Mastering Reversal Candlestick Patterns for Better Trading Decisions

The reversal candlestick patterns in a trading chart are a type of technical analysis tool that helps you indicate a potential ending of an ongoing trend and the beginning of the opposite one. Financial analysts recognise more than 40 candlestick patterns and divide them between bullish and bearish categories. In this blog, let us explore some of the crucial reversal patterns, both bullish and bearish, so that you can make informed trade decisions.

What are the Reversal Candlestick Patterns?

Before diving into the definition of the reversal candlestick patterns, you must first have a basic idea of how a candlestick typically forms in a trading chart. Candlesticks are essentially a graphical representation of asset prices with price points such as their opening, closing, highs and lows.

Depending on these factors, multiple candle forms appear on a trading chart, and when they appear at the end of an uptrend or a downtrend of an asset price, it signals that a reversal might be near.

Let us understand the concept of reversal with better clarity with an easy example. Suppose the asset you are tracking, its stock prices fall from INR 1,000 to INR 800. It then forms a bullish reversal pattern near INR 800, which may indicate the beginning of an upward move.

On the other hand, suppose a stock climbs from INR 800 to INR 1,200. It forms a bearish reversal pattern near INR 1,200. It might suggest the start of a price decline.

Therefore, like other traders, if you spot these patterns efficiently on a trading chart, you might be able to make buying or selling decisions by locating the potential entry and exit points.

A Discussion on the Bullish Reversal Candlestick Patterns

A bullish reversal candlestick is one of the trend reversal patterns that typically appear at the end of a downtrend of an asset’s prices. It essentially indicates that continuation of the price drop might be over, and an uptrend might be on the horizon.

Here are 6 of the bullish reversal candlestick patterns that you must learn about to make potential gains when they appear on a chart:

1. Bullish Engulfing Pattern

   In this pattern, there is one smaller bearish candle and next to that is a larger bullish candlestick. Suppose a stock opens at INR 500 and closes at INR 490 on the first day. The next day, it opens at INR 485 and closes at INR 510. Thus, the larger bullish candle (at INR 510) engulfs the bearish one, signalling a strong buying pressure.

2. The Hammer Pattern

   It is one of the patterns in the spectrum of trades and typically acts as a bullish reversal candlestick. You can spot it on the chart as it appears in the form of a hammer, as the name implies. It has a small red or green body and a longer lower wick. This wick represents buyers’ rejection of the price at lower levels and indicates an upward reversal.

3. Inverted Hammer Pattern

   An inverted hammer is seen on a trading chart at the bottom of a price downtrend. You can spot it by closely looking at its formation. Unlike the hammer, it has a small body, an upper shadow 2 times the size of the body and little to no lower shadow. Here, the longer upper wick represents that buyers are pushing prices upwards for a potential bullish reversal.

4. The Morning Star Pattern

   Being one of the bullish reversal candlestick patterns, this one usually appears at the bottom of downtrends. It has 3 candles, where the first candle is typically a long red bearish candle, followed by a red or green candle, and a smaller candle. Its formation completes when a 3rd green long candle appears, gapping beyond the middle one, showing a renewed buying pressure.

5. Morning Doji Star

   Similar to a morning star pattern, this reversal candlestick comes with a Doji between its two candles. Here, the first bearish candle shows the overall domination of sellers in the previous session. The Doji, however, represents that the opening and closing prices are the same. As the third candlestick appears, it shows buyers taking control.

6. Tweezer Bottom Pattern

   As one of the reversal candlestick patterns, this one appears with a bearish candlestick representing the previous trend and close to the support level. Being close to the support lines, buyer pressure increases, and a bullish candlestick of equal size forms.

   Suppose a stock opens at INR 520 and closes at INR 500, forming a bearish candle near the support line. On Day 2, it opens slightly lower at INR 495 and closes at INR 520, creating a bullish candle.

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Details About Bearish Reversal Candlesticks

Opposite to a bullish reversal, a bearish reversal candlestick usually appears at the end of a price uptrend of a certain asset. It indicates that the upward movement of asset prices might be at its end, and the market might enter into a bearish sentiment.

Here are 3 types of bearish reversal candlestick patterns that you must make a note of before you trade and make important decisions:

1. The Hanging Man Pattern

   It is a 1-candlestick that appears at the top of the uptrend in a trading chart or at the resistance level, indicating a potential reversal. It has a small real body with a wick or shadow 2-times the body. Once this candle appears, you can confirm the reversal once another bearish candle appears next to it.

2. Shooting Star Pattern

   A shooting star is also a 1-candle formation and is categorised as one of the reversal candlestick patterns. It appears with a small body with a shadow 2-times the size of its body. The wick represents that buyers pushed prices up, but in the end, sellers regained control.

3. Evening Star Candlestick Pattern

   This reversal candle is composed of 3 consecutive candles in a technical chart. Typically, the first candle here is long and bullish. A smaller candle of indecision follows, and then a bearish candle appears. Suppose, after a strong rally, a stock closes at INR 600. Then it forms a small candle or Doji near INR 610, and drops to INR 570 on confirming the bearish reversal.

Strategies to Use the Reversal Candlestick Patterns

Now you have the idea about both the bearish and the bullish reversal candlesticks, take a look at how you must strategise while trading with these:

1. Identification of the Reversal Point

   As a trader, you must note that a reversal point typically appears at the resistance or a critical support level. You can use trendlines combined with moving averages and the pattern on the chart to locate this point. Also, chances of reversals are typically high when these two levels appear to coincide with strong reversal indicators.

2. Trade Using Multiple Indicators

   For successful trading with the reversal candlestick pattern, it is always wise to use other indicators. For example, a trader may wait for a hammer to form near a support level, accompanied by an RSI. It shows oversold conditions before entering a long trade. The combination of chart patterns and indicators provides greater confidence in the trade.

Mistakes Traders Must Avoid Using Reversal Candlestick Patterns

As a trader, you must avoid following mistakes that other traders typically make, which might lead to losses:

Traders often overanalyse every candlestick that appears before a potential bearish or bullish trend reversal happens. Thus, they lose focus on a bearish or a bullish candlestick appearing near the support or resistance level.

It might lead to jumping into trades without a confirmation, and if the market goes against the signal, they incur losses. As already mentioned, avoid jumping into trades solely relying on a reversal pattern and check for indicators like volume, trendlines, RSI, etc.

Conclusion

Reversal candlestick patterns, either bullish or bearish, appear in a trading chart, typically after an uptrend or downtrend of asset prices. To avoid potential losses, you must wait for the bearish or the bullish candle to appear next to the pattern to confirm the shift. You can spot it using their shapes, colours, and by further confirming a reversal with other supporting tools, you can make buy or short decisions.

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FAQs on Reversal Candlestick Patterns

1. What is the best reversal candle?

There is no specific best reversal candlestick pattern. However, traders typically consider the hammer, hanging man, engulfing, and Doji patterns to be powerful and reliable indicators.

2. What is the 3-drive pattern reversal?

A 3-drive pattern is a trend reversal indicator which has 3 main drives or moves. It also has 2 intermediate pullbacks forming higher lows in a bullish situation and lower highs in a bearish situation.

3. Which indicator is best for reversal?

Traders typically use RSI, moving averages, MACD, trade volumes, etc, as indicators in combination with the reversal pattern for confirmation.

4. How to spot the reversal candlestick patterns?

To spot a reversal candlestick pattern successfully, you must look at the resistance or the support level. Also, their shapes play a crucial role. For instance, a hammer with a longer lower wick suggests a potential bullish move, while a long upper wick of a shooting star typically indicates a bearish move.