Candlestick patterns can give you invaluable insight into price action at a glance. While the basic candlestick patterns can tell you what the market is thinking, they often generate false signals because they are so common. Here we introduce you to more advanced candlestick patterns, with a higher degree of reliability, as well as explore how they can be combined with gaps to produce profitable trading strategies.

Island Reversal Patterns
Island reversals are strong short-term trend reversal indicators. They are identified by a gap between a reversal candlestick and two candles on either side of it. Here are two examples that occurred on the chart of Doral Financial (DRL).

AT_AdvdCandlesticks_V2_1r.gif
Figure 1
AT_AdvdCandlesticks_V2_2r.gif
Figure 2

Here are some important things you need to consider when using this pattern:

  • Entry: Confirming the reversal pattern - When looking for an island reversal, you are looking for indecision and a battle between bulls and bears. This type of scenario is best characterized by a long-ended doji candle that has high volume occurring after a long prior trend; it is important to look for these three elements to confirm any potential reversal pattern.
  • Exit: Defining the target and stop - In most cases, you will see a sharp reversal (as seen in Figs. 1 and 2) when using this pattern. This reversal pattern does not necessarily indicate a medium- or long-term reversal, so it would be prudent to exit your position after the swing move has been made. If the next candle ever fills the gap, then the reversal pattern is invalidated, and you should exit prudently.

Island reversals can also occur in "clusters" - that is, in a multi-candle reversal pattern, such as an engulfing, as opposed to a single candle reversal. Clusters are easier to spot, but they often result in weaker reversals that are not as sharp and take longer to occur.

Hook Reversal Patterns
Hook reversals are short- to medium-term reversal patterns. They are identified by a higher low and a lower high compared to the previous day. Figures 3 and 4 are two examples that occurred on the chart of Microsoft Corp. (MSFT).

AT_AdvdCandlesticks_V2_3r.gif
Figure 3
AT_AdvdCandlesticks_V2_4r.gif
Figure 4

There are several important things to remember when using this pattern:

  • Entry: Confirming the reversal pattern - If the pattern occurs after an uptrend, then the open must be near the prior high, and the low must be near the prior low. If the pattern occurs after a downtrend, then the opposite is true. As with the island reversal pattern, we are also looking for high volume on this second candle. Finally, the stronger the prior trend, the more reliable the reversal pattern.
  • Exit: Defining the target and stop - In most cases, you will see a sharp reversal (as seen in Figs. 3 and 4) when using this pattern. If the next candle shows a strong continuation of the prior trend, then the reversal pattern is invalidated, and you should exit quickly, but prudently.

San-Ku (Three Gaps) Patterns
San-ku patterns are anticipatory trend reversal indicators. In other words, they do not indicate an exact point of reversal; rather, they indicate that a reversal is likely to occur in the near future. They are identified by three gaps within a strong trend. Here is an example that occurred on the chart of Microsoft Corp. (MSFT).

AT_AdvdCandlesticks_V2_5r.gif
Figure 5

Here are some important things to remember when using this pattern:

  • Entry: Confirming the reversal pattern - This pattern operates on the premise that prices are likely to retreat after sharp moves because traders are likely to start booking profits. Therefore, this pattern is best used with other exhaustion indicators. So, look for extremes being reached in indicators such as the RSI (relative strength index), MACD (moving average convergence divergence) crossovers, and other such indicators. It is also useful to look for volume patterns that suggest exhaustion.
  • Exit: Defining the target and stop - In most cases, when using this pattern, you will see a price reversal shortly after the third gap takes place (as seen in Fig. 5). However, if there are any breakouts on high volume after the last gap, then the pattern is invalidated, and you should exit quickly, but prudently.

Kicker Patterns
Kicker patterns are some of the strongest, most reliable candlestick patterns. They are characterized by a very sharp reversal in price during the span of two candlesticks. Here's an example that occurred on the Microsoft (MSFT) chart.

AT_AdvdCandlesticks_V2_6r.gif
Figure 6

Here are some important things you need to remember when using this pattern:

  • Entry: Confirming the reversal pattern - This kind of price action tells you that one group of traders has overpowered the other (often as a result of a fundamental change in the company), and a new trend is being established. Ideally, you should look for a gap between the first and second candles, along with high volume.
  • Exit: Defining a target and stop - When using this pattern, you will see an immediate reversal, which should result in an overall trend change. If the trend instead moves sideways or against the reversal direction, then you should exit quickly, but prudently.

Using Gaps with Candlesticks
When gaps are combined with candlestick patterns and volume, they can produce extremely reliable signals. (For further reading, see Playing The Gap.) Here is a simple process that you can use to combine these powerful tools:

  1. Screen for breakouts using your software or website of choice.
  2. Make sure that the breakouts are high volume and significant (in terms of length).
  3. Watch for reversal candlestick patterns (such as the ones mentioned above) after the gap has occurred. This will typically happen within the next few bars, especially if the bars are showing indecision after a long trend.
  4. Take a position when such a reversal occurs.

Attempting to play reversals can be risky in any situation because you are trading against the prevailing trend. Do make sure that you keep tight stops and only enter positions when trades meet the exact criteria. (To learn more, see Retracement Or Reversal: Know The Difference.)

Conclusion
Now you should have a basic understanding of how to find reversals using advanced candlestick patterns, gaps and volume. The patterns and strategies discussed in this article represent only a few of the many candlestick patterns that can help you better understand price action, but they are among the most reliable. For further reading, see The Art Of Candlestick Charting - Part 1, Part 2, Part 3 and Part 4.

Related Articles
  1. Charts & Patterns

    How To Use Volume To Improve Your Trading

    The basic guidelines to analyzing volume may not apply in all situations, but overall, they can help direct entry and exit decisions.
  2. Trading Strategies

    4 Common Active Trading Strategies

    Active trading entails buying and selling securities with the intent of profiting from short-term price movements.
  3. Chart Advisor

    These 3 ETFs Suggest Commodities Are Headed Lower (COMT,CCX,DBC)

    The charts of these three exchange traded funds suggest that commodities are stuck in a downtrend and it doesn't look like it will reverse any time soon.
  4. Term

    Swing Trading Risks and Rewards

    Swing trading is the attempt to capture gains in a stock within one to four days.
  5. Stock Analysis

    3 Risks U.S. Equities Face in 2016

    Find out why the probability of a U.S. stock bear market is increasing in 2016 and what the greatest risks are to the bull market that is almost 7 years old.
  6. Chart Advisor

    Watch For a Bounce in These Emerging Markets (BRF, PEK)

    While downtrends are clearly in control of the direction of many emerging market ETFs, short-term indicators suggest a bounce higher could be in the cards.
  7. Investing Basics

    Valuation Models: Apple’s Stock Analysis With CAPM

    The capital asset pricing model, or the CAPM, estimates the expected return of an asset based on the systematic risk of the asset’s return.
  8. Investing Basics

    What is an Indicator?

    Investors use indicators to measure economic conditions and forecast financial and economic trends.
  9. Active Trading

    What a Golden Cross Might Mean

    Many technicians see a golden cross as a sign that a stock’s value is headed higher. If a stock’s performance continues to lag, and no golden cross appears, its moving averages will remain roughly ...
  10. Stock Analysis

    3 Early Warning Signs You Can Use to Exit Positions

    Use these three early warning signs to take fast exits on open positions.
RELATED FAQS
  1. What is the Wide-Ranging Days formula and how is it calculated?

    A wide-ranging day is simply a trading session in which price's true range is particularly large compared to its past performance. ... Read Full Answer >>
  2. What are the main disadvantages of using an Equivolume Chart?

    EquiVolume price charts were introduced by Richard W. Arms, who also created the ARMS/TRIN Index. Arms' chart builds on many ... Read Full Answer >>
  3. What are the main differences between an Equivolume chart and a Candlestick chart?

    Equivolume charts are very similar in appearance and interpretation to Japanese candlestick charts. They both represent ways ... Read Full Answer >>
  4. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  5. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  6. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center