Price action trading and candlestick patterns are some of the most commonly used concepts in technical analysis.

However, misconceptions and half-truths can cause confusion and lead to poor trading decisions.

In this blog post, we’ll explore the five best candlestick patterns and provide insights on how to trade them effectively.

We’ll also address common issues traders face when working with price action trading.

4 Tips for Candlestick Patterns Trading

 

1. Context and Location

The foundation of price action and candlestick trading lies in understanding context and location. Always compare the current candlestick to recent price action to get the full picture. Focusing too much on individual candlesticks without considering the broader context can lead to mistakes. Location is equally important; candlesticks at significant price levels, such as a pinbar at a double top or bottom, carry more weight than random candlesticks in the middle of a chart.

2. Size

The size of a candlestick can reveal a lot about the market’s strength, momentum, and trends. Larger candles often indicate a stronger trend, while small candles after a prolonged rally can signal a potential reversal or the end of a trend.

3. Wicks

Long wicks at key support or resistance levels often suggest potential reversals. Wicks indicate rejections and failed attempts to push the price higher or lower. While long wicks around double tops or bottoms can be strong signals, not all wicks indicate reversals. It’s crucial to assess the context in which they appear.

4. Body

The body of a candlestick represents the range between the opening and closing prices. The body’s size and the presence of wicks offer insights into market sentiment. For instance, a small body with large wicks shows indecision, while a large body without wicks suggests strength. Understanding the relationship between the body and wicks is key to interpreting candlestick patterns.

 

The 5 Best Candlestick Patterns

While there are many candlestick patterns to learn, mastering a few key ones can greatly enhance your trading strategy.

Below are five of the best candlestick patterns, explained in the context of the four principles discussed above.

#1 Abandoned Baby – Evening Star

The abandoned baby and evening star patterns are most effective on daily charts but can also appear on lower timeframes. These patterns involve a sequence of candles:
Uptrend: A long green candle followed by a small candle with a gap up, then a large red candle with a gap down.
Downtrend: A long red candle followed by a small candle with a gap down, then a large green candle with a gap up.
Key Concepts: The gap between candles is not mandatory, but the sequence is crucial. The small candle often has wicks on both sides, indicating a struggle between bulls and bears.

Meaning: This is a classic reversal pattern. After a strong trend, the price gaps but fails to maintain momentum, and the third candle confirms the reversal. Waiting for the third candle to close is essential to validate the pattern.

#2 Doji – Spinning Top

Dojis are common candlestick patterns that often signal indecision in the market. A Doji candle typically has a small body with wicks on both sides.
Key Concepts: A Doji alone is not a trading signal but a heads-up to potential market changes. They often appear after strong trends or at key support/resistance levels. The size of the wicks can indicate the intensity of the battle between bulls and bears.

Meaning: Dojis indicate a pause in the market, where buyers and sellers are reevaluating their positions. They’re an opportunity to adjust your stop-loss or take partial profits in anticipation of a possible reversal.

#3 Engulfing or Outside Bar

The engulfing bar, also known as an outside bar, is a strong signal when it appears in the right context. This pattern involves a smaller candle followed by a larger one that completely engulfs the previous candle.
Key Concepts: The pattern is more powerful when the second candle has small or no wicks and is significantly larger than the first. A rejection wick on the larger candle can further strengthen the signal.

Meaning: Engulfing bars can signal either a trend reversal or continuation, depending on the direction of the second candle. During a trend, they often mark the end of a retracement and a continuation of the trend.

#4 Inside Bar and Fakey

The inside bar pattern is a smaller candle that falls entirely within the range of the previous, larger candle. The Fakey pattern occurs when the price breaks out of the inside bar’s range, only to reverse direction immediately.
Key Concepts: Patience is crucial when trading inside bars. Wait for the candle after the inside bar to confirm the breakout before entering a trade. The Fakey pattern often exploits the impatience of amateur traders who place pending orders.

Meaning: Inside bars represent a pause in the market, often before a significant move. The Fakey pattern can indicate a false breakout, trapping traders who entered too early.

#5 Pinbar, Hammer, Kangaroo Tail

The pinbar is one of the most popular and powerful candlestick patterns, characterized by a long wick and a small body. It often indicates a potential reversal in the market.
Key Concepts: A pinbar can signal a trend reversal when it appears after a prolonged trend or during a trend when it acts as a continuation signal. The long wick usually represents the failed attempts of amateur traders to predict market movements.

Meaning: The pinbar’s wick shows where the market attempted to move but was quickly rejected, leading to a reversal. This pattern is particularly useful for identifying potential turning points in the market.

Concluding Thoughts

Understanding and applying candlestick patterns can significantly enhance your trading strategy. By focusing on the context, size, wicks, and body of candlesticks, traders can gain valuable insights into market sentiment and potential price movements. While it’s tempting to memorize numerous candlestick patterns, mastering a few key ones and understanding the underlying principles is more effective. Always remember to use these patterns in conjunction with other technical analysis tools and sound money management practices to maximize your trading success.

Trading price action through candlestick patterns is one of the most effective methods for identifying market opportunities.

Candlesticks visually represent price movements and provide traders with essential data at a glance.

Trading strategies based on candlesticks involve identifying high-probability patterns for market entry and managing trades according to pre-established rules that align with your money management strategy.

Japanese rice traders developed the candlestick by incorporating open, high, low, and closing prices, leading to the identification of numerous patterns that offer high-probability trading opportunities.

These patterns vary in size and shape, from single-period candlesticks like pin bars to multi-bar patterns like the Three White Soldiers.

However, not all patterns deliver the best win rates in trading.

We have identified eight major candlestick patterns that consistently work.

Let’s explore how you can benefit from these patterns and develop trading strategies around them.

#1: Pin Bar Reversal Patterns

Pin bars are highly effective for trading candlesticks as they often create high-probability price action setups.

A pin bar forms when the price moves up or down during a single period, but the closing price remains within the previous bar’s range.

In the example below, we identify two pin bars, one bullish and one bearish.

To trade pin bars, wait for the price to break above or below the high or low, respectively, and enter the market at that point.

Pinbar setups are triggered when the next candlestick’s price breaks above the body of the pin bar.

After your order is triggered, you can look for the next support and resistance levels to find your primary profit target.

If you’re a short-term trader, you can aim for a reward-to-risk ratio of 3:1 or another ratio that suits your strategy.

If pin bars form at the extreme high or low of a sustained trend, it could signal a complete reversal of the prevailing trend.

In such cases, trailing your open position based on ATR or X-bar stop losses could maximize your long-term profit.

#2: Bullish and Bearish Engulfing Patterns

Bullish and bearish engulfing candlestick patterns, like pin bars, signal a trend reversal.

In Western trading, these patterns are known as Bullish Outside Bars (BUOB) and Bearish Outside Bars (BEOB).

An outside bar has higher highs and higher lows than the previous bar.

If the closing price is lower than the opening price, it’s a BEOB; if higher, it’s a BUOB.

In the example below, a large bearish candlestick engulfs a smaller bullish candlestick, creating a BEOB.

Placing a sell stop order a few pips below the BEOB’s low and targeting the next pivot zone could result in a winning trade with a decent reward-to-risk ratio.

Engulfing patterns are best used at the top or bottom of a trend for reversal signals, but they can also be effective in range-bound markets.

Engulfing candlesticks often break above or below a range, offering breakout trading opportunities.

Due to the longer size of engulfing candles compared to pin bars, the required stop loss is typically larger.

One way to mitigate this is by drawing Fibonacci retracements based on the engulfing bar’s high and low and setting a stop loss at a specific Fibonacci level.

#3: Inside Bars for Reversals and Continuations

Inside bars are unique in that they can signal both trend reversal and trend continuation, depending on where they form on the chart.

An inside bar is the opposite of an engulfing bar, with its high and low shorter than the previous bar’s, forming within the larger bar’s range.

To trade inside bars, wait for the price to break above or below the previous (longer) bar’s high or low.

In the example below, after a large bullish bar, two smaller bars formed within the previous bar’s high and low.

Inside bars like these can range from a single bar to several, and they remain valid as long as they don’t cross the larger bar’s high or low.

When the price breaks above the larger bar (mother bar), it signals the start of a momentum trade, often leading to a trend continuation.

If you find inside bar patterns during a strong trend, they may also signal trend continuation.

In either case, set your stop loss above or below the mother bar.

For traders needing a smaller stop loss, setting it above or below the range of inside bars is an option, though riskier and not recommended for beginners.

#4: Doji Bars Signal Indecision

A Doji forms when the opening and closing prices are nearly identical.

Officially, both prices must be the same, but a difference of a pip or two is acceptable.

Several variants of Doji exist based on how the price moved before reversing.

For example, if the high and low are equally distant from the open and close, it’s called a Star Doji.

If the price moves up and down but closes at the opening price, it forms a Gravestone or Dragonfly Doji, indicating bearish or bullish signals, respectively.

A Doji formation signals market indecision, but the context matters.

If a Doji forms during a strong trend, it may signal continuation if the price breaks above or below the Doji.

In the example below, a Doji forms during an uptrend, signaling temporary equilibrium in the market.

As soon as the price breaks above the Doji, the uptrend continues.

Placing a buy stop order a few pips above the Doji allows you to increase your long exposure or enter the market for the first time.

Given that Doji bars are typically small, setting a tight stop loss can maximize your reward-to-risk ratio.

#5: Three Bar Reversal Patterns

Three-bar patterns are among the easiest candlestick patterns to identify.

They include the Three White Soldiers (bullish reversal) and Three Black Crows (bearish reversal).

As the name suggests, when three consecutive bullish or bearish bars form at the top or bottom of a sustained trend, they signal a reversal.

In the example below, three bearish bars form at the top of an uptrend, signaling a reversal.

While the first bearish bar’s high wasn’t the highest peak, this is acceptable.

As long as the three bars form near the top of a bullish trend, it’s considered a Three Black Crows pattern.

Once the price breaks below the lowest bearish bar, the downtrend continues.

Sometimes, after the low is broken, the price may retrace slightly, but that’s normal.

Set your stop loss above the highest Crow.

The same principle applies to Three White Soldiers, a bullish signal pattern.

#6: Hanging Man Signals Bearish Reversal

A Hanging Man pattern forms when a large bearish movement occurs, but the price closes near the opening price, leaving a long shadow twice the size of the candle’s body.

The Hanging Man resembles a bullish pin bar but forms at the top of an uptrend, often with a gap.

However, the pattern is still valid without a gap.

The Hanging Man pattern is always a bearish signal.

A similar pattern at the bottom of a downtrend, called a Hammer, signals bullishness.

In the example below, a Hanging Man forms, and as soon as the low of the bar is broken, a bearish trend ensues.

Set your stop loss just above the high of the Hanging Man.

#7: Rising and Falling Three Methods

The Rising and Falling Three Methods candlestick patterns are more complex.

The Rising Three Method pattern features a large bullish candle followed by three smaller bearish candles that stay above the first candle’s low.

A fifth bullish candle then engulfs the three bearish candles and closes above the first candle’s high.

In the example below, a large bullish candle is followed by three smaller bearish ones.

The fifth bullish candle engulfs the three bearish candles and closes above the high of the first candle, completing the Rising Three Method pattern.

To trade these patterns, wait for the fifth candle to close and then enter with a market order.

Aggressive traders may set a stop loss below the third bearish bar’s low, while conservative traders may place it below the first bullish candle’s low.

The same approach applies to the Falling Three Method pattern on the opposite side.

#8: Harami Cross as a Reversal Signal

The Harami Cross pattern consists of a bullish or bearish candle at the trend’s top or bottom, followed by a Doji that forms within the previous candle’s range.

If a bullish candle is followed by a Doji, expect a bearish retracement soon.

In the example below, a Harami Cross forms at the top of a bullish trend.

Wait for the price to break below the bullish candle’s low and place a Sell Stop order a few pips below it.

Concluding Thoughts

Candlestick pattern-based strategies are straightforward to implement, as they often require waiting for the pattern to form and placing a buy or sell stop order.

This approach allows you to enter the market when the trade confirmation occurs.

While entering the market using the discussed candlestick strategies is simple, successful implementation requires prudent money management and strategic decision-making regarding when and how to exit.