Advanced Candlestick Patterns
Candlestick patterns provide insight into price action at a glance. While the basic candlestick patterns may provide some insight into what the market is thinking, these simpler patterns often generate false signals because they are so common. Below, we will look at more advanced candlestick patterns that offer a higher degree of reliability. These include the island reversal, hook reversal, three gaps and kicker patterns.
Island Reversal Pattern
Island reversals are strong short-term trend reversal signals. They are identified by a gap between a reversal candlestick and two candles on either side of it. Here is a bullish example. The price is moving down, gaps lower, then gaps up and continues higher.
Here is a bearish example of the same pattern.
Entry: The island reversal shows indecision and a battle between bulls and bears. This is often characterized by a long-ended doji candle that has high volume occurring after an extended trend. It is after the gap and move in the opposite direction that a trade is taken. For the bearish pattern, enter short after the gap and move in the opposite direction. For the bullish pattern, enter long after the gap and move in the opposite direction.
Exit: An exit refers to both the target and stop-loss. With this pattern, you want to capture the thrust in price that follows that pattern, but once that thrust starts to weaken, it is time to get out. If the price moves back to fill the gap, then the reversal pattern is invalidated, and you should exit right away. Therefore, a stop-loss can be placed in the gap or near the "island" candle.
Hook Reversal Pattern
Hook reversals are short- to medium-term reversal patterns. They are identified by a higher low and a lower high compared with the previous day. Here are bullish and bearish examples of the patterns.
Entry: On the bullish pattern, there is a downtrend, followed by two up days. The first or second up day breaks the high of the last down day. It is the second up day when a long trade should be taken, as the pattern indicates that the price could continue to rally. For the bearish pattern, there is an uptrend, followed by two down days, and either the first or second down day breaks the low of the last up day. It is the second down day on which a short trade should be taken, as the pattern indicates the price could slide lower.
Exit: Know your exit points before trading this pattern. In most cases, you will see a sharp reversal, as shown in the chart above. Anything to the contrary indicates that the pattern is not working, so exit immediately. Therefore, a stop-loss can be placed above the recent high for a bearish pattern, or below the recent low for the bullish pattern. We can't know how long the reversal will last based on the pattern alone. Therefore, maintain the trade for as long as the price is moving in the expected direction. When the move weakens or a pattern in the opposite direction occurs, take your profit.
San-Ku (Three Gaps) Pattern
The San-ku pattern is an anticipatory trend reversal signal. The pattern does not indicate an exact point of reversal. Rather, it indicates that a reversal is likely to occur in the near future. The pattern is created by three trading sessions in a row with gaps in between. While each candle doesn't necessarily have to be large, usually at least two or three of the candles are.
Here is a three gaps pattern that signalled the end of an uptrend. The price is accelerating higher. There are three gaps higher in a row. Since such momentum can't last forever, the buyers are eventually exhausted and price moves the other way.
Entry: This pattern operates on the premise that the price is likely to retreat after a sharp move because traders will start taking profits. For additional evidence of the possibility of a reversal, look for extremes in the relative strength index (RSI) or await a crossover of the moving average convergence divergence (MACD).
Exit: This pattern anticipates a reversal. If it doesn't happen, get out of any trade that was taken because of this pattern. Price must follow through in the anticipated direction in order for the signal to be valid. Stop-loss orders can be placed above the high of the pattern if going short. Ride the downward momentum while it lasts. Since it is unknown how long the sell-off will last, take profits when you see a reversal signal in the opposite direction or when the selling momentum slows.