In the last chapter, I gave you a brief introduction to the Japanese candlestick charts. In this chapter, I am going to tell you how a simple chart can help you predict some impactful movements in the market.
With experience and a keen eye, an able trader can identify potential market drops or bottoms and even make a reasonable forecast as to when a possible breakout can happen.
In this chapter, I will tell you everything you need to know about the most common candlestick patterns and how you can use them for technical analysis to predict the market trends.
The Double Top
After a drastic bullish market or a strong price rally, a trader can look forward to a double top candlestick. The double top pattern looks like two mountain peaks and forms an ‘M’ like shape in the graph which makes it easily identifiable.
A strong resistance in the market is what causes the two sharp peaks in the chart. It means that the bull cannot break through the resistance. The bullish trends hit the resistance level at first and bounce off it and finds support after the market retracement.
The bull gives a second try. It again pushes the market and starts to go to the top, raising the market prices to meet the resistance level. However, the bull lacks the strength to break through the resistance level. So, the price again drops for a second time in a row, thus creating the second peak.
When the chart shows a double top pattern, it usually denotes a bullish exhaustion. This is a common signal that the market will tip over very soon.
In the double top candlestick pattern, the containment line is known as the “neckline”. It is the point where the bullish trend line bounced off the support line after the first peak.
An experienced trader knows that the the best trading strategy for a double top pattern is to wait for the curve to form a second peak followed by small price breaks just below the neckline. However, this is not the only way to gain profits.
Look at this example of a double top pattern:
This kind of pattern is the best way to identify a bullish exhaustion in the market as well as market tops. In the example above you can clearly see how the market double topped as well as broke through the neckline. This is how the trader could make a profit in the bearish trade.
The Double Bottom
The double bottom is the exact opposite of the double top pattern in the candlestick chart. In the chart, it makes a ‘W’ like pattern and forms after a strong bearish movement in the market.
The pattern usually forecasts a bearish exhaustion. It forms when the bullish trend starts to gain strength at the support level.
The first bullish rejection forms a ‘V’ pattern at the support level. While the bear strives to drive the prices lower but the bull fights back and the prices start climbing higher.
As the market price moves higher, it reaches resistance and the bear tries to bring the prices down again. The market prices go down and reach the support level for the second time. Just as that happens, the bull again enters the scene. It drives the prices up again thus creating another ‘V’ rejection shape.
This is the last move in the double bottom of the candlestick pattern.
In this pattern, the point at which the trend line finds the resistance after the first trough is called the ‘neckline’. The double bottom pattern is finished and has taken its effect when the prices go higher and break through the neckline.
Check the chart below to find an example of the double bottom pattern:
In the chart, you can easily see that as the prices found at the support level, the bear could no longer bring the prices down. The bull continued to push through and battle the bear creating the classic double bounce pattern. The final push by the bull successfully drives the prices higher.
Traders enter a long position after the price breaks the highest points of the neckline, just after the trend line bounces off the support line for the second time. However, as I had mentioned before, there are more than one ways to deal with the double top and double bottom pattern.
I will advise you to have a clear strategy decided from the start and never get caught up chasing price.
Double bottom and double top are best at forecasting the market trend when they are used for larger time frames.
Head And Shoulders
Head and shoulder mostly form when the market has gone in the same trend for a long time. It is another indicator for market exhaustion in the candlestick pattern.
Here is a fundamental head and shoulders pattern which forms on top of a bullish trend.
This kind of candlestick pattern has a head and two shoulders. Similar to double top and double bottom patterns, head and shoulders are indicators of bullish exhaustion. They form on top of bullish trends in the market.
The left shoulder of the pattern is created when the bull rises high but finds the resistance level followed by going down and bouncing off the support level. However, at this point, the pattern remains ambiguous.
The bull again takes charge and gain strength. The market prices start rising higher, breaking through the previous resistance level. At this point, however, the market cannot maintain the high prices and the price falls again, below the resistance level. This was an instance of a false break.
This false break creates the ‘head’ part of the candlestick pattern. After the first fail, the bull again gathers its strength and tries to push the market prices higher. However, the resistance holds its ground making the market prices fall down again as it hits the support. With this move, the last right shoulder is created and the pattern is complete.
Once again, the containment line that took the role of the support during the entire span of the pattern is called the neckline. The ideal trading move would be to open a selling position when the market prices break through the neckline just after the signal.
Check the chart below to see a head and shoulder pattern.
The chart shows how the bullish exhaustion is clearly demonstrated by the head and shoulders pattern of the candlesticks. The pattern is usually formed just after a strong bullish move in the market. As the neckline is breached, the market sold off aggressively.