Investors and traders use technical analysis to identify trends, breakouts, reversals etc. In a bear market prices keep falling; so an investor who wishes to take long positions will have to wait until the market reverses. The breakout trader may take long or short positons based on bullish or bearish breakouts.
In my previous article "Candlestick Patterns in Indian stock markets" we discussed about engulfing pattern. Candlestick Charting is a complex and interesting subject. Steve Nison has authored a couple of books viz. Candlestick Charting Techniques and Beyond Candlesticks. Both offer excellent insight into various aspects of candlestick charting. Candlesticker is another site which explains reversal and continuation patterns with plenty of illustrations.
Candlesticks offer effective trading signals which are not available with other methods of charting. Several reversal and continuation patterns have been recognized but few of them (like abandoned baby) are very rare. Certain candlestick patterns require 3, 4 or 5 trading sessions to form. Therefore, two day candlestick formations are more common.
Following are the common two day candlestick patterns:
Engulfing (bullish & bearish)
Harami (bullish & bearish)
Harami cross (bullish & bearish)
Piercing line (bullish)
Dark cloud cover (bearish)
Shooting star (bearish)
The available literature suggests that engulfing & harami cross patterns are more powerful than others (of course it depends on where the formation occurs; rarely, a harami pattern has been found to be effective compared to engulfing pattern on a similar chart.)
It is to be remembered that the overall technical picture needs to be studied thoroughly before attempting to experiment on candlestick patterns. This of course comes with practice and patience.
Bullish engulfing pattern is formed when real body of a green candle engulfs (wraps around) real body of a red candle. This is the basic definition; however there are several variations as shown below:
1. The entire black candle, including shadows (this is the computer age; so red candle) is engufed by real body of white candle (green candle).
2. The real body of red candle is engulfed by real body of green candle and shadows of red candle are engulfed by shadows of green candle.
3. Real body of red candle and its lower shadow are engulfed by real body of green candle but upper shadow of red candle is not engulfed by either real body or shadow of green candle.
4. Real body of red candle and its upper shadow are engulfed by real body of green candle but lower shadow of red candle is not engulfed by either real body or shadow of green candle.
5. Real body of red candle is engulfed by real body of green candle but neither upper shadow nor lower shadow of red candle is engulfed by real body or shadows of green candle.
Based on available literature, my own observation and trading experience, I've created a checklist for engulfing and harami patterns (bullish). It is recommended to have checklist for each candlestick pattern.
Bullish engulfing / harami candlestick pattern checklist
- Is the stock on a down trend?
- Is the downtrend fast, protracted?
- Is the green day volume more than red day volume?
- Is the green day volume more than 21 day moving average?
- Is the entire red candle is engulfed?
- Are the shadows of red candle engulfed by shadows of green candle?
- Does the entire green candle lies within real body of red candle? (Harami)
- Are the shadows of green candle within the shadows of red candle? (Harami)
- Does the candlestick formation occur after a critical support is tested?
- Is there positive divergence in case the stock makes a new low while candlestick pattern is formed?
- Is the red candle a ‘long black’ candle? (Harami)
- Is the green candle a ‘long white’ candle? (Engulfing)
- Is the first candle doji? (Engulfing)
- Is the second candle doji? (Harami)
- Does the red candle have minimal upper shadow?
- Does the green candle have minimal lower shadow?
- Are the candlestick centerlines nearly equal?
- Does the green candle engulf more than one real body?