There are dozens of bearish and bullish reversal patterns. We have elected to narrow the field by selecting a few of the most popular reversal candlestick patterns for detailed explanations: the long shadow reversals.
It took nearly two centuries for candlestick charts to make the leap to the Western hemisphere from Japan — and just a quarter century to become the preferred charting technique of traders from Wall Street to Main Street.
It is believed that technical analysis was first used in 18th century feudal Japan to trade rice receipts, eventually evolving into candlestick charting in the early 1800s. Steve Nison is recognized as having introduced candlesticks to the West in 1989 when he wrote about them for Futures magazine while working for Merrill Lynch.
Part of their appeal to technical analysts is their visualization of market behavior at key turning points. Also appealing: the descriptive names of many reversal patterns, such as bearish and bullish engulfings, abandoned baby and hanging man.
Technicians also like their flexibility. “You can use them in any market, and any time frame,” Nison said in an interview with MarketWatch, “as long as you have [a price for] an open, high, low and close.”
Simply put, the candle’s body is the area between the opening and closing prices. If the close is above the open, the candle is left open, or white; if the close is below the open, the body is colored in. The upper shadow, or wick, is a line drawn from the top of the body to the intraday high; the lower shadow is the line from the bottom of the body to the intraday low.
Despite Nison’s affinity for candlesticks, he still recommends a “triad” approach to technical analysis that incorporates candlesticks, Western technicals — which include moving averages, relative strength analysis, and horizontal resistance and support lines — and capital preservation and trade management through risk-reward analysis.
The following charts are an example of some important candlestick reversal patterns, as described by Steve Nison in his book, “Japanese Candlestick Charting Techniques.”
There are two pairs of single candlestick reversal patterns made up of a small real body, one long shadow, and one short or non-existent shadow. Generally, the long shadow should be at least twice the length of the real body, which can be either black or white. The location of the long shadow and preceding price action determine the classification.
The first pair, Hammer and Hanging Man, consists of identical candlesticks with small bodies and long lower shadows. The second pair, Shooting Star and Inverted Hammer, also contains identical candlesticks, but with small bodies and long upper shadows. Only preceding price action and further confirmation determine the bullish or bearish nature of these candlesticks. The Hammer and Inverted Hammer form after a decline and are bullish reversal patterns, while the Shooting Star and Hanging Man form after an advance and are bearish reversal patterns.
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The Hammer and Hanging Man look exactly alike but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower shadows and short or non-existent upper shadows. As with most single and double candlestick formations, the Hammer and Hanging Man require confirmation before action.
The Hammer is a bullish reversal pattern that forms after a decline. In addition to a potential trend reversal, hammers can mark bottoms or support levels. After a decline, hammers signal a bullish revival. The low of the long lower shadow implies that sellers drove prices lower during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. While this may seem like enough to act on, hammers require further bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. Such confirmation could come from a gap up or long white candlestick. Hammers are similar to selling climaxes, and heavy volume can serve to reinforce the validity of the reversal.
The image below is an example of how to use in forex trading the hammer candle formation to enter a long trade, while placing a stop-loss below the hammer candle and a take profit at a high enough level to ensure a positive risk-reward ratio.
The Hanging Man is a bearish reversal pattern that can also mark a top or resistance level. Forming after an advance, a Hanging Man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of selling pressure raises the yellow flag. As with the Hammer, a Hanging Man requires bearish confirmation before action. Such confirmation can come as a gap down or long black candlestick on heavy volume.
The Inverted Hammer and Shooting Star look exactly alike but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or nonexistent lower shadows. These candlesticks mark potential trend reversals but require confirmation before action.
The Shooting Star is a bearish reversal pattern that forms after an advance and in the star position, hence its name. A Shooting Star can mark a potential trend reversal or resistance level. The candlestick forms when prices gap higher on the open, advance during the session, and close well off their highs. The resulting candlestick has a long upper shadow and small black or white body. After a large advance (the upper shadow), the ability of the bears to force prices down raises the yellow flag. To indicate a substantial reversal, the upper shadow should be relatively long and at least 2 times the length of the body. Bearish confirmation is required after the Shooting Star and can take the form of a gap down or long black candlestick on heavy volume.
Traders could take advantage of the shooting star candle by executing a short trade after the shooting star candle has closed. Traders could then place a stop loss above the shooting star candle and target a previous support level or a price that ensures a positive risk-reward ratio. A positive risk-reward ratio has been shown to be the key for those who learned how to trade forex successfully.
The Inverted Hammer looks exactly like a Shooting Star, but forms after a decline or downtrend. Inverted Hammers represent a potential trend reversal or support levels. After a decline, the long upper shadow indicates buying pressure during the session. However, the bulls were not able to sustain this buying pressure and prices closed well off of their highs to create the long upper shadow. Because of this failure, bullish confirmation is required before action. An Inverted Hammer followed by a gap up or long white candlestick with heavy volume could act as bullish confirmation.
Hanging Man, Shooting Star, Hammer, and Inverted Hammer is kind of similar candlestick patterns. This can lead to some confusion.
The hanging man appears near the top of an uptrend, and so do shooting stars. The difference is that the small real body of a hanging man is near the top of the entire candlestick, and it has a long lower shadow. A shooting star as a small real body near the bottom of the candlestick, with a long upper shadow. Basically, a shooting star is a hanging man flipped upside down. In both cases, the shadows should be at least two times the height of the real body. Both indicate a potential slide lower in price.
The hanging man and the hammer are both candlestick patterns that indicate a trend reversal. The only difference between the two is the nature of the trend in which they appear. If the pattern appears in a chart with an upward trend indicating a bearish reversal, it is called the hanging man. If it appears in a downward trend indicating a bullish reversal, it is a hammer. Apart from this key difference, the patterns and their components are identical.
Like all candlestick reversal patterns, the success rate can be improved if they combine with other technical signals. A reversal candlestick pattern at a resistance level, with a bearishly diverging technical indicator, would be a stronger sell signal than a reversal candle pattern by itself.
Depending on the user’s risk tolerance and investment time frame, a bearish reversal doesn’t have to mean it’s time to bet on a decline. “When we talk about being bearish, it isn’t always about getting out of a trade,” explains Nison. “It could also be about protecting yourself,” against a selloff.
Understanding how Hanging Man, Shooting Star or Inverted Hammer candlestick patterns works is important, but if you want some help, the MT5 platform offers a useful Candlestick toolkit and our trainers can provide you the right guidance. Play around in a forex demo account and notice how reversal candlestick patterns can make you serious money.