What is a Candlestick?
A candlestick is a way of displaying information about an asset’s price movement. Candlestick charts are one of the most popular components of technical analysis, enabling traders to interpret price information quickly and from just a few price bars. This article focuses on a daily chart, wherein each candlestick details a single day’s trading. It has three basic features: 1.The body, which represents the open-to-close range 2.The wick, or shadow, that indicates the intra-day high and low 3.The color, which reveals the direction of market movement – a blue (or white) body indicates a price increase, while a red (or black) body shows a price decrease
The candlestick was invesnted as a method to represent price action during specific period by Japanese rice traders several hundred years ago. This method of representing price gained popularity in the West following the work by Steve Nison (see Trading Books). Each candle represents the struggle between buyers and sellers and the Japanese recognised certain patterns (groups of candlesticks) as being able to forecast future price direction. For example:
As you may know, technical analysis price patterns come in only two flavours - continuations and reversals. Continuation patterns indicate the prior trend may resume whilst reversal patterns suggest that it won't. We are going to focus on the 3 candle reversal pattern in this article.
The 3 Candle Reversal (3CR)
Looking at the above cheat sheet, you can see there are several 3 candle reversal patterns - the morning and evening star, the abandoned baby but there are more. A generic 3 candle (or bar) reversal is best shown diagramatically:
For the long (or buy) 3CR, low 2 is the lowest low in the pattern and bar 3 high exceeds the high of bar 1. For the short ( or sell) 3CR, bar 2 has the highest high and bar 3 low is lower than bar 1.
How to trade a 3 candle reversal
In order to trade this pattern, a trader sets an entry order at the bar 1 high or low depending on the direction of the trade. The stop is placed at bar 2's high or low. Some traders like to wait for a close above the bar 1 entry level and others like to see a pullback to the entry level to see it tested and rejected therefore confirm the reversal. The article on the 3CR trading strategy goes into this in more depth. However, your trading setup would look something like this:
How effective are candlestick patterns in predicting price?
One issue with price patterns is that they fail - the pattern appears to complete and then boom, it doesn't! So how effective are these patterns in prediciting price? The team at The 5%ers have looked into this question and have some useful answers.
Candlestick Pattern Research
In their first study, they searched and identified patterns only on the Daily and Weekly timeframes. Daily timeframe patterns (positions) had 100 pips on both stoploss and take profit levels, while weekly timeframe patterns (positions) had 250 pips on both stoploss and take profit levels.
There was no time limit on any position (only price limit), so holding periods were different and not consistant with each other.
They tested 10 different patterns independently from one another in 5 different markets (Forex, Futures, Equities, Crypto and Bonds), for a time period of 22 months with more than 50 case studies for each and every single pattern. The success rates are as follows:
Ascending/Descending triangles – 39.5%
Double Top/Bottom Pattern – 41.2%
Head & Shoulders Pattern – 48.6%
Trend lines – 37.0%
Engulfing Candlestick – 42.7%.
Bullish/Bearish Flags – 44.4%
Morning/Evening Star Candlestick – 45.9%
Ascending/Descending Wedges – 38.2%
Exhaustion Gap – 42.6%
Hammer Candlestick – 45.5%
It's bad news - not one price pattern gave a success rate greater than 50%. This means that price patterns tend to fail more than 50% of the time. The patterns therefore have no statistical edge and are unreliable on their own.
Adding Support & Resistance Levels
So the team ran a second study where they combined each of the patterns individually against a set of support and resistance levels, which improved the end results significantly in comparison to the first study were the patterns were not backed up by support and resistance levels.
1. Ascending/Descending triangles – 59.1%
2. Double Top/Bottom Pattern – 63.8%
3. Head & Shoulders Pattern – 84.1%
4. Trend lines – 67.5%
5. Engulfing Candlestick – 72.0%
6. Bullish/Bearish Flags – 74.2%
7. Morning/Evening Star Candlestick – 65.9%
8. Ascending/Descending Wedges – 58.6%
9. Exhaustion Gap – 82.9%
10. Hammer Candlestick – 81.3%
They concluded that you should not use any of these basic patterns as a stand-alone trading technique. Instead, you should marry these patterns with a strong support & resistance system. This prevents you trading a pattern that may fail because of strong support or resistance near to your entry level. In other words, if you couple any of these patterns with a reliable support or resistance key level, the statistical data flips on its head, upside down.
Further, they believe when the same information is accessible to every single trader and investor out there, there can be no real advantage to anyone of them. They state "if everyone is using the same “profitable” tools and techniques, then surely everyone should be on the winning side of the scale. But as we all know very well, that is not even remotely the case. It is simply not how markets work."
Concluding thoughts on 3CR.
Once again, the moral of the story is don't rely on a single indicator or pattern by which to trade. In order to get an edge, you need to combine indictors and patterns to create a strategy that ensures a high probability of profit over time.
So the question you may be asking yourself is what indicators and patterns do I combine to create a trading strategy with a real edge? That is the whole point of this website: we have brought you a bunch of strategies that have a statistical edge and if applied consistently, will boost your trading success.
Download your 3CR indicator HERE
Download your Support and Resistance indicator HERE
Download your candlestick trading book HERE
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