Candlestick Chart Patterns

Introduction

The Japanese began using candlestick patterns for over 100 years before the West developed the bar and point and figure system. the candlestick charting basics used today was developed by Homma Candlestick Charting has now become more popular and use, credit all goes to Steve Nisson and Greg Morris. According to Steve Nison, candlestick charting first appeared sometime after 1850.

Whether you trade in forex, stocks, options or futures this candlestick patterns is best tool for technical analysis of stocks. Once you become familiar that how to read candlestick patterns you will quickly assimilate and easily interpret them.
How to read candlestick patterns - Each candlestick is represented by 4 price points: Closing price Highest price Opening price Lowest price The distance between the closing and opening values is defined as the body.
When the closing value is higher than the opening price, then the candlestick is bullish (going up) and its body normally has a white (or green) color. and a bearish (going down) candlestick isformed whenever the opening price is above theclosing value. This is usually black (or red).
By Using candlestick patterns always increases accuracy. The reason to increase accuracy is to increase profits. If you can get “more accurate” you can become more profitable

---

Long Candles Vs Short Candles- Generally long candle indicates more intense buying or selling pressure, Moreover short candle indicates  less buying or selling pressure

---

Check out the various candlestick patterns and formation below to understand it better.

---

Abandoned Baby- The abandoned baby indicates strong reversal signal, composed of a doji star, This pattern usually seen in a down trend or in up trend, usually on a first long candle and and second day doji candle appears with gap of previous day closing. As you can seen in image below.

---

Dark Cloud Cover- is a top reversal pattern / bearish reversal pattern. It can be formed at the end of an uptrend, or during a bounce within a downtrend, or at the resistance. A Dark Cloud Cover Pattern occurs when a bearish candle on Day 2 closes below the middle of Day 1's candle, price gaps up on Day 2 only to fill the gap and closed 50% from the 1st candle. As see it on image below.

---

Doji- is a very powerful trading signal.A Doji will often appear as a cross or plus sign. The larger the time frame the more important the signal. It is at this juncture that we often see dramatic reversals in the market.

---

Downside Tasuki Gap:- The downside tasuki gap begins with a set of 3 candlesticks. The first candlestick is large and bearish and clearly states the bearish intent of the trend. The next day, price gaps down to the second candlestick which is also bearish. The third candlestick is a bull candlestick that attempts to close the gap but doesn’t do so.

---

Dragonfly Doji:- Indicates Pattern is strongest after an established bearish trend. A candle forms with a very small to almost nonexistent body with a long lower wick. Little or no upper wick. In this pattern, open, high, and close are at the high of the day. Long positions can be taken once high of the candle is exceeded

---

Engulfing Pattern:- is very effective when found in oversold area, at the end of a continues downtrend or the overbought area for the pattern. The Engulfing pattern consists of two bodies. The first body is the same color as the current trend, the second is the opposite color. The signal day opens lower than the previous days close, then it trades higher so by the end of the day, it will close above the previous days open.

---

Evening Doji Star:- It is a reversal candlestick pattern which is bearish in nature and appears at the end of bullish trend. It is a complex pattern made of three candles. The first candle is bullish in nature, the second is indecisive in nature and third candle is bearish in nature. This pattern appears just before price fall, and it contains a doji.

---

Evening Star:- A large white body followed by a small body that gaps above the white body. The third candlestick is a black body that closes 50% or more into the white body, Interpretation: A top reversal signal..

---

Falling Three Methods:- The Falling Three Methods is a bearish continuation pattern. It indicates continuation of bearish trend. The first candle is strong, in which case it should have a long black body. The next three candles that follow are small relative to the first candle and in the opposite direction, in this case up days. The last candle, is another long black (bearish) candle that should close below the real body of the first candle.

---

Gravestone Doji:- The Gravestone Doji has a long upper shadow and no lower shadow, and it forms when the open, low and close are equal. The high is what creates the long upper shadow
The Gravestone Doji signal indicates that prices were driven higher during the session, and by the end of the session, the prices came back down to the opening level and the session low as a result of the sellers. As with other Doji's, this candlestick has a potential to change direction..

---

Hammer:- A hammer is a bottom reversal signal. It has long lower shadow & a small real body -black or white at its top, There should be a continues downtrend formation in order for the hammer to reverse the trend. The stronger the downtrend before it and the longer the lower shadow the more bullish this formation is.

---

Hanging Man:- The hammer and hanging man both looks alike but have totally different meanings depending on past price action. Both have little bodies (black or white), long lower shadows, and short or absent upper shadows. After a long uptrend, the formation of a Hanging Man is bearish because prices hesitated by dropping significantly during the day

---

Harami:- One of the major candlestick patterns is called the harami. The bullish harami is a two-candle pattern. The first candle is usually a large black one. The second candle opens above the previous day's close and closes below the previous day's open. The pattern is more effective when the second, smaller candlestick is a doji (a candlestick with no, or a very small, body). Harami means "pregnant" in Japanese. A harami at the support level, associated with other indicators, can provide indications of a significant reversal.

---

Harami Cross:- The Harami Cross is a indicator of trend reversal, particularly when it occurs after a long body in a downtrend. It is the same as the Harami, except that the second candle is a Doji. How to Recognise a Harami Cross: The second candle has the same open and close prices, i.e. it is a Doji. The Doji candlestick fits within the longer body of the preceding trading period. The longer body is part of a sustained directional trend.

---

Inverted Hammer:- This is a bullish reversal candlestick pattern. It occurs at the bottom of a trend. Inverted hammer occurs at the bottom of a downtrend and indicates the possibility of reversal of the downward trend.

---

Long Day:- This is a candlestick pattern which has a body with a very long range (long body) and a very small shadow..

---

Long-Legged Doji:- The Long-legged Doji has a long upper and lower shadows with the price in the middle of the range (Closing and opening almost at same price.). This shows indecision of traders

---

Long Shadows:- The upper or lower shadows of candlesticks are the thin lines stretching above and below the body. The price distance between the open and high is called the upper shadow. The price distance between the open and the low is called the lower shadow.
If a candlestick has a long upper shadow and short lower shadow, that means the demand increases the price, but for some reasons or another, sellers involve in and bring prices back down.
If a candlestick has a long lower shadow and short upper shadow, that means there is a selling pressure that forces price lower, but for some reasons or another, buyers involve in and bring prices back up.

---

Marubozu:- A long candlestick (black or white) with no shadow or tail. The high and the lows represent the opening and the closing prices. Considered a continuation pattern either bullish or bearish..

---

Morning Doji Star:- Seems to form a little star that appears after a black bearish candlestick and then little star makes the atmosphere becomes bright. This indicates reversal from bearish trend to bullish.

---

Morning Star:- A long black day is followed by a small day that gaps in the direction of the trend. The third day is a white day which closes in the top half of the black day. it happens in a downtrend or during a pullback within an uptrend, the market gaps down but enough buyers step in to halt the weakness.

---

Piercing Line:- A long black body forms in a downtrend which continues the bear trend. A gap to the downside on the next days open further perpetuates the bearishness. the next day after, the market rallies all day and closes much higher. In fact the close is above the midpoint of the body of the long black day..

---

Rising Three Methods::- This pattern indicates a rest in market action It happens when the market is on an uptrend. Day 1 has a long white bullish candle Then there are small bodies defining a brief downtrend but it stays between the range of Day 1 on the second, third and fourth days and then Day 5 has a long white candlestick opening above the close of Day 4 and closing at a new high. .

---

Shooting Star:- The Shooting Star candlestick formation is a bearish reversal candlestick pattern that mainly occurs at the top of bullish trend. The Shooting candlestick is created when the open, low, and close are roughly the same price..

---

Spinning Top:- Candlesticks with a long upper shadow, long lower shadow and small real bodies are called spinning tops. The pattern indicates the indecision between the buyers and sellers. The upper and lower long wicks tell us that both the bulls and the bears had the upper hand at some point during the time period the candle represents.

---

Stick Sandwich:- it consists of two dark candles with a white candle in between. The closing prices of the two black candles are equal. This indicates an support price. The probability of a reversal in the trend is high from this area..

---

Three Black Crows:- This three black crows pattern is also known as three winged crows. It contais three consecutive black candles that opens with upside price gap. This three black crows pattern is a bearish reversal candlestick pattern, so it is valid when it occurs in bull trend. The three candles should close at or near their lows.

---

Three White Soldiers:- A long bullish candle that indicates the end of a bear trend. A second long bullish candle that continues the rally & closes near the high. A third long bullishh candle that takes the market higher and also closes near the high This formation is more significant if it occurs at an support.

---

Upside Gap Two Crows:- Two crows is actually a warning of top reversal It happens when market is on an bullish trend The long bullish candlestick on the Day 1 shows the continuation of the bullish trend A bear body appears on 2 day with a gap. And Another bear candle appears on Day 3. The opening is higher than that of Day 2 and its closing is lower than Day 2 and Day 3 close is above the close of Day 1.

---

Upside Tasuki Gap:- The upside tasuki gap is a bullish continuation trend and is the result of temporary profit booking in a strong bullish market. In another words it signifies a continuation of a prevailing trend, even after a correction day, &it is considered to be a rare pattern.

The Federal Open Market Committee (FOMC), a branch of the US Federal Reserve Board that decides US monetary policy, meets eight times every year at intervals of 5 to 8 weeks. Investors in capital markets all over the world, including India, follow these meetings with a great deal of interest, because policy announcements made after the meeting have significant ramifications for stock and bond markets. The Federal Reserve (commonly known as the Fed) has several monetary policy tools to influence money supply, interest rates and inflation in the US economy.

Money Supply, Growth and Inflation

Money supply, which is the total stock of cash and cash equivalents (liquid instruments) in the economy, is a very important macro-economic factor because it has a direct impact on the economic activity of a country. Increase in money supply puts more money in the hands of the consumer for spending on goods and services, which in turn increases business activity and employment. Increase in money supply also typically lowers interest rates (interest rates, after all, depend on the demand and supply of money), which incentivizes companies to borrow and invest in capital projects, which in turn results in future economic growth.

Increase in money supply is good for the economy as it can then lead to higher GDP growth. It should, however, be noted that, increase in money supply has an undesirable effect too. More money in hands of people results in more spending, which in turn causes prices to go up (inflation). Controlling inflation (price stability) is an important policy objective of central banks. Monetary policies of central banks (like the Fed and RBI - Central Bank for such decision making in case of India) therefore, have to carefully balance between growth and inflation.

Short history of Fed actions since 2008

We had said earlier that, there are several tools in the arsenal of the Fed (and other central banks) to influence money supply, interest rates and inflation. The primary tool of the Fed to manage money supply in the US economy is Open Market Operations, by which the Fed buys or sells US Government (Treasury) securities.

When Fed buys Treasury securities, it pumps liquidity in the US economy, or in other words, increases the money supply. When Fed sells Treasury securities, it sucks liquidity out of the economy, or in other words, decreases the money supply.

In the financial crisis of 2008, there was a severe liquidity shortage in the US economy and several large banks were on the verge of collapse (investment banks like Bear Sterns and Lehman Brothers did fail). In order to prevent larger banks from failing, the Fed embarked on an extraordinary program of Open Market Operations to inject liquidity (money supply) in the economy, known as Quantitative Easing (QE).

The key difference between normal Open Market Operations of the Fed and Quantitative Easing (QE)was that, in normal Open Market Operations short maturity US Treasury securities, while QE also included purchase of long maturity US Treasury securities and also mortgage backed securities (one of the main antagonists of the 2008 crisis). The scale of QE was also much bigger than the normal Open Market Operations of the Fed. The Fed pumped in trillions of dollars of liquidity (money) in the US economy through QE.

Quantitative easing by the Fed had the desired effect. It injected much needed liquidity in the US banking system and kept US interest rates low. Low interest rates and US Treasury yields made emerging equities (including India) attractive to investors from a risk return perspective.

In the two years after QE was initiated in the US, our Nifty rose by 115% (47% CAGR). Investors should know that, every monetary policy action of central banks like the Fed have a goal. When the goal is achieved, central banks have to re-calibrate their monetary policies, because continuing a policy after the goal is achieved can have adverse side-effects for the economy.

In 2013, the Fed thought that, the objectives of QE were largely met and began tapering (reducing the US Treasury securities purchase program). QE was totally stopped by the end of 2014. Investors who have been following the capital markets know that, the QE tapering led to a mini crisis in capital markets in 2013. The Nifty corrected sharply in June to August 2013. Bond prices fell and yields rose sharply; in fact, for a few days in the middle of 2013, even liquid funds in India gave negative returns. However, investors should note that, the market usually over-reacts to any monetary policy change. Normalcy was restored in the market in September 2013 and it resumed its upward trend again.

The QE achieved two important policy objectives; ensuring liquidity in the US banking system and stimulating US GDP growth (and employment). At a global level, it restored investor’s confidence in the capital markets. Investors should understand that, from 2008 to December 2015, the Fed locked interest rates next to zero (0 – 25bps as per official target).

Low interest rates allow the consumer to borrow and spend more money, thereby boosting economic growth. Equity investors benefit from low interest rate and higher economic growth. Low interest rates have benefited Foreign Institutional Investor (FII) funds flow to emerging markets like India. We had discussed earlier that, central banks have to carefully balance between their growth and inflation objectives. The US GDP and employment has been rising gradually in the low interest rate regime, even after the cessation ofQE.

By 2015, the Fed has been increasingly concerned about inflation in the US. At the start of this post we had discussed that, the Fed has several monetary policy tools in its arsenal to influence money supply, interest rates, GDP growth and inflation. Till 2013 – 14, QE was the primary tool of the Fed, but from 2015 onwards, the FOMC has been discussing the use of another important monetary policy tool in its arsenal, the Federal Funds Rate.

Federal Funds Rate

The Federal Funds Rate is the interest rate at which US banks borrow money from each other. The Fed Funds Rate is controlled by the US Federal Reserve through its monetary policy announcements and through its open market operations. You should understand that, the central bank of a country has unlimited capacity to manage interest rates because it has the power to print currency notes, a power which no bank, or for that matter, anyone else in the country has.

If the Fed (or RBI which is Central Bank for such decision making in case of India) wants to reduce interest rates, it can simply print money and buy US treasury securities (or GOI securities) through open market operations; the interest rates will automatically go down. If the Fed (or RBI - Central Bank for such decision making in case of India) wants to increase interest rates to control inflation, it can slow down the purchase of US treasury securities (or GOI securities) held by banks through open market operations; the interest rates will go up automatically.

The Fed Funds Rate is essentially the interbank rate and the basis of the prime lending rate (PLR) for US banks. In the last 20 years, the highest Fed Funds Rate was 9.75% in 1988. In 2008, the Fed reduced the Funds Rate to near zero (0.25%). From 2015 onwards, the Fed has used the Fed Funds Rate as a monetary policy tool. In December 2015, the Fed raised the Fed Funds Rate by 25 bps and it now stands at 0.5%. In the last FOMC meeting, the Fed kept the Fed Funds Rate unchanged, but as per latest developments in the market, it is expected to go up over the next few months, probably as early as December, because employment and inflation is rising gradually in the US.

Relationship between Fed Funds Rate and Stock Prices

The Fed Funds Rate has an impact on stock market returns because cost of capital increases with increase in interest rates. For example, you expect 15% returns from equity. From risk free debt, let us assume that, you could have got 8%. Assuming, you have 50% allocation to equity and 50% to debt, your portfolio return will be 11.5%. After increase in interest rates, let us assume you get 9% from risk free debt, while you get the same equity returns (15%). You can get 11.5% returns now, from 42% equity and 58% debt asset allocation. If 11.5% is your return objective, then you are better off reducing your exposure to equities by 8% and increasing debt by 8%, because you are improving your risk / return trade-off. When you are reducing equity exposure, you are selling stocks and therefore, the stock price will go down. Typically, when interest rates are raised, it results in falling stock prices. Conversely, when interest rate falls, there is greater demand for equities, which can give higher returns.

Relationship between Fed Funds Rate and Indian Stock Market

Indian investors should know that, for global investors the safest asset class is not Gold (strange, as it may, sound to some of our readers). The safest asset class for global investors is US Treasury Securities. If interest rates increase in the US, the price of US Treasury securities will fall and the yields will increase. This will make US Treasury securities (US Government Bonds) more attractive to investors. FIIs will want to lock in higher risk free yields and, therefore, take money out of Indian stock markets. This will cause stock prices in India to fall, but you should remember that, it will only be a short term effect. Over the past 9 to 12 months, we saw stock prices falling, whenever we had the rumour of increase in US Fed Funds rate (interest rates).

Long term effect of interest rates on stock prices

Let us be realistic, interest rates (Fed Funds Rate) cannot forever be in the 0.25% - 0.5% range; it has to rise in the future, whether two months from now or a year later, is simply a matter of conjecture. While higher interest rates have an impact on short term share prices, from a fundamental perspective, however, in the longer term, rising interest rates do not necessarily imply falling stock prices. There is a lot of noise in the market now about US Fed Funds Rate hike and how it will impact stocks. As a long term investor, you should ignore these noises. Higher GDP, employment and, consequently, higher prices (inflation) will create, interest rate increase notwithstanding, will create more money to be invested in emerging markets like India.

Conclusion

While Fed Funds Rate increase can have a negative short term impact on Indian equities, from a longer term perspective, we do not see Fed Funds Rate increase as negative for India. In fact, given our strong macros, we believe that, India is strongly positioned within the emerging market basket, and can actually benefit from a US interest rate increase, since it can lead to incremental FII fund flows to India.