Bursa Malaysia: Level 2: Getting to the Heart of the Stock Marke

Author: Lee TG | Publish date: Wed, 26 Jan 14:18 | >> Read article in Blog website

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Open any classic text book on economics and you are sure to find that the explanation for pricing comes down to supply and demand. The idea that supply and demand is the sole factor on the determination of prices is as familiar as Newtonian gravity. If there is more demand than supply then prices will rise; if there are more sellers than buyers, then prices will fall.

This is a simple market model and looking at pure Level 1 real time prices gives no indication on what is going on beyond the moves of the Bid (demand) and Ask (supply). This information is limited and thus difficult to read. In the old days of the ticker reading, acute or perhaps deluded, speculators could divine the next price move from the sequence before. But those were the days when there could be minutes between ticks. This is as far from modern trading as the pony express is from email.

Chartists can point at tick charts and try to understand and predict the movement of the markets from them, but what you see is a two dimensional representation of the past action. What you need is a three dimensional representation and one that contains information that makes up the future.

While the buy-and-hold investor sails calmly over the sea of volatility unshakable in his resolve to ride economic progress to nirvana, the trader is looking to jump onto the volatility and time his entry and exit. He plans to get paid for providing liquidity by capturing the noise of random swings that are the markets tick-by-tick volatility.

To do this he must have as much information as possible, and Level 2 is the view of the inner workings of the market. Level 2 is the leading edge of market data. Happily, it is a multidimensional data stream, and information contained in it does give information about the future--or at least a very strong indication of this.

Market Depth in Level 2

The Level 2 information covers not only the Bid and Ask for a stock, but also the "market depth". Level 2, as the name suggests, is the next step up in market information. Level 1 shows the Bid and Ask (the buy and sell price of a stock), whereas Level 2 includes so called "market depth." The "market depth" is the whole spectrum of buy and sell orders at different volumes and different prices. Buy orders are on the Bid side and sell orders on the Ask side. Different markets have different flavors of Level 2, so that the Nasdaq flavor, called TotalView, is a bit different from NYSE's Open Book. However the basic principles are the same. The order book for a stock on Level 2 is like a pile of orders. The bid orders are buyers offering to buy quantities of stock at price levels at the current bid and at lower prices. If you want to sell, you 'hit' the bid price of the best bid. The opposite is the case for ask orders.

You could place a buy order on the bid by entering an order at the bid price or lower. For example, you could place an order for MSFT at $2 below the current bid, and if the price fell that far, you would get your order at that price. If you placed a buy order at the bid, you would be added to the end of the bid queue at that particular bid price. This would be the last order filled at that price before the market moves onto the near Bid price level. Level 2 is a queue, and it is the way in which everyone lines up with their orders that makes the market.

While the orders that you see are real, they can be entered and removed by the trader at any time if these were not met. This means that an order to buy can disappear and new orders to buy and sell can appear at any time and at any price level. This makes the Level 2 a fluid environment with orders coming and going when they are filled, or just merely cancelled before they are met.

Orders can be placed on the Level 2 book for reasons other than buying or selling. Bid orders might be an artificial show of strength to suggest support for a price, but this support might melt away if a significant seller appears. Conversely, a large buyer will not put all his orders into the market at once and will instead break up his order into smaller pieces in order to conceal his intent. All markets tend towards game play and the games certainly come thick and fast on Level 2.
Level 2 and the Ax Force

Participants on the Level 2 book are named and, in many instances, there is a party whose order or general interest is the dominant factor in the action of that stock. The order or the participant interest and hence the participant themselves, is known as the 'Ax'.

Many traders make their living simply by judging the direction of the market and its participants and following along behind them. Like the Remoras swimming under the shark, they do not try to guess the market; they try to guess what the big guys with the big orders are doing. A market maker, who makes his money from the spread with a huge buy order, will drive the price up and, likewise, a market maker with a big position to dump will push the price down. Many simple traders watch for the tell tale sign that there is a big order being filled before going with the flow. This flow will be the 'Ax', and likely to be a market maker working an order flow to try and get the best price.

Simply riding on the coat tails of the 'Ax' makes these traders their money. These 'Axes' will be trading with computers, so working out what is going on in a Level 2 book is as much of an art as any kind of trading

You can imagine that every stock is a miniature market, in which a group of players bargain to set the price. The 'Ax' is the main player with the big position who will set the pace and scope of the play.

For example a market maker may have an order to buy 10 million shares of a stock. As no one else has a big position to buy or sell, his actions will dominate the market while he has this position to fill.

He will not simply put a 10,000,000 share order in at a price. That order would be liable to drive the price higher. So the 'Ax' will put a 50,000 stock order in, at say $50 a share, which is the current bid and wait. As the 50K order is filled he will put in a new order at $50 and so on to fill his big order. This may well be executed by his computers, which would be connected to the market by what is known as a 'program trade.'

The system will try and hide the fact that there is a buyer at $50 a share by varying the price, timing and size of the broken up order. This disguises what is going on. Only a small part of the whole order will be placed as an order into the market book, yet the 'Ax' will have, in effect, put a level of support on the price by his buying action. If the order has a price range it may well drive the price higher. In any event, the floor on the price will mean that while the market is very unlikely to go below this $50 level, the upside is open to the turn of events. This, in a way, is a one way bet.

Sadly it is not often that a single 'Ax' will stay in place for very long periods of time and the 'Ax' will pass between players. Yet this understanding of what is going on in a stock market is only to be had via a Level 2 screen.

Conversely if an Ax has been holding a price down all day or is driving the market upward, it is obvious that, at some point, he will get a complete fill. When his play is finished, it is a fair bet that the price of that stock will move in the opposite position for a while. The markets are always reverting to a mean, and as players enter and exit, so the noise of their actions jerks the price away from a smooth transition. In the intense day trader environment, this translates into the constant vibration of price, and a trader is trying to catch the extremities of this shaking to capture a profit.
Conclusion: Level 2 as an Advanced Tool

From a Level 2 perspective, the market is an enormous poker game. With real orders waiting to be filled, iceberg orders with larger volume stealthily preloaded and phantom orders designed to spook out other traders, this is no simple map for the uninitiated. This doesn't make the Level 2 world a simple one, but it is the actual state of play and without Level 2 you may as well trade from the prices in the morning papers.

What is clear (or clear for some) is the flow of trades. When a stock like Cisco starts to trade fast, it can go from 30 trades a minute to 500. To the naked eye it is hard to pick out what exactly is happening except that trading has got very fast.

Level 2 is an arms race just like Level 1 was before it. Without the most advanced tools-unless the angels are on your side-you may as well stay away from the markets.

Source: http://www.stockmarketlevel2.com

Climatic Actions: Buying and Selling Climax

Author: Lee TG | Publish date: Tue, 25 Jan 10:53 | >> Read article in Blog website

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Nailing market tops and bottoms is impossible, but there are signs that increase the probabilities during relatively shorter timeframes or trends. Add to that the ability to recognize resistance and the SM Campagn lights up. Notice that single bars are valuated as clues, multiple bars reveal tactics, but the campaign comes in waves of accumulation and distribution based on the levels of supply and demand. During these waves are the phases of Mark Up or Mark Down which tend to run as Trends.

Trends

A market moves up not necessarily because there is more buying than selling going on, but that there is no substantial bouts of selling [profit taking] to stop the up move. Major buying [demand] has already taken place at a lower price level during the accumulation phase, until substantial selling starts to take place [appears as excessive volume on up bars] the trend of the market will still be up. A bear market takes place not because there is necessarily more selling than buying as the market falls day after day, but because there is insufficient buying [support] from the major players to stop the down move. Selling has already taken place during the distribution phase at a higher price level and until you see buying coming into the market [excessive volume on down bars], the market will remain bearish. There is little or no support in a bear market [buying] so prices fall. Herein lies the reason markets fall much faster than they rise... [TW]

Climax: the peak, the extreme or the end of something and as the point of highest dramatic tension or a major turning point in the action. Some synonyms are: top, pinnacle, height, maximum, consummation, culmination or turn of the tide. What does a climax do? A climax stops a trend either temporarily or permanently depending on the subsequent action. A climax is preceded by some sort of a trend.

Climactic action is hall-marked by wide spreads up on very high volume, but the price does not respond upwards. A good trader will now be looking to short the market or sell calls on any low volume up-move (no demand). [TW]

There are two tactics that are used when a Trend is about to reverse: the Selling Climax and Buying Climax.

An important point here is to know the tactics of Retracements versus Reversals. Retracements have: a lack of volatility; small Spreads; and decreased Volume. Reversals, on the otherhand, have: increased Volatility; large spreads; increasing volume. To see this on a chart simply draw arrows for the stock movement and the volume. In retracements the arrows are in the same direction; in reversals the arrows will be in opposite directions.

The Buying Climax

There are two types of buying climactic action seen in the indices with only one major distinction. After a substantial bull move has already taken place, the market moves even higher on wide spreads up. Good news, excitement, elation abounding. You observe the volume is Ultra-high. This indicates that you may have seen a buying climax. [TW]

If the volume is seen to be exceptionally high, accompanied by narrow spreads into new high ground, you can be assured that this is a 'buying climax'. It is called a buying climax because to create this phenomenon there has to be a huge demand for buying from the public, fund managers, banks and so on. It is into this buying frenzy, that syndicate traders and market-makers will dump their holdings, to such an extent that higher prices are now impossible. In the last phase of the buying climax, the market will be seen to close in the middle or high of the bar.

Those traders that have been waiting to buy start buying - afraid they will miss out on a bigger move up. Even traders that already have positions, buy more. This gives the SM a chance to unload huge amounts of their holdings in this stock, bought at lower levels, without moving the price down against their own selling. After this Buying Climax they sell the stock short, knowing that there is no support or demand at these high prices. This process guarantees huge profits.

The Buying Climax (BC) is the climax ending an uptrend. The buying gradually builds up & builds up and finally comes in with a rush until it exhausts itself on the BC. The BC has increased volume and a widening spread as it moves up. Following a BC one of two things can occur, either a Automatic Rally (AR) or a lateral move. This in turn is followed by one of two things: either a continuation of the uptrend or a Secondary Test (ST). If the supply is to weak to drive the stock down or demand to strong to allow it to go down instead of having the AR the stock will have the lateral move. Usually however, it will have some form of an AR. That AR may have increased volume, heavy volume or no volume. It may have wide price spread, or relatively narrow price spread.

The Selling Climax

The news will definitely be 'bad' This, together with the pain of previous falls will panic the herd into selling. This will give SM the opportunity to place substantial amounts of money into the market at bargain prices. Ultra wide spreads down, with exceptionally high volume, usually closing on or near the highs of the day. If the price action does not close on the highs but on the lows and the next day is up closing on the high, this can be regarded as similar action. Add more bullishness if the news is really bad. [TW]

The classic characteristics of a selling climax:

• Abnormally large volume
• Wide spreads
• An acceleration of the downtrend

In the chart below there is a Test for supply (2nd bar in red box), then only light volume and a Spring Trap. This was the go-ahead for the rally to begin.

Back to Wyckoff: "Abnormally large and swift volume expansion marks a turning point."

Source:http://www.informedtrades.com/

The business of accumulating a stock is like any other campaign. It requires planning,
good judgement, effort, concentration, trading skill and money to buy stock in very
large amounts without putting the price up against your own buying. [Tom Williams (TW)]

Candlestick Bullish Reversal Patterns

There are dozens of bullish reversal candlestick patterns. I have elected to narrow the field by selecting the most popular for detailed explanations. Below are some of the key bullish reversal patterns with the number of candlesticks required in parentheses.

• Bullish Engulfing (2)
• Piercing Pattern (2)
• Bullish Harami (2)
• Hammer (1)
• Inverted Hammer (1)
• Morning Star (3)
• Bullish Abandoned Baby (3)

The hammer and inverted hammer were covered in the article Introduction to Candlesticks. This article will focus on the other six patterns. For a complete list of bullish (and bearish) reversal patterns, see Greg Morris' book, Candlestick Charting Explained.

Before moving on to individual patterns, certain guidelines should be established:

• Most patterns require bullish confirmation.
• Bullish reversal patterns should form within a downtrend.
• Other aspects of technical analysis should be used as well.

Bullish Confirmation

Patterns can form with one or more candlesticks; most require bullish confirmation. The actual reversal indicates that buyers overcame prior selling pressure, but it remains unclear whether new buyers will bid prices higher. Without confirmation, these patterns would be considered neutral and merely indicate a potential support level at best. Bullish confirmation means further upside follow through and can come as a gap up, long white candlestick or high volume advance. Because candlestick patterns are short-term and usually effective for only 1 or 2 weeks, bullish confirmation should come within 1 to 3 days after the pattern.

Existing Downtrend

To be considered a bullish reversal, there should be an existing downtrend to reverse. A bullish engulfing at new highs can hardly be considered a bullish reversal pattern. Such formations would indicate continued buying pressure and could be considered a continuation pattern. In the Ciena example below, the pattern in the red oval looks like a bullish engulfing, but formed near resistance after about a 30 point advance. The pattern does show strength, but is more likely a continuation at this point than a reversal pattern.

The existence of a downtrend can be determined by using moving averages, peak/trough analysis or trend lines. A security could be deemed in a downtrend based on one of the following:

• The security is trading below its 20-day exponential moving average (EMA).
• Each reaction peak and trough is lower than the previous.
• The security is trading below its trend line.

These are just examples of possible guidelines to determine a downtrend. Some traders may prefer shorter downtrends and consider securities below the 10-day EMA. Defining criteria will depend on your trading style and personal preferences.

Other Technical Analysis

Candlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase reversal robustness. Below are three ideas on how traditional technical analysis might be combined with candlestick analysis.

Support

Look for bullish reversals at support levels to increase robustness. Support levels can be identified with moving averages, previous reaction lows, trend lines or Fibonacci retracements.

Momentum

Use oscillators to confirm improving momentum with bullish reversals. Positive divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R would indicate improving momentum and increase the robustness behind a bullish reversal pattern.

Money Flows

Money Flows: Use volume-based indicators to access buying and selling pressure. On Balance Volume (OBV), Chaikin Money Flow (CMF) and the Accumulation/Distribution Line can be used in conjunction with candlesticks. Strength in any of these would increase the robustness of a reversal.

For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for bullish candlestick reversal in securities trading near support with positive divergences and signs of buying pressure.

A number of signals came together for IBM in early October. After a steep decline since August, the stock formed a bullish engulfing pattern (red oval) and this was confirmed three days later with a strong advance. The 10-day Slow Stochastic Oscillator formed a positive divergence and moved above its trigger line just before the stock advanced. Although not in the green yet, CMF showed constant improvement and moved into positive territory a week later.

Bullish Engulfing

The bullish engulfing pattern consists of two candlesticks, the first black and the second white. The size of the black candlestick is not that important, but it should not be a doji which would be relatively easy to engulf. The second should be a long white candlestick – the bigger it is, the more bullish. The white body must totally engulf the body of the first black candlestick. Ideally, though not necessarily, the white body would engulf the shadows as well. Although shadows are permitted, they are usually small or nonexistent on both candlesticks.

After a decline, the second white candlestick begins to form when selling pressure causes the security to open below the previous close. Buyers step in after the open and push prices above the previous open for a strong finish and potential short-term reversal. Generally, the larger the white candlestick and the greater the engulfing, the more bullish the reversal. Further strength is required to provide bullish confirmation of this reversal pattern.

In Jan-00, Sun Microsystems (SUNW) formed a pair of bullish engulfing patterns that foreshadowed two significant advances. The first formed in early January after a sharp decline that took the stock well below its 20-day exponential moving average (EMA). An immediate gap up confirmed the pattern as bullish and the stock raced ahead to the mid-forties. After correcting to support, the second bullish engulfing pattern formed in late January. The stock declined below its 20-day EMA and found support from its earlier gap up. This also marked a 2/3 correction of the prior advance. A bullish engulfing pattern formed and was confirmed the next day with a strong follow-up advance.

Piercing Pattern

The piercing pattern is made up of two candlesticks, the first black and the second white. Both candlesticks should have fairly large bodies and the shadows are usually, but not necessarily, small or nonexistent. The white candlestick must open below the previous close and close above the midpoint of the black candlestick's body. A close below the midpoint might qualify as a reversal, but would not be considered as bullish.

Just as with the bullish engulfing pattern, selling pressure forces the security to open below the previous close, indicating that sellers still have the upper hand on the open. However, buyers step in after the open to push the security higher and it closes above the midpoint of the previous black candlestick's body. Further strength is required to provide bullish confirmation of this reversal pattern.

In late March and early April 2000, Ciena (CIEN) declined from above 80 to around 40. The stock first touched 40 in early April with a long lower shadow. After a bounce, the stock tested support around 40 again in mid April and formed a piercing pattern. The piercing pattern was confirmed the very next day with a strong advance above 50. Even though there was a setback after confirmation, the stock remained above support and advanced above 70. Also notice the morning doji star in late May.

Bullish Harami

The bullish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether they are bullish reversal or bearish reversal patterns, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bullish reversals after a decline and potential bearish reversals after an advance. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.

In his book Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but that the most bullish are those that form with a white/black or white/white combination. Because the first candlestick has a large body, it implies that the bullish reversal pattern would be stronger if this body were white. The long white candlestick shows a sudden and sustained resurgence of buying pressure. The small candlestick afterwards indicates consolidation. White/white and white/black bullish harami are likely to occur less often than black/black or black/white.

After a decline, a black/black or black/white combination can still be regarded as a bullish harami. The first long black candlestick signals that significant selling pressure remains and could indicate capitulation. The small candlestick immediately following forms with a gap up on the open, indicating a sudden increase in buying pressure and potential reversal.

Micromuse (MUSE) declined to the mid sixties in Apr-00 and began to trade in a range bound by 33 and 50 over the next few weeks. After a 6-day decline back to support in late May, a bullish harami (red oval) formed. The first day formed a long white candlestick, and the second a small black candlestick that could be classified as a doji. The next day's advance provided bullish confirmation and the stock subsequently rose to around 75.

Hammer

The hammer is made up of one candlestick, white or black, with a small body, long lower shadow and small or nonexistent upper shadow. The size of the lower shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to range over the last 10-20 days.

After a decline, the hammer's intraday low indicates that selling pressure remains. However, the strong close shows that buyers are starting to become active again. Further strength is required to provide bullish confirmation of this reversal pattern.

Nike (NKE) declined from the low fifties to the mid thirties before starting to find support in late February. After a small reaction rally, the stock declined back to support in mid March and formed a hammer. Bullish confirmation came two days later with a sharp advance.

Morning Star

The morning star consists of three candlesticks:

1. A long black candlestick.
2. A small white or black candlestick that gaps below the close of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a morning doji star.
3. A long white candlestick.

The black candlestick confirms that the decline remains in force and selling dominates. When the second candlestick gaps down, it provides further evidence of selling pressure. However, the decline ceases or slows significantly after the gap and a small candlestick forms. The small candlestick indicates indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long white candlestick provides bullish confirmation of the reversal.

After declining from above 180 to below 120, Broadcom (BRCM) formed a morning doji star and subsequently advanced above 160 in the next three days. These are strong reversal patterns and do not require further bullish confirmation, beyond the long white candlestick on the third day. After the advance above 160, a two-week pullback followed and the stock formed a piecing pattern (red arrow) that was confirmed with a large gap up.

Bullish Abandoned Baby

The bullish abandoned baby resembles the morning doji star and also consists of three candlesticks:

1. A long black candlestick.
2. A doji that gaps below the low of the previous candlestick.
3. A long white candlestick that gaps above the high of the doji.

The main difference between the morning doji star and the bullish abandoned baby are the gaps on either side of the doji. The first gap down signals that selling pressure remains strong. However, selling pressure eases and the security closes at or near the open, creating a doji. Following the doji, the gap up and long white candlestick indicate strong buying pressure and the reversal is complete. Further bullish confirmation is not required.

In April, Genzyme (GENZ) declined below its 20-day EMA and began to find support in the low thirties. The stock began forming a base as early as 17-Apr, but a discernible reversal pattern failed to emerge until the end of May. The bullish abandoned baby formed with a long black candlestick, doji and long white candlestick. The gaps on either side of the doji reinforced the bullish reversal.

Additional Reading

• Have you read our previous article on Candlesticks and Resistance?
• You may also be interested in our next article on Candlestick Bearish Reversal Patterns.
• Reference Tool: Candlestick Pattern Dictionary
  
  

Candlestick Bearish Reversal Patterns

There are dozens of bearish reversal patterns. I have elected to narrow the field by selecting a few of the most popular patterns for detailed explanations. For a complete list of bearish and bullish reversal patterns, see Greg Morris' book, Candlestick Charting Explained. Below are some of the key bearish reversal patterns, with the number of candlesticks required in parentheses.

• Bearish Abandoned Baby (3)
• Engulfing, Bearish (2)
• Harami, Bearish (2)
• Dark Cloud Cover (2)
• Evening Star (3)
• Shooting Star (1)

It is important to remember the following guidelines relating to bearish reversal patterns:

• Most patterns require further bearish confirmation.
• Bearish reversal patterns should form within an uptrend.
• Other aspects of technical analysis should be used as well.

Bearish Confirmation

Bearish reversal patterns can form with one or more candlesticks; most require bearish confirmation. The actual reversal indicates that selling pressure overwhelmed buying pressure for one or more days, but it remains unclear whether or not sustained selling or lack of buyers will continue to push prices lower. Without confirmation, many of these patterns would be considered neutral and merely indicate a potential resistance level at best. Bearish confirmation means further downside follow through, such as a gap down, long black candlestick or high volume decline. Because candlestick patterns are short-term and usually effective for 1-2 weeks, bearish confirmation should come within 1-3 days.

Time Warner (TWX) advanced from the upper fifties to the low seventies in less than two months. The long white candlestick that took the stock above 70 in late March was followed by a long-legged doji in the harami position. A second long-legged doji immediately followed and indicated that the uptrend was beginning to tire. The dark cloud cover (red oval) increased these suspicions and bearish confirmation was provided by the long black candlestick (red arrow).

Existing Uptrend

To be considered a bearish reversal, there should be an existing uptrend to reverse. It does not have to be a major uptrend, but should be up for the short term or at least over the last few days. A dark cloud cover after a sharp decline or near new lows is unlikely to be a valid bearish reversal pattern. Bearish reversal patterns within a downtrend would simply confirm existing selling pressure and could be considered continuation patterns.

There are many methods available to determine the trend. An uptrend can be established using moving averages, peak/trough analysis or trend lines. A security could be deemed in an uptrend based on one or more of the following:

• The security is trading above its 20-day exponential moving average (EMA).
• Each reaction peak and trough is higher than the previous.
• The security is trading above a trend line.

These are just three possible methods. Some traders may prefer shorter uptrends and qualify securities that are trading above their 10-day EMA. Defining criteria will depend on your trading style, time horizon and personal preferences.

Other Technical Analysis

Candlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase the robustness of bearish reversal patterns.

Resistance

In Jan-00, Nike (NKE) gapped up over 5 points and closed above 50. A candlestick with a long upper shadow formed and the stock subsequently traded down to 45. This established a resistance level around 53. After an advance back to resistance at 53, the stock formed a bearish engulfing pattern (red oval). Bearish confirmation came when the stock declined the next day, gapped down below 50 and broke its short-term trend line two days later.

Momentum

Use oscillators to confirm weakening momentum with bearish reversals. Negative divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R indicate weakening momentum and can increase the robustness of a bearish reversal pattern. In addition, bearish moving average crossovers in the PPO and MACD can provide confirmation, as well as trigger line crossovers for the Slow Stochastic Oscillator.

Money Flows

Use volume-based indicators to assess selling pressure and confirm reversals. On Balance Volume (OBV), Chaikin Money Flow and the Accumulation/Distribution Line can be used to spot negative divergences or simply excessive selling pressure. Signs of increased selling pressure can improve the robustness of a bearish reversal pattern.

For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for a bearish candlestick reversal in securities trading near resistance with weakening momentum and signs of increased selling pressure. Such signals would be relatively rare, but could offer above-average profit potential.

A number of signals came together for RadioShack (RSH) in early Oct-00. The stock traded up to resistance at 70 for the third time in two months and formed a dark cloud cover pattern (red oval). In addition, the long black candlestick had a long upper shadow to indicate an intraday reversal. Bearish confirmation came the next day with a sharp decline. The negative divergence in the PPO and extremely weak money flows also provided further bearish confirmation.

Bearish Engulfing

The bearish engulfing pattern consists of two candlesticks; the first is white and the second black. The size of the white candlestick is not that important, but should not be a doji, which would be relatively easy to engulf. The second should be a long black candlestick. The bigger it is, the more bearish the reversal. The black body must totally engulf the body of the first, white, candlestick. Ideally, the black body should engulf the shadows as well, but this is not a requirement. Shadows are permitted, but they are usually small or nonexistent on both candlesticks.

After an advance, the second black candlestick begins to form when residual buying pressure causes the security to open above the previous close. However, sellers step in after this opening gap up and begin to drive prices down. By the end of the session, selling becomes so intense that prices move below the previous open. The resulting candlestick engulfs the previous day's body and creates a potential short-term reversal. Further weakness is required for bearish confirmation of this reversal pattern.

After meeting resistance around 30 in mid-January, Ford (F) formed a bearish engulfing (red oval). The pattern was immediately confirmed with a decline and subsequent support break.

Dark Cloud Cover

The dark cloud cover pattern is made up of two candlesticks; the first is white and the second black. Both candlesticks should have fairly large bodies and the shadows are usually small or nonexistent, though not necessarily. The black candlestick must open above the previous close and close below the midpoint of the white candlestick's body. A close above the midpoint might qualify as a reversal, but would not be considered as bearish.

Just as with the bearish engulfing pattern, residual buying pressure forces prices higher on the open, creating an opening gap above the white candlestick's body. However, sellers step in after the strong open and push prices lower. The intensity of the selling drives prices below the midpoint of the white candlestick's body. Further weakness is required for bearish confirmation of this reversal pattern.

After a sharp advance from 37 1/2 to 40.5 in about 2 weeks, Citigroup (C) formed a dark cloud cover pattern (red oval). This pattern was confirmed with two long black candlesticks and marked an abrupt reversal around 40.5.

Shooting Star

The shooting star is made up of one candlestick (white or black) with a small body, long upper shadow and small or nonexistent lower shadow. The size of the upper shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to the range over the last 10-20 days.

For a candlestick to be in star position, it must gap way from the previous candlestick. In Candlestick Charting Explained, Greg Morris indicates that a shooting star should gap up from the preceding candlestick. However, in Beyond Candlesticks, Steve Nison provides a shooting star example that forms below the previous close. There should be room to maneuver, especially when dealing with stocks and indices, which often open near the previous close. A gap up would definitely enhance the robustness of a shooting star, but the essence of the reversal should not be lost without the gap.

After an advance that was punctuated by a long white candlestick, Chevron (CHV) formed a shooting star candlestick above 90 (red oval). The bearish reversal pattern was confirmed with a gap down the following day

Bearish Harami

The bearish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether a bullish reversal or bearish reversal pattern, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bearish reversals after an advance and potential bullish reversals after a decline. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.

In his book, Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but the most bearish are those that form with a black/white or black/black combination. Because the first candlestick has a large body, it implies that the bearish reversal pattern would be stronger if this body were black. This would indicate a sudden and sustained increase in selling pressure. The small candlestick afterwards indicates consolidation before continuation. After an advance, black/white or black/black bearish harami are not as common as white/black or white/white variations.

A white/black or white/white combination can still be regarded as a bearish harami and signal a potential reversal. The first long white candlestick forms in the direction of the trend. It signals that significant buying pressure remains, but could also indicate excessive bullishness. Immediately following, the small candlestick forms with a gap down on the open, indicating a sudden shift towards the sellers and a potential reversal.

After a gap up and rapid advance to 30, Ameritrade (AMTD) formed a bearish harami (red oval). This harami consists of a long black candlestick and a small black candlestick. The decline two days later confirmed the bearish harami and the stock fell to the low twenties.

Merck (MRK) formed a bearish harami with a long white candlestick and long black candlestick (red oval). The long white candlestick confirmed the direction of the current trend. However, the stock gapped down the next day and traded in a narrow range. The decline three days later confirmed the pattern as bearish.

Evening Star

The evening star consists of three candlesticks:

1. A long white candlestick.
2. A small white or black candlestick that gaps above the close (body) of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a evening doji star.
3. A long black candlestick.

The long white candlestick confirms that buying pressure remains strong and the trend is up. When the second candlestick gaps up, it provides further evidence of residual buying pressure. However, the advance ceases or slows significantly after the gap and a small candlestick forms, indicating indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long black candlestick provides bearish confirmation of the reversal.

After advancing from 68 to 91 in about two weeks, AT&T (T) formed an evening star (red oval). The middle candlestick is aspinning top, which indicates indecision and possible reversal. The gap above 91 was reversed immediately with a long black candlestick. Even though the stock stabilized in the next few days, it never exceeded the top of the long black candlestick and subsequently fell below 75.

Bearish Abandoned Baby

The bearish abandoned baby resembles the evening doji star and also consists of three candlesticks:

1. A long white candlestick.
2. A doji that gaps above the high of the previous candlestick.
3. A long black candlestick that gaps below the low of the doji.

The main difference between the evening doji star and the bearish abandoned baby are the gaps on either side of the doji. The first gap up signals a continuation of the uptrend and confirms strong buying pressure. However, buying pressure subsides after the gap up and the security closes at or near the open, creating a doji. Following the doji, the gap down and long black candlestick indicate strong and sustained selling pressure to complete the reversal. Further bearish confirmation is not required.

Delta (DAL) formed an abandoned baby to mark a sharp reversal that carried the stock from 57 1/2 to 47 1/2. Although the open and close are not exactly equal, the small white candlestick in the middle captures the essence of a doji. Indecision is reflected with the small body and equal upper and lower shadows. In addition, the middle candlestick is separated by gaps on either side, which add emphasis to the reversal.

Additional Reading

• Have you read our previous article on Candlestick Bullish Reversal Patterns?
• Reference Tool: Candlestick Pattern Dictionary