How to trade two day candlestick patterns?

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

1. Is the stock on a down trend?
2. Is the downtrend fast, protracted?
3. Is the green day volume more than red day volume?
4. Is the green day volume more than 21 day moving average?
5. Is the entire red candle is engulfed?
6. Are the shadows of red candle engulfed by shadows of green candle?
7. Does the entire green candle lies within real body of red candle? (Harami)
8. Are the shadows of green candle within the shadows of red candle? (Harami)
9. Does the candlestick formation occur after a critical support is tested?
10. Is there positive divergence in case the stock makes a new low while candlestick pattern is formed?
11. Is the red candle a ‘long black’ candle? (Harami)
12. Is the green candle a ‘long white’ candle? (Engulfing)
13. Is the first candle doji? (Engulfing)
14. Is the second candle doji? (Harami)
15. Does the red candle have minimal upper shadow?
16. Does the green candle have minimal lower shadow?
17. Are the candlestick centerlines nearly equal?
18. Does the green candle engulf more than one real body?

The ideal answer for all 18 questions above is YES; but it may not be always possible to achieve it. Interested investors and traders may start paper trading with these ideas and try to arrive at a conclusion as to what works and what doesn't in real trading.

Nifty at crossroads; Crucial week ahead!

In the previous post "Nifty and (no) confidence vote" I had mentioned that the Nifty had turned bullish for the short term. We discussed 3 possible scenarios for the uptrend:

1. The current rally may be expected to continue for a while since wave 1 has just started.
2. Nifty may witness a minor correction or sideways movement before further upward movement.
3. Nifty may have an extended rally (only to fall back again to support levels).

After two weeks, Nifty has followed scenario 1.

In the daily chart shown above, it can be seen that Nifty had gained consecutively for 5 days in a row from July 17. In other words, it went up from 3790 to 4539. It could not penetrate the resistance trendline and a down trend had started. The support at 4216 was broken on July 29. However Nifty bounced back strongly forming a "three inside up" pattern i.e. harami pattern followed by a higher close. It is likely to face strong resistance at around 4450 which is only 27 points away from Friday's high. Will it break the resistance trendline? Will it break the next resistance at 4539 to move higher? We'll find out the answers this week.

While looking at price and volume for predicting future price action, the slope of the trend plays an important role. High slope indicates a strong demand but when the supply begins, a sell off is inevitable. Low slope is identified by weakening demand.

The wave 1 obviously had a too high slope. The fact that it failed to break the resistance trendline is also an indication that some correction was on the cards. But, the harami candlestick pattern at the support level confirmed the reversal.

We may consider the formation of wave 1 very important. Given the high slope, the Nifty is likely to consolidate for a few more days before breaking out. In this case, 4159 should act as a strong support. If the Nifty does not break the resistance and falls below that level it means that the short term bullish trend has reversed.

So, basically we are at crossroads - just waiting to see where to go. Monday's trading session becomes crucial in deciding further movement of the Nifty.

The weekly chart indicates that Nifty has managed to retrace more than 38.2% fall from 5299 to 3790. This week's trading range was entirely within the previous week (also known as inside day pattern) which many traders use for market entry. 61.8% retracement works out to 4723.

In the monthly chart of Nifty, last month's low of 3790 was below the support trendline. Though the index has managed to bounce back, this is a warning that more downside exists for long term investors. Moreover, Nifty has closed below the 21 month moving average for 2 months in a row i.e. June and July 2008. This could well be the end of the long term bull market.

Weekly Review of India stock market

Couple of weeks ago the Nifty lost by 3.70%. Last week, Nifty had gained 3.57% whereas this week it has lost 3.62%. This has lead Nifty to a rangebound weekly movement. A hammer was formed four weeks ago. It was followed by a near hammer; similar pattern appeared last week as well. It can be observed from the weekly chart that during the last 4 weeks the Nifty has moved within the range of the week ended January 25.

Hammer which appears at the end of a downtrend could be a sign of reversal if supported by other indicators.

In the combined charts shown above, 3 “hammers” could be seen on the weekly chart. While no strong reversal sign has appeared yet, the rangebound activity suggests that market could be heading towards a short term bottom.

In the daily chart, we can see the higher bottoms being formed. A bullish harami candlestick pattern was formed on Thursday but could not be confirmed. 5040 should act as a strong support area for the Nifty based on the current trendline. It has closed below 38.20% retracement level of 5152 and the 61.8% retracement works out to 5020. One may expect the index to reverse between the range of 5020 to 5040. Considering other scenarios, if the above levels could not be held, the recent low at 4804 and 4449 are likely to act as supports.

45.5% of the stocks advanced during the week while 53% declined and 1.5% remained unchanged. Some notable gainers were GTC Industries, OCL India, Hexaware, Bank of Rajasthan and Gujarat NRE coke while JP Associates, Indiabulls Real estate, HDFC, ABB and Lanco InfraTech were amongst losers.