Reversal candle patterns are a critical aspect of trading and can help traders avoid significant losses. The crypto market can be volatile, making it challenging to identify when a trend is about to change.
By using reversal candle patterns, traders can identify potential trend reversals before they occur, allowing them to make informed trading decisions.
It's essential to understand the difference between a reversal and a retracement. A retracement is a temporary pause or reversal within a trend, while a reversal is a more significant shift in the trend's direction.
Reversal candle patterns indicate that a trend is about to change direction, while retracement patterns suggest that the trend will continue after a brief pause.
Traders should know several powerful reversal candle patterns, including the Hammer, Hanging Man, Shooting Star, and Doji. These patterns can help traders identify potential trend reversals and adjust their strategies accordingly.
By learning to identify reversal candle patterns and how they differ from retracements, traders can improve their chances of making successful trades and avoid significant losses.
Researching and utilizing multiple indicators to confirm any potential trend changes before making trading decisions is essential.
What's a reversal candle pattern
When traders are trying to predict market trends, they use technical analysis tools such as candlestick charts.
A reversal candle pattern is a candlestick chart pattern that helps traders identify when a trend is about to end and a new one is likely to begin. This pattern is formed when a series of Japanese candlesticks show a change in market sentiment, indicating that the current trend is expected to reverse.
These candlestick patterns are essential for traders because they give visual cues that indicate when a trend is about to change. This allows traders to make informed decisions about when to enter or exit a trade, potentially avoiding significant losses.
Reversal candle patterns are easy to spot and use, making them valuable in any trader's toolbox.
Differences between bullish reversal candle patterns and bearish reversal candle patterns
To simplify it, bullish reversal candles occur when the market transitions downward to upward.
At the same time, bearish reversal candles happen when the market shifts from upward to downward. The two main differences between the two are the pattern's shape and the pattern's location within the trend.
The shape of the pattern is determined by the arrangement and sequence of the candles, some of which produce large candle bodies, while others have large wicks or shadows.
The pattern's location within the trend also plays a crucial role. When a pattern appears in a downtrend, it signals a potential rally and a change in trend from downward to upward.
On the other hand, when a reversal pattern forms in an uptrend, it warns traders that the price may correct or even plummet.
How is a reversal different from a retracement?
Retracements are also known as pullbacks or corrections. They are brief price movements against the current trend, which will eventually resume in the same direction.
Various factors, including market sentiment, economic indicators, or news events, can cause retracements.
Retracements can be identified by using technical analysis tools such as Fibonacci retracements or moving averages. Traders use retracements as a buying opportunity in an uptrend or a selling opportunity in a downtrend.
However, it's essential to distinguish a retracement from a reversal since a misinterpretation can lead to significant losses.
While retracements and reversals are significant in trading, reversal patterns are considered more potent because they signal a complete trend reversal.
In contrast, retracements only indicate a temporary pause in the current trend.
Top bullish reversal candlesticks
Three white soldiers
The three white soldiers pattern is a reliable bullish reversal pattern that traders can use in crypto trading.
It consists of three consecutive long-bodied candlesticks that indicate a strong uptrend. Each candlestick opens within the previous candle's body and closes above the last candle's high.
The wicks, or shadows, should be relatively small, indicating minimal setback during the market rally.
This pattern suggests that the bulls have overtaken and closed near the candle's high for three consecutive sessions, indicating a potential trend reversal. Traders should also look for increased volume accompanying the three white soldiers pattern, which lends additional strength to the signal.
Overall, the three white soldiers pattern is a powerful tool for traders to identify bullish trends in the crypto market.
Dragonfly doji
To add more context, the dragonfly doji is a significant bullish reversal pattern formed when the open, high, and close prices are the same, and there is no tiny upper shadow but a long lower shadow.
It indicates that sellers were in control of the market during the trading period, pushing the price down, but buyers managed to regain control and push the price back up to the opening level.
The long lower shadow suggests that the market rejected lower prices, indicating a possible trend reversal. The dragonfly doji is a strong bullish signal, especially when it appears after a downtrend.
Bullish abandoned baby
The bullish abandoned baby pattern comprises three candles. The first candle is bearish and large, a small body characterizes the second one, and the third is green.
This pattern has similarities with the morning star pattern, but it differs in that the second candle gaps below the lower wick of the first candle—moreover, the third candle gaps above the second one.
Bullish engulfing
The bullish engulfing pattern is a solid bullish signal, showing that bulls have taken control of the market after a period of selling pressure. The long bullish candlestick that engulfs the previous bearish candlestick indicates a significant shift in market sentiment.
Traders may interpret it as a potential trend reversal from bearish to bullish. It's important to note that this pattern is more reliable when it appears after a downtrend or a period of consolidation.
Morning star
The morning star pattern is a bullish reversal pattern that can help traders identify potential trend reversals.
The first candle in the design signifies the continuation of the existing downtrend. The second candle indicates that the bears are still in control, as the price makes a new low.
However, the long lower shadow on the second candle suggests that the bears are losing their momentum, and the bulls are starting to push the price higher.
Finally, the third candle confirms the trend reversal as it opens higher than the second candle's close and rallies upward, closing well into the first candle's body.
The larger the third candle, the stronger the bullish reversal signal. The morning star pattern is reliable, but traders should wait for confirmation from other technical indicators before taking a position.
Morning doji star
The morning doji star pattern is a three-candlestick formation that begins with a bearish candle, followed by a doji candle and ends with a large bullish candle.
The doji candle, with its small body and lengthy wicks, indicates indecision in the market. The appearance of the doji candle between the bearish and bullish candles is a sign of a potential trend reversal, with the bulls taking control of the market.
This pattern is particularly effective when the doji appears at or near a support level, indicating a possible price bounce back up.
Reverse head and shoulders
The inverse head and shoulders are a multi-candlestick pattern to identify potential market bottoms. It begins with a left shoulder as prices fall to a new low, followed by a short-term relief rally retracing a small portion of the downtrend.
This is then followed by a lower trend to create the head, which drops below the left shoulder's low. Another relief rally takes place, but this one stall near the price point of the first relief rally, creating the neckline.
The market then corrects lower one more time, producing the right shoulder, which holds above the price low of the head. Due to the time it takes to make this pattern, it can signal a powerful rally is about to take place.
Three-line strike
The three-line strike is a bearish reversal pattern that signals the end of an uptrend. The first three candles are long and bullish, each closing higher than the previous one, while the fourth candle is a long and bearish candle that closes below the opening price of the first candle.
This pattern indicates that the bulls are losing control, and the bears are taking over, potentially leading to a significant price decline. Traders may use this pattern to identify potential short opportunities or to take profits on long positions.
Piercing line pattern
The piercing line pattern is a two-candlestick formation in which the first candle is bearish and has an average or larger-sized body.
The second candle is bullish and significant because it opens below the low of the first candle but closes at least halfway into the body of the first candle. This formation indicates that the bulls are beginning to gain market control after a period of bearishness.
Bullish harami
A bullish harami pattern is characterized by two candlesticks, where the first one is a significant bearish candle, followed by a small green candle.
What sets this pattern apart is that the second candle opens higher than the previous close, but its body is small. This formation may be a consolidation phase, but it indicates a potential shift in the trend from bearish to bullish sentiment.
Hammer candlestick
A hammer candlestick is a single candlestick formation easily recognizable on crypto charts. It is characterized by a relatively small body and a long tail or wick to the bottom.
The color of the hammer can be either green or red, but the long wick to the downside suggests a potential rally in the making. This is because even though the market has traded lower, it has only done so briefly, and prices have since rallied up near the opening.
Top bearish reversal candles
Shooting star
A shooting star is a single candlestick pattern commonly seen at an uptrend's end. This candlestick has a small body with a long wick to the upside.
This formation occurs when prices rally to new highs at the candle's opening but then reverse back to near the opening price. The long topside wick indicates a strong group of sellers as the market trades higher, but their influence is only temporary.
Evening star
The evening star pattern consists of three candles and is a bearish reversal pattern that signals a potential downward correction. The first candle is a large bullish candle, followed by a smaller one suggesting indecision in the market.
The third candle is a bearish candle that closes below the midpoint of the first bullish candle, indicating a shift in momentum to the downside.
This pattern requires three candles to form and is considered a more conservative pattern since more data is needed to complete the formation. The bullish version of this pattern is the morning star.
Dark cloud cover
The dark cloud cover pattern is a two-candle formation. The first candle is a strong bullish one, and the second is a strong bearish candle.
The key to this formation is that the second candle will continue to push to a new high, then reverse lower. The second candle will finish within the upper body of the first candle.
Hanging man candlestick
The hanging man candlestick pattern is a bearish reversal pattern that typically appears at the end of an uptrend. It's formed when the price opens, trades higher during the session, but then sells off significantly to close near the session lows.
The long lower shadow, or wick, indicates that sellers have taken control and are pushing the price lower. Traders typically watch for confirmation through follow-through selling in subsequent sessions.
Bearish engulfing
The bearish engulfing pattern is a powerful reversal signal that occurs at the end of an uptrend. It suggests buyers have lost market control, and a new downtrend may begin.
The pattern is formed by a long bullish candle followed by a larger bearish candle that completely engulfs the previous candle. The larger the bearish candle, the more significant the reversal signal.
Bearish abandoned baby
The bearish abandoned baby is a three-candle pattern similar to the evening star but with a unique middle candle.
The middle candle gaps to a new high without any overlap between its lows and the previous candle's high, indicating a solid rally that fails to follow through to the upside. The third candle then retraces most of the first candle, completing the bearish formation.
Three black crows
The absence of wicks or tails on each of the three candles indicates that the bears have taken control of the market with little resistance from the bulls and that the selling pressure is likely to continue.
The pattern is even stronger if the candles are extended; each closes below the previous one.
Evening doji star
The evening doji star is a three-candle pattern that signals a potential trend reversal from bullish to bearish.
The first candle is a long bullish candle, followed by a small doji candle indicating indecision, and then a bearish candle that closes well below the first candle's opening.
This pattern is often seen as a strong sell signal, suggesting buyers have lost control, and the sellers are taking over the market.
What to do when a reversal candle formation appears when you are trading
When a reversal candle formation is identified, assessing the signal's strength is essential before taking any action. If the signal is strong, traders have three options:
Firstly, if they're holding a position following the old trend's direction, they can exit all of their work.
Secondly, if the reversal signal appears relatively weak, traders can consider tightening their stop loss or closing out a portion of their position to secure profits.
Thirdly, if they're not currently in the market, they can use the signal to initiate a new position in the direction of the reversal. For example, if a bullish reversal pattern appears, they can consider opening a new bullish position.
Traders planning to take a new position in a changing trend can follow the guidelines below.
Entry points
After a pattern completes, traders can consider entering a position in the direction of the reversal on the opening of the next candle, regardless of whether it is a single, dual, or three-candlestick pattern. This allows for prompt entry without requiring additional confirmation.
Stop loss
A stop loss is a critical risk management tool traders use to limit potential losses. A pre-determined order closes a position at a certain price level to prevent further losses beyond a particular threshold.
In the case of a bullish reversal pattern, placing the stop loss below the low of the pattern makes sense as it suggests that the bears have lost their grip and the bulls have taken control.
If the price falls below the low, the reversal pattern has failed, and the trend may continue to move lower.
Conversely, placing the stop loss above the pattern's high can protect against potential losses when you see a bearish reversal.
If the price rises above the pattern's high, it suggests that the reversal pattern has failed, and the trend may continue to move higher.
Take profit
Setting a take-profit level is essential to trading as it helps lock in profits. A common strategy is to set the take profit level at a distance from the entry point at least twice the length of the stop loss.
For example, if the stop loss is set at 3%, the take profit level should be set at 6% or more. This ensures that if the trade moves in your favor, you can exit the trade with a profit before the market reverses.
Are reversal candles reliable?
Not all reversal candlestick patterns are reliable in signaling a change in trend. The context in which they occur is also crucial to consider.
A bullish pattern appearing at the top of a prolonged uptrend does not necessarily guarantee a continuation of the trend. However, if the same way seems at the end of a long downtrend, it is more likely to signal a reversal.
It is important to note that no pattern is 100% accurate, and thus, risk management should always be prioritized by setting a stop loss on every trade.
Closing thoughts
Japanese reversal candle patterns serve as a valuable tool for traders to anticipate a change in market trends. However, it is essential to recognize that these patterns have limitations.
Their reliability can vary depending on the traded market, the timeframe, and the trader's overall strategy.
While not foolproof, understanding these patterns can assist in interpreting market potential and inform more strategic decision-making. These technical tools can be a powerful resource for achieving desired outcomes with proper application.
