a small body is formed -
this means that bearish trend weakens. Bulls become more aggressive as strong white body is being
formed. In the ideal pattern the gaps between real bodies should be both before and after the middle
candle (a star). Although the second gap is a rare thing it does not make the pattern less effective. The
main factor of importance is how deep the third candle pierces the first candle. Sometimes the pattern
has more than one star.

The Evening Star is an opposite pattern to the Morning Star, and it has a bearish character:
The Evening Star

Intensifying factors for the Morning / Evening Star pattern:

the second gap;

the more the third candles real body covers the real body of the first candle
the stronger the pattern;
lower volume on the first candle and higher volume on the third candle.

Doji star
In case of a doji star (a star with no real body, open price at the same level as close price) Morning
Doji and Evening Doji stars are formed. This means that there is a strong signal for reversal:
Morning and Evening Doji stars

Shooting Star and Inverted Hammer

The Shooting Star and the Inverted Hammer are the next reversal signals but not so strong as the
previous ones:

The Shooting Star and The Inverted Hammer

Their characteristics:

A small real body of any color is at the bottom of a candle.

Upper shadow is very long.
Lower shadow is very small or missing.

A real body of the ideal Shooting Star / Inverted Hammer and a prior candle's real body have a gap
between them but it is not required.
The Shooting Star

Harami
Previously described patterns have quite strong reversal characteristics, and Harami pattern is used for
predicting a flat market. Harami (in Japanese means "pregnant") is a pattern formed with two candles.
The second candle with a short real body is placed inside relatively long real body of the prior candle.
The long candle is a "mother" and the short candle is her "baby":

Harami

If in the engulfing patterns candles should be of different colors for Harami it is not a requirement.
The only requirement for Harami is that its second candles real body must be short and the first
candles real body must be long. The second candles real body must be completely inside the first
candle. Size and relative position of the shadows do not matter. The smaller the second real body the
better the signal. If the second candle is a Doji then Harami is called a Harami Cross (or a Petrifying
Patten). Such a pattern is more significant as it is comprised of an "almighty" doji.

An example of the Harami pattern

Continuation Patterns
As the Japanese say: "When it is time to sell sell, when it is time to buy buy, when it is time to rest
rest". Most of the continuation patterns signal that the market has resumed the trend taken before
the continuation pattern emerged.

Gaps
When bar low is above the prior bar high, or when bar high is below the prior bar low we see the
formation of a price gap. In the future gaps will be support or resistance levels. If prices rebound and
gapping disappears but opposite to the prevailing trend market participants are still aggressive then
wait for the reversal. As a rule once the gap is formed price moves back so it is a good time to initiate a
position. Place Stop Loss orders under (above) the gap when opening a buy (sell) position.

Analysis rules:

If once a gap has appeared and you have register from eight to ten rising highs
(falling lows) then wait for the correction. As in the Japan saying: "Stomach is
80% full".
 If gap is not closed within next three bars then wait that the market will move
in the gap direction.
Once three gaps have been formed upward (downward) wait for the high
(bottom). Once the third gap has formed and you see the reversal pattern the
prevailing trend is about to change.

Doji
Doji is a candle which is formed when the bar open and close prices are at the same levels or have
several pips difference:

Examples of Doji

Once doji has appeared on the chart you must consider that it is a strong reversal signal.

Doji is important only on the markets where it appears rarely. 15 minutes charts are useless for
analyzing this pattern as there are lots of them there.

If doji is formed at the high this is the strongest signal of all as at the bottom dojis magical abilities to
reverse the market may disappear. When doji appears after a tall white candle it is time for the bulls to
keep a bright lookout as it is the most meaningful signal.

Rickshaw man and Gravestone Doji leave no chance for the upward momentum.

Once doji appears on the chart its open/close prices will be support/resistance levels.

Three Stars is a rare but significant reversal pattern. Three stars are formed by three doji, and the
middle is a Doji star:

The Three Stars pattern