Candlestick Reversal Patterns: Volume Trading Strategy

Candlestick Reversal Patterns

We introduced candlesticks as a popular charting tool in Chapter 4, and gave one example of a candlestick pattern that signaled trend continuation. Here we switch the subject to reversals, where several well-known candlestick patterns can play a valuable part in their identification.

Spinning-Top Reversal

A spinning top is a classic candlestick pattern showing trader indecision following an advance or a decline. The small real body shows little difference between the opening and closing prices, yet the long shadows show that there was considerable intraday action on the part of both buyers and sellers.

The spinning-top formation is a sign that sentiment may be changing, as the day's trading activity essentially ends in a stalemate. Volume can also give clues as to the validity of such patterns, showing the sentiment of traders. Chart 5.14 for Citigroup (C) shows two examples of spinning tops, one following an uptrend and one a downtrend.

After the uptrend through late April, the spinning top, looking somewhat like an elongated plus sign, formed on very low volume, signifying that there was not much positive sentiment or buying power left to prolong the advance. Price reversed the next day, beginning a six-week decline. At the end of the decline in mid-July, another spinning top formed. This time it was on a noticeable increase in volume, signifying that buyers were stepping up to meet the sellers and putting the brakes on the decline. The elevated volume with the spinning-top pattern showed a short-term change in sentiment that led to a furious six-day rally. As Chart 5.14 shows, it is the change in volume along with the shape of the candlestick and the prior price

Chart 5.14 Spinning-Top Candlestick Reversals, Citigroup

behavior that indicates a reversal. A weakening of volume indicates a weakening of the prevailing sentiment, while a significant strengthening shows a greater struggle emerging between buyers and sellers.

Doji Reversal

A doji is formed when the day's opening and closing prices are virtually equal, causing the real body to look like a dash or a straight line. A doji is like a spinning top, except with much shorter upper and lower legs —that is, much less intraday price fluctuation. It is also an indication of indecision, signaling that the forces behind the prevailing trend may be weakening. Lower volume on a doji is an indication that those who have wanted to participate in the trend have done so for the time being, while an increase in volume shows that there may be a struggle for near-term direction underway between buyers and sellers. It either case, a doji can represent a short-term change in sentiment and thus price direction.

In Chart 5.15 for Freeport-McMoRan (FCX), note how the doji formed after a move higher through virtually the entire month of November 2004. The two white candles before the doji occurred on decreasing volume; that was a sign of trouble. The formation of the doji on increasing volume was

Chart 5.15 Doji Candlestick Reversal, Freeport-McMoRan

a sign that a reversal —in this case, a correction —was near. Price reversed lower the very next day, leading to a decline of 17 percent over the next seven trading days. This is a fairly basic doji reversal pattern, and there are many others beyond the scope of this book.

Hammer Reversal

A hammer is a bullish reversal pattern that forms after a decline. The pattern consists of a small real body at the top of the candle with a long shadow or tail, a bit like a piston in an automotive engine. The pattern shows that sellers drove the price lower earlier in the session, but then buyers saw value and came in to provide support to prices. This is a form of climax selling that is validated by heavy volume. The reversal is confirmed by either a gap up or a large white candle the following day on heavy volume.

In Chart 5.16, the S&P 500 shows a classic bullish hammer reversal. Note how price had declined prior to the formation of the hammer, so there was prior negative price action to reverse. The day following the hammer formation was a large white candle (bullish) on even heavier volume, confirming the start of a new uptrend.

 

Chart 5.16 Bullish Hammer Candlestick Reversal, S&P 500

Note that the same pattern inverted, with an upside-down hammer, indicates a bearish reversal. The long tail above the hammer body reflects a stronger buying interest that failed intraday, giving way to weakness to follow. To interpret such candlesticks, it also helps to look at intraday volume: That is, where the higher volume occurred on the formation of the tail—on the way up, or on the way down. Weak volume on the up-leg with stronger volume on the downward intraday move, of course, would show weakness.

Exhaustion Gaps

A gap is caused by a break in the price pattern —or a “blank spot” on the chart where no trading occurs at specific price levels. Gaps most commonly occur on opening prices following a specific news event that causes a large number of either buy or sell orders to accumulate prior to the open. That accumulation causes a large adjustment in price relative to the prior close.

We first described gaps in Chapter 4 in the context of “continuation gaps”; here they come up again as part of a reversal pattern called an exhaustion gap. Exhaustion gaps occur following a strong move in the price of a security as demand overwhelms supply, or vice versa. The large

Chart 5.17 Exhaustion Gap, Citigroup

gap in the direction of the trend along with a spike in volume suggests that trader conviction may have exhausted itself While a gap higher on strong volume can look very bullish, and a gap lower on strong volume can look very bearish, recognizing these reversal patterns can help a trader lock in profits and preserve capital.

Chart 5.17 for Citigroup shows an exhaustion gap on December 17, 2009, following a long downtrend. Notice how price gapped strongly to the downside on a huge spike in volume. That was a sign that the selling had reached a crescendo there and that a bottom could be expected in that price area. Gaps are not always an indication of a quick turn in the other direction, but at the very least there should be little or no pressure left to continue the previous trend. The continuation gap (see Chapter 4) occurs after a period of indecision; the exhaustion gap acts more like a crescendo at the end of a definable trend.

Blow-Off Tops

Blow-off reversals are associated with tops and are similar in psychology to exhaustion gaps in that they occur at the end of trends and are characterized by one last thrust higher, giving a sharp peak on the price chart.

Chart 5.18 Blow-Off Top, Silver

Following the final thrust of an uptrend, price usually reverses sharply lower, as all of the buying pressure has been exhausted during the final push into the high. That leaves a vacuum, which allows price to fall very rapidly as the profit takers and late buyers sell their shares.

The weekly chart of silver in Chart 5.18 shows how the uptrend accelerated in early 2008. Notice how, as price reached what would turn out to be the top, volume accelerated very rapidly, signaling that a change in direction was imminent. Notice also the sharp reversal in price, which makes this a textbook example of a blow-off top.

It is also possible to have blow-off bottoms, which are simply the inverse of the blow-off top pattern.

Parabolas

Parabolas are reversal patterns showing a sharp acceleration in buying; they are most frequently associated with tops. The parabolic move begins with an acceleration that moves higher off an established trendline, often in a parabolic or curved fashion. As price accelerates higher, it no longer moves in a normal, linear uptrending manner. The advance takes on the shape of a curve or parabola. This pattern shows very strong,

 

Chart 5.19 Parabolic Reversal, iShares Silver Trust ETF (SLV)

almost frenzied activity among buyers. Parabolas have a pronounced increase in volume as they come into the high, typically the highest point of volume for the move. If a trader stays too long, these patterns end badly, with sharp increases in volume as price falls rapidly.

Chart 5.19 for the iShares Silver Trust ETF (SLV) is a classic example of how a parabolic move begins with an acceleration that launches off an established trend line. Once the move is complete on the highest volume to date for the move, SLV reverses sharply on even larger volume, signaling that the up move is definitely over.

Double and Triple Reversals

We conclude this chapter with a description of double and triple reversals, a commonly used set of patterns indicating exhaustion prior to reversal after a long uptrend or downtrend.

Double Bottom Reversal

A double bottom reversal is a pattern formed off of a long uptrend. The pattern consists of two consecutive lows at relatively the same level with a moderate "swing peak” formed in between them. It signifies that selling has run its course for the trend and that trader sentiment is changing. The pattern takes the shape of a W, with volume typically lower on the second low point than on the first. Double bottoms are typically a long-term signal; that is, they occur over the course of several days or even weeks.

Chart 5.20 for Hewlett-Packard (HPQ) shows how a double bottom is formed. Price had been in a prolonged downtrend prior to the formation of the double bottom in the summer and fall of 2002. The double bottom reversal developed as follows:

• Price came down and made a new low at point A, which was the first line in the W pattern.
• Price then rallied to set a moderately higher peak at point B, which formed the next line in the W pattern.
• Following the peak at point B, price went back down to a point very similar to the first low, point C, which formed the third line of the W. Notice how volume coming into the low at point C was very light as compared to the low at point A.
• Price then moved higher from the low at point C on accelerating volume, indicating a change in sentiment and forming the final line in the W pattern.
• The reversal and a new uptrend were not confirmed until price moved above resistance at point B. After price moved above point B, long trades should have been considered.

Chart 5.20 Double Bottom Reversal, Hewlett-Packard

Double Top Reversal

A double top reversal is the opposite of a double bottom. It is formed following a long uptrend and consists of two consecutive highs at relatively the same level, with a moderate swing low formed in between. It signifies that demand for the stock or contract is weakening, which leaves the door open for a change in direction as sentiment is changing. This pattern takes the shape of an M, with volume typically lower on the second high. Generally, this also is a long-term signal.

We'll use Hewlett-Packard as an example again. Chart 5.21 shows how a double top is formed. Price had been in a prolonged uptrend prior to the formation of the double top in the summer and fall of 2002. The double top reversal developed as follows:

• Price made a new high at point A, which was the first line in the M pattern.
• Price then declined to set a moderately lower trough at point B, which formed the next line in the M pattern.

Chart 5.21 Double Top Reversal, Hewlett-Packard

• Following the low at point B, price went back up to a point similar to the first high, point C, forming the third line of the M. Notice how volume coming into the high at point C was very light as compared to the high at point A.
• Price then moved lower from the low at point C on accelerating volume, indicating a change in sentiment, which formed the final line in the M pattern.
• The reversal and a new downtrend were not confirmed until price moved below support at point B. After price moved below point B, long trades should have been exited, and short trades could have been considered.

Triple Top Reversal

The triple top reversal pattern consists of three peaks at relatively the same price level with two intervening swing lows, or troughs. The pattern is resolved by breaking down through the support line drawn connecting the two trough points in the pattern. As with the double top pattern, volume plays a key role in both identifying the pattern and then confirming the reversal in the triple top. The triple top is, of course, similar to the double top, except that the confirming break through support doesn't occur until after the third top.

Oracle (ORCL) in Chart 5.22 shows how a triple top is formed. Price had been in a prolonged uptrend prior to late 2007, when this chart begins. The triple top reversal formed as follows:

• Price made a new high at point A.
• Price then declined down to point B. At the time, this looked like nothing more than a normal swing low in an uptrend.
• Price then moved higher to a price almost equal to point A. This formed point C. At point C, this could have been a double top in the process of forming. But remember, the swing low at point B would have to be taken out to confirm a reversal.
• Price then declined to point D, which was higher than point B, so no reversal signal was given.
• Price rallied and stopped at point E, which was virtually equal to point C at the $23.50 level. Notice how, at point E, volume contracted after price hit resistance at $23.50. That showed a lack of demand at that level, which indicated that a change in sentiment was beginning to take hold as the third attempt to get through $23.50 was faltering.

 Chart 5.22 Triple Top Reversal Pattern, Oracle Corporation

• Price declined from the high at point E on accelerating volume.
• Price broke through the support line (point B to point D) on increasing volume, which confirmed the reversal in sentiment and trend.

It should be obvious that if the double top reversal isn't confirmed in a chart, there is still a chance for a triple top, and it should continue to be tracked for such. Again, the key is to watch price and volume behavior as the price approaches the support level.

Triple Bottom Reversal

The triple bottom reversal pattern consists of three lows, or troughs, at relatively the same price level, with two intervening swing highs or peaks. The pattern is resolved by breaking up through the resistance line drawn connecting the two high points in the pattern. As with the double bottom pattern, volume plays a key role in both identifying the pattern and confirming the reversal.

Chart 5.23 for Yahoo! (YHOO) shows how a triple bottom is formed. Price had been in a prolonged downtrend prior to the formation of the pattern. The triple bottom reversal formed as follows:

• Price hit a low at point A. This low actually consists of two points: the first high-volume push down and then the low-volume drift back down to the low area once emotions settled down.
• Price then advanced up to point B. Volume on the advance was weak, signaling that investor sentiment had not yet changed.
• Price then moved lower to a price almost equal to point A. This formed point C, which could be the second low in a double bottom; but that it was the second low could not be verified unless price broke through the high at point B.
• Price then advanced to point D, which was lower than point B, so no double bottom reversal signal was given.
• Price declined and stopped at point E, which was virtually equal to point C. Notice how volume contracted to almost nothing at point E. That showed a lack of supply at that level, which indicated that a change in sentiment was beginning to take hold as the third trip down to the low area was faltering.

 Chart 5.23 Triple Bottom Reversal Pattern, Yahoo! Inc.

• Price advanced from the low at point E on accelerating volume.
• Price broke through the resistance line (B to D) as volume exploded, confirming the reversal in sentiment and trend.

Summary

• A combination of price and volume patterns can signal and confirm a trend reversal, whether they occur in the broad market or in an individual security, and whether they be longer-term macro or shorter term. Throughout our Volume Analysis of these reversal patterns, the traders mantra continues to hold true: volume precedes price.
• Important reversal patterns include wedges, head-and-shoulders, certain candlestick patterns, double and triple tops and bottoms, exhaustion gaps, blow-off tops, and parabolas. A trader should recognize the pattern and confirm it with volume behavior.
• Every technical price reversal pattern has a volume pattern component; this volume component can be used to verify a trader's translation of the reversal pattern. In the absence of volume pattern confirmation, a trader's translation of a trend reversal pattern should be questioned.