Reversal PatternsReversal Patterns

Lesson 3

Reversal PatternsReversal Patterns

Introduction

Single Candlestick Reversal Patterns1. Hammer and Hanging Man

2. Towers

Multi-Candlestick Reversal Patterns1. Engulfing Patterns

2. Harami Patterns

3. Tweezers Tops and Bottoms

4. Mountain Tops and Bottoms

5. Head and Shoulders / Inverted Head and Shoulders

6. Twin Tower Tops and Bottoms

Level 3Level 3

Introduction

IntroductionIntroduction

Candlesticks primarily focus on trend reversals. Reversal patterns are indicators that the previous trend is about to:

Reverse,

flatten out and continue,

or flatten out and reverse

As you can see, reversal patterns can signal several different outcomes. This is why we need to have a firm grip on reversal patterns before we proceed any further. Successful traders have the ability to know what the trend is doing and is going to do. They do this by mastering the ability to recognize reversal patterns and then implementing the knowledge gained to improve their trading positions.

The Main Use of Reversal The Main Use of Reversal

PatternsPatterns

The main use of reversal patterns is to signal when to exit a trade. They should not be used to signal when to enter a trade. The reason is because a reversal pattern can signal that the trend is reversing, flattening and resuming or flattening and reversing. We must wait until we get more information after the reversal pattern to make our move.

We Will Discuss…We Will Discuss…

The reversal patterns that we will discuss are divided into two sections. Single candle reversal indicators and multi-candle reversal indicators are:

Single Candle Reversal Indicators

Hammer and Hanging Man

Towers

Multi-Candle Reversal Indicators

Engulfing Patterns

Harami Patterns

Tweezers Tops and Bottoms

Mountain Tops and Bottoms

Head and Shoulders / Inverted Head and Shoulders

Twin Tower Tops and Bottoms

Lesson 3Lesson 3

Hammer and Hanging Man

The Hammer and Hanging The Hammer and Hanging

ManManHammer – a bullish reversal pattern that

forms during a downtrend. It is named because the market is hammering out a bottom.

Hanging man – a bearish reversal pattern that will often mark a top or strong resistance level. When price is rising, the formation of a hanging man indicates that sellers are beginning to outnumber the buyers. The long lower shadow demonstrates that sellers pushed prices lower during the session.

Note: The longer the shadow and the shorter the body; the more valid the signal becomes.

Hammer and Hanging Man Hammer and Hanging Man

CriteriaCriteria

Hammer

1. A long lower shadow about two or three times the length of the real body.

2. Little or no upper shadow.

3. The real body is at the upper end of the trading range.

4. The color of the real body is not important, however, a green body is more bullish than a red body.

Hanging Man

1. A long lower shadow about two or three times the length of the real body.

2. Little or no upper shadow.

3. The real body is at the upper end of the trading range.

4. The color of the real body is not important, however, a red body is more bearish than a green body.

What Makes Them DifferentWhat Makes Them Different

Two aspects that make Hammer and Hanging Man different are:

Trend

Hammer – Must always come after a downtrend.

Hanging Man – Must always come after an uptrend.

Length of the Trend

Hammer – The length of the trend doesn’t matter.

Hanging Man – The length of the trend must be extensive.

Examples of a HammerExamples of a Hammer

Examples of a Hanging ManExamples of a Hanging Man

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Towers

TowersTowers

Towers are single candlestick reversal signals. There are bullish towers and bearish towers.

Occurs after a bearish trend, Bullish Towers are strong green candlesticks that have a low that is the same as it’s open and closes at or near it’s high.

Occurs after a bullish trend, Bearish Towers are strong red candlesticks that have a high that is the same as it’s open and closes at or near it’s low.

Tower UsesTower Uses

Towers should be used to forecast reversals.

Bullish towers should forecast a rally.

If the next candlestick closes under the bullish tower, the reversal signal becomes void.

Bearish towers should forecast a downtrend.

If the next candlestick closes above the bearish tower, the reversal signal becomes void.

Towers can be used to confirm support and resistance.

Bullish towers can be used to confirm support.

If a candlestick breaks the support level, look for the trend to end.

Bearish towers can be used to confirm resistance.

If a candlestick breaks the resistance level, look for the trend to end.

Example of a Bullish TowerExample of a Bullish Tower

Example of a Bearish TowerExample of a Bearish Tower

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Multi-Candlestick Reversal

Patterns

MultiMulti--Candlestick Reversal Candlestick Reversal

PatternsPatterns

The hammer, hanging man, bullish tower, and bearish tower are all

examples of single candlestick reversal patterns. They are powerful

tools to signal reversals, however, most candlestick signals are

multi-candlestick patterns. The multi-candlestick patterns that we will

discuss are:

Engulfing Patterns

Harami Patterns

Tweezers Tops and Bottoms

Mountain Tops and Bottoms

Head and Shoulders / Inverted Head and Shoulders

Twin Tower Tops and Bottoms

Lesson 3Lesson 3

Engulfing Patterns

Engulfing PatternsEngulfing Patterns

Engulfing patterns are important reversal signals that are composed of two opposite color real bodies. The second candlestick must be the opposite color and be larger than the previous candlestick.

Occurs during an uptrend, a Bullish Engulfing Pattern is comprised of a red real body, then is engulfed by a larger green real body.

Occurs during a downtrend, a Bearish Engulfing Pattern is comprised of a green real body, then engulfed by a larger red real body.

Criteria for an Engulfing Criteria for an Engulfing

PatternPatternThere are three criteria for an engulfing pattern to be valid. They are:

The trend

A bullish engulfing pattern must come after a downtrend.

A bearish engulfing pattern must come after an uptrend.

The colors

A bullish engulfing pattern must comprise of a red real body engulfed by a larger green real body.

A bearish engulfing pattern must comprise of a green real body engulfed by a larger red real body.

Note: the only exception is if the first candlestick is a doji

The size

The second candlestick must always engulf the first candlestick.

Note: the second candlestick only needs to engulf the real body

Factors that Increase Your Factors that Increase Your

OddsOdds

There are several factors that we need to consider when evaluating the reliability of an engulfing pattern. They are:

If the first candlestick in the pattern is a doji or a very small real bodied candlestick, the odds of a reversal occurring are increased. The reason being is because the doji or very small real bodied candlestick represents the trend losing steam. The engulfing second candlestick only supports this conclusion.

If the engulfing pattern occurs after one or more large candlesticks, the odds of a reversal occurring are increased. This occurs because the market is either overbought or oversold which makes vulnerable to profit taking.

If the engulfing candlestick is a high volume trading session, the odds of a reversal occurring are increased.

Engulfing Patterns as Support Engulfing Patterns as Support

and Resistanceand Resistance

Engulfing patterns primary use is to signal trend reversals, however, they can also be used to offer support and resistance levels.

Bullish engulfing patterns can offer support levels. Use the lowest low of the two candlesticks.

Bearish engulfing patterns can offer resistance levels. Use the highest high of the two candlesticks.

Example of a Bullish Engulfing Example of a Bullish Engulfing

PatternPattern

Example of a Bearish Engulfing Example of a Bearish Engulfing

PatternPattern

Lesson 3Lesson 3

The Harami Pattern

The Harami PatternThe Harami Pattern

The Harami pattern is a small real bodied candlestick that is contained within a long real red or green bodied candlestick. Harami is an old Japanese word meaning “pregnant”. The Japanese have nicknames for the long real bodied candlestick “mother” and “baby” for the small real bodied candlestick. Meaning, the first larger “mother” candlestick is giving birth to the second smaller “baby” candlestick. The harami pattern can also be used as a support or resistance level when paired with another harami.

Note: Only the real body of the second candlestick must be within the larger first real body. You don’t have two concentrate on the shadows.

Differentiating the Harami and Differentiating the Harami and

Engulfing PatternsEngulfing Patterns

The Harami

The first candlestick is a tall real body.

The second candlestick is a small real body.

The two real bodies can be any color,

however, they will most likely be opposite

colors.

The Engulfing Pattern

The first candlestick is a small real body.

The second candlestick is a tall real body.

The two real bodies should be opposite in

color.

The Bullish and Bearish The Bullish and Bearish

HaramiHaramiThe Bullish Harami

Must come after a bearish trend.

The first candlestick in the pattern must be a tall

real bodied candlestick.

The second candlestick in the pattern must be a

small real bodied candlestick.

The two candlesticks do not need to be opposite

colors, however, the odds of the pattern being a

valid reversal signal increase if the are opposite.

The Bearish Harami

Must come after a bullish trend.

The first candlestick in the pattern must be a tall

real bodied candlestick.

The second candlestick in the pattern must be a

small real bodied candlestick.

The two candlesticks do not need to be opposite

colors, however, the odds of the pattern being a

valid reversal signal increase if they are opposite.

Example of a Bullish HaramiExample of a Bullish Harami

Example of a Bearish Example of a Bearish

HaramiHarami

Harami CrossHarami Cross

The harami cross pattern is composed of a long real bodied candlestick followed by a doji candlestick. The Harami cross pattern is more powerful than the regular harami pattern. The reason being, the smaller the second real bodied candlestick is the less steam the market has in that direction, meaning a reversal is very likely.

Note: The harami cross should only be used to call top reversals.

An example of Bearish Harami An example of Bearish Harami

CrossCross

Lesson 3Lesson 3

Tweezers Top and Bottoms

TweezersTweezers

Tweezers are two or more candlesticks with matching highs (tweezers tops) or lows (tweezers bottoms). The tweezers can be composed of real bodies, shadows, and/or dojis. Ideally tweezers should have a tall first real body followed be a small real body.

Note: Tweezers are very important. They make other reversal patterns more important if they are also tweezers.

Tweezers Top and BottomsTweezers Top and Bottoms

Tweezers Tops

Tweezers tops occur after a bullish trend. The first candlestick must be a long green candlestick, followed by a small real bodied candlestick with the same high.

Note: If there is a bearish (for a top reversal) candlestick signal that is also a tweezers top, the pattern becomes a more reliable signal.

Tweezers Bottoms

Tweezers bottoms occur after a bearish trend. The first candlestick must be a long red bodied candlestick, followed by a small real bodied candlestick with the same low.

Note: If there is a bullish (for a bottom reversal) candlestick signal that is also a tweezers bottom, the pattern becomes a more reliable signal.

Examples of Reversal Patterns Examples of Reversal Patterns

also Being Tweezersalso Being Tweezers

A Hammer as Tweezers Bottoms

Occurs after a bearish trend. A hammer forming at the

bottom of a bearish trend signals a possible bullish

reversal. The fact that the first and second

candlesticks in the pattern are tweezers (have the

same lows) only increases the possibility of this

signal becoming valid. This is true because it

proves that the bears (sellers) are losing control of

the market to the bulls (buyers).

A Hanging Man as Tweezers Tops

Occurs after a bullish trend. A hanging man forming at

the top of the bullish trend signals a possible

bearish reversal. The fact that the first and second

candlesticks in the pattern are tweezers (have the

same highs) only increases the possibility of this

signal becoming valid. This is true because it

proves that the bulls (buyers) are losing control of

the market to the bears (sellers).

Example of a Tweezers TopExample of a Tweezers Top

Example of a Tweezers Example of a Tweezers

BottomBottom

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Mountain Tops and Bottoms

Peaks and ValleysPeaks and Valleys

Mountain Tops – Occurs when the

market makes three unsuccessful

attempts at a high, especially, if

the third high is stopped by a

reversal candlestick or pattern.

Mountain Bottoms – Occurs when

the market makes three

unsuccessful attempts at a low,

especially, if the third low was

stopped by a bullish reversal

candlestick or pattern.

Example of Mountain TopsExample of Mountain Tops

Example of Mountain Example of Mountain

BottomsBottoms

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Head and Shoulders /

Inverted Head and Shoulders

Head and Shoulders / Head and Shoulders /

Inverted Head and ShouldersInverted Head and Shoulders

Head and Shoulders – occurs when the central

mountain top is significantly higher than the

others. The line drawn from the two bottoms

of the head is called the neckline. Typically,

the neckline makes a great resistance level.

Inverted Head and Shoulders – is the same

pattern only inverted. This pattern occurs

when the central mountain bottom is

significantly lower than the others. The line

drawn from the two tops of the inverted head

is called the inverted neckline. Typically, the

inverted neckline makes a great support

level.

Criteria for Head and Shoulders /Criteria for Head and Shoulders /

Inverted Head and ShouldersInverted Head and Shoulders

There are several criteria for a head and shoulders / inverted head and shoulders that must take place in order for the patterns to be valid reversal patterns. They are:

The price

The price must be at a high in order for a head and shoulders to occur.

The price must be at a low in order for an inverted head and shoulders to occur.

A tested high/low

The high must be tested 3 times, without breaking the resistance level in order for a head and shoulders to occur.

The low must be tested 3 times, without breaking the support level in order for a head and shoulders to occur.

The size

The middle mountain top must be significantly higher than the other two mountains.

The middle mountain bottom must be significantly lower than the other two mountains.

Example of Head and Example of Head and

ShouldersShoulders

Another Example of Head and Another Example of Head and

ShouldersShoulders

Example of Inverted Head and Example of Inverted Head and

ShouldersShoulders

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Twin Tower Tops /

Twin Tower Bottoms

Twin Tower Tops and Twin Tower Tops and

BottomsBottomsTwin Tower Tops – occurs after a rally.

The pattern begins with a long green

tower followed by several small bodied

candlesticks, finishing with a long red

tower. Hence, the name twin tower

tops.

Twin Tower Bottoms – occurs after a

bearish trend. The pattern begins with

a long red tower followed by several

small bodied candlesticks, finishing

with a long green tower. Hence, the

name twin tower bottoms

Criteria for Twin Tower Tops Criteria for Twin Tower Tops

and Bottomsand BottomsThere are three criteria for a twin tower top or bottom to be valid. They are:

The trend

A twin tower top pattern must come after an uptrend.

A twin tower bottom pattern must come after a downtrend.

The colors

A twin tower top pattern must comprise of a long green real body followed by several small bodied candlesticks, finishing with a long red real body.

A twin tower bottom pattern must comprise of a long red real body followed by several small bodied candlesticks, finishing with a long green real body.

Note: The twin towers must be of opposite color.

The size

The twin towers must be significantly long real bodied candlesticks.

Example of Twin Tower Example of Twin Tower

TopsTops

Example of Twin Tower Example of Twin Tower

BottomsBottoms