Single Candle Patterns

Single Candle Patterns - Shooting Star, Hanging Man, Inverted Hammer

Having spent a good deal of time exploring the intricacies of the Hammer I hope you’re now happy with the idea that a candlestick can be broken down into its component parts to work out the direction of travel that it represents. Armed with this we can now move on to several new patterns and quickly get a grasp of how they’re formed and why they suggest a reversal.

The Hammer belongs to a family totalling 4 patterns, all with similar characteristics, ie, small real bodies at one extreme of the pattern, leaving one shadow much longer than the other.

The next such pattern that we’ll dissect and study is the Shooting Star.

Shooting Star

 

Construction/getting inside the pattern

As you can see this is pretty much the opposite of the Hammer. This time the long upper shadow is at the top end of the day’s range, and the real body is near the bottom. Also, we’re looking for this pattern in a rising market as opposed to a downtrend.

So let’s think about the price action that goes into the construction of a Shooting Star. Let’s do the same thing as we did with the Hammer, and look at a live market example. Below is a daily candlestick chart for gold in May 2006 when highs not seen since the early 1980s were hit.

          

Figure 3-9: CBOT 100 oz Gold futures; daily (all sessions) candlestick continuation chart (no adjustment for roll-over); 10 April 2006 to 13 June 2006, showing Shooting Star Candlesticks on 12 May 2006 and 17 May 2006

As you can see there are actually two Shooting Star patterns on this chart, the one that defined the absolute top of the move, then another just 3 days later. The one we’ll zoom in on is the first one, the high of the move. Let’s look at a 15-minute chart for that day.

Psychology

I often talk about charts and the markets using sporting analogies, many of these using my beloved football, or soccer to those living anywhere other than the UK.

This session was akin to a match that was pretty quiet and predictable in the first half, and honours went to the team in green, who trotted in 1-0 up at half time. Incidentally the team in green had won 5 of their last 6 matches, so no one was that surprised that they were winning this one, especially as the reds were near the bottom of the league.

But in football sometimes things change. Manchester United aren’t going to be the best team in the land forever, thank heavens!

The red team’s manager says something at half-time, and the second half starts with a bang. Over the next 45 minutes we are treated to the best display of football in living memory, with goals galore, and by the end of the game the reds win 5-4.

Whose fans go home happier? Which team is likely to feel better going into the next game? Generally the team that dominates the second half of a match will finish the stronger and win the match. It is exactly the same with a day in the life of the markets. If the bulls win the first half, but the bears win the second half, and the bears keep their pressure on until the end, we’ll likely post a candlestick with a long upper shadow; often a Shooting Star.

Can you see how even a single candlestick can be an extremely effective reader of price action over a particular time period?

I may seem like a stuck record at the moment, but by making sure you get used to the idea of thinking about the direction of travel that goes into the construction of a particular shaped candlestick, you will breeze through the rest of this book, and candlesticks will immediately become a strong ally in your trading or reading of the markets.

        

Figure 3-10: CBOT 100 oz Gold futures; 15-minute candlestick chart (all sessions); 12 May 2006

On the intra-day chart in Figure 3-10 we have plotted the four pieces of data that make up the Shooting Star on the daily candlestick chart: that day’s open, high, low and close. As you can see, the direction of travel on the day was upwards in the early part of the session, followed by weakness in the second half, culminating in a weak close.

This is the opposite of the Hammer. Instead of a “V” shaped direction of travel we see an arc or “A” shaped movement.

The bulls are in charge going into the session, remember that. So when the market starts to rally in morning trade no one is surprised. The bulls continue on their happy way while the bears continue to get beaten up.

But at 732.3 the balance between buyers and sellers changes and the buyers are suddenly not dominating. The second half of the session, as evidenced by the wild assortment of candlesticks, was a ding-dong affair.

Examples

         

Figure 3-11: LIFFE June 2008 Short Sterling futures; weekly candlestick chart; 18 June 2007 - 9 June 2008

You can see from the chart that the top of this move was defined by a Shooting Star in the week of 21 January 2008 - 25 January 2008. Although there is a bit of lower shadow showing on this candle I’m sure you’ll agree that the long upper shadow definitely smacked of a rejection of the upside. Another reason I like this chart is because of the two previous examples in mid-November and late November. Again neither was a textbook example, and in these instances they didn’t lead to a reversal. The big jump in volume, and the sheer volatility of the candlestick that actually gave us the top, alerted us that it was something not to be ignored. The break of trend support (labelled T1 on the chart) a few weeks later confirmed our suspicions, and the subsequent break of the bottom of the Shooting Star week (the horizontal line labelled T2) added further weight to the argument for a top.

          

Figure 3-12: LIFFE June 2008 Short Sterling futures; 60-minute candlestick chart; 21 January 2008 - 25 January 2008

This is a short-term chart showing direction of travel over the course of the Shooting Star week highlighted in Figure 3-11.

Another example

         

Figure 3-13: Eurex September 2008 Bund futures; 30-minute candlestick chart; 6 and 9 June 2008

          The move in the first few hours of this particular morning came as something of a surprise at the time, but the market was in a downtrend overall, so many traders were looking for a chance to sell any strength. The up move ended with a high volume Shooting Star on the 30-minute candle chart. A severe sell off followed.

The colour of the real body

As with the Hammer we are relatively unconcerned by the colour of the real body for a Shooting Star, although a red real body does show that the market sold off through the opening price towards the end of the candle’s life, and therefore it may carry slightly more significance. It’s not essential for the pattern though, and Shooting Stars are generally credited with being a powerful reversal pattern, whatever the colour of the real body.

Shooting Star summary

You can see that the Shooting Star is the exact opposite to the Hammer. The construction and psychology are exactly the same but in reverse.

It is a single candlestick in a rising market with a long upper shadow and a small real body at the bottom end of the candle’s range.

In summing up the Hammer I said that it was one of my favourites, so it follows that its bearish opposite number will also be high on my list. It is indeed. These patterns are so simple yet so effective. Just the sort of technical analysis I like!

As with the Hammer it’s also worth highlighting that these are generally great patterns to look out for on short-term charts (10 to 30-minute) for futures contracts or equities that trade with a combination of good volume and volatility.

Now we’re going to look at two familiar looking patterns, and work out why they are given different names to those we’ve come across already.

Inverted Hammer

Getting inside the pattern

Does this shape of candlestick look familiar? It should do, because it’s exactly the same shape as a Shooting Star, in fact conditions 1, 2, 3, 4, and 5 are all the same. The only difference is the last condition, ie, what the trend is when we see a pattern of this shape.

If you see a candlestick shaped like a Shooting Star during a downtrending market, you’re looking at an Inverted Hammer, which is a bullish reversal pattern.

It’s not the strongest of patterns, and if we once again go through the steps of thinking about the price action, we’ll soon see why. We are in a downtrending market, so the bears are dominating. On this day we see a strong rally followed by a sell-off, which gives us the long upper shadow. As with the Shooting Star the market moves in an arc shaped direction of travel, moving higher then lower.

So why could this possibly be a reversal? After all, by the end of the day we’re back on the lows and the bears are dominating.

A note about backtesting

Backtesting involves going back over historical data on your chart, whatever the time frame, to test a trading strategy. It is a useful (arguably essential) exercise, except that most people aren’t honest with themselves about the reality of their entries or exits.

I always suggest a “worst case scenario” approach to this. Say for example you get a buy signal after a candle with a close at 1.10, and the next candle sees the market trade up from an open at 1.12 to a close at 1.20. Do you say you bought at 1.10, 1.12 or 1.20?

My answer would be 1.20, because in reality you wouldn’t pay 1.10 because you don’t know until after the close on that first day that you’ve got a buy signal. You may pay 1.12, as you would attempt to enter the market early on the second day, but what happens if the market traded a tiny amount at 1.12 then immediately jumped to 1.20? Here is a fact: unless you have access to the intra-day data you would be making baseless and dangerous assumptions about where you entered the trade.

Why not work on a “worst case scenario” and if your trading strategy still makes money, then it should do even better when the slippage is taken out. One more thing to think about regarding backtesting: you have to pay your broker’s commission, or your trading fees, so this also needs to be in the equation. I’ve seen so many trading systems presented where the results exclude commission costs. I would like their broker’s name, as I too would like to trade with zero commission!

Finally, you also might want to add a little word called reality into the equation when you’re backtesting strategies. For example once a month, on the first Friday, we get the US Employment Report, and the world’s debt markets go berserk. Are you happy to take a signal from your system two minutes before this regularly market-moving event? A release that you know could move the market significantly up or down? Or would you want to put on a trade hours before a big interest rate announcement, or a company’s results, or a crop report? Some would say yes, and I’m not going to argue with them. We all have our own different risk parameters. All I’m pointing out is that if you are uncomfortable with this sort of trading then you can’t include these pre¬event signals in your test results, even if most of the trades worked well. If in reality you’d never have put the trades on, then you’re kidding yourself!

Psychology

Well, here’s the thing. The bulls did give us that move higher in the early part of the session, so they can make a difference. They showed an ability to move the market higher, even if on this particular occasion they couldn’t sustain the push to the upside. The selling in the second half of the day saw the market move back down to where it started, more or less.

So possibly this is more of a warning signal, rather than a strong reversal signal per se.

In my experience these do not make strong reversal patterns, but can appear in the run up to a bottom, so can serve a purpose in warning us that things may be changing.

But don’t take my word for it: if you have a favoured market that you trade, and a favoured time frame for your trading, you should fire up a chart that suits your needs and look back to find the candlestick patterns that have done a good job historically. We can make the assumption that the participants in the market you’re viewing don’t change dramatically over time, so patterns of behaviour can and will be repeated, and the candlestick chart is merely a representation of the behaviour of the market in any instrument. So if Inverted Hammers work beautifully on your chart, then place more importance on the next one you see.

This is why I shy away from giving candlestick reversal patterns a star rating on their potency: it’s because some patterns work better in certain markets than others, and the only way to decide what provides the strongest signal is to do the leg-work and backtest to find what worked best in the past for your market on your chart.

Examples

          

Figure 3-14: HSBC pic; daily candlestick chart; 31 January 2007 - 11 May 2007, showing 28 February 2007 Inverted Hammer

This Inverted Hammer didn’t signal an end to the trend, but if you had allowed yourself to consider the idea of a reversal after you’d seen it, you wouldn’t have been so surprised when the market bottomed out a few weeks later.

The bottom, as you can see, was a Hammer day with a lower shadow that had breached the previous support. Even then, there were a few more small bodied candlesticks seen after that before the bulls finally got their act together.

The following chart is interesting, as it has a plethora of Inverted Hammers, as highlighted. This once again proves the importance of confirmation for any candlestick pattern. If your trading strategy in this instance was “if we see an Inverted Hammer then buy” you wouldn’t have any money left after the first three to take advantage of the fourth pattern, the one that did actually give us a reversal.

          

Figure 3-15: CME NASDAQ futures (unadjusted active continuation); daily candlestick chart; 27 August 2002 - 1 November 2002, showing Inverted Hammers on 18 September, 19 September, 27 September and 9 October

But if you’d simply asked to see a green candlestick following the Inverted Hammer you would have stayed out of the first three and jumped in after the fourth one, when the market gapped higher two days later (as highlighted by the light blue arrow). Even though you would be buying 68 ticks off the lows, you still wouldn’t be complaining. Also you could have placed your initial stop below gap support at 856. Nice. Incidentally this was the absolute low of this index after the dotcom bubble had burst.

Inverted Hammer summary

The Inverted Hammer isn’t generally the strongest of reversal patterns. However, it can be a good warning of an impending reversal because it’s a candle that illustrates that the bulls aren’t completely dead and buried; they’re starting to make noises, even if on this occasion it came to nothing because the bears stepped back in to sell into the gains towards the end of the formation of the candle.

One reason I wanted to cover this pattern was to complete the picture and differentiate it from the similarly shaped Shooting Star.

Hanging Man

The last candlestick in this family is the Hanging Man, and what a marvellously descriptive name it has! Does anyone think this might be a bullish pattern? No, I didn’t think so! There can’t be much upside to being strung up on the gallows, I’ve always felt.

Getting inside the pattern

We’ve established, just by hearing the name, that this is a bearish pattern. As we can see from the properties panel it’s the same shape as the Hammer, except this time it’s seen during a rising market. Our first five rules are exactly the same, it’s just the last one, the “where” rule, that changes.

A Hanging Man is formed during an uptrend on a day when the market sells off then rallies to take back most or all of the losses seen earlier in the session. It represents a “V” shaped direction of travel over the course of the life of the candle.

As with the Inverted Hammer the idea of this being a reversal is a little tough to grasp at first as we’re talking about a candlestick that’s formed by a market that sold off early on, but was rising neatly again by the time the session ended.

Psychology

The reasoning behind this pattern is akin to the Inverted Hammer, but in reverse: the long lower shadow shows that the bears managed to push things lower, even if they couldn’t sustain the push over the course of the whole day. The point is they gave it a go, so they’re not completely dead in the water. It’s possible they’re waking up and may in the near future be capable of mounting something a little more sustainable.

Examples

         

Figure 3-16: ICE Brent Crude Oil futures (unadjusted active continuation); daily candlestick chart; 27 December 2005 - 15 February 2006, showing Hanging Man on 30 January 2006

On this chart a Hanging Man sandwiched in between two similar highs was posted. Once the low between these highs was broken a Western chart pattern called a Double Top had been completed. The Hanging Man wasn’t really the main driver of any change of trend at this time, however it would have added a bit of weight to one’s conviction once the sell signal given by the Double Top was seen a few days later.

          

Figure 3-17: Euro vs US Dollar Forex Cross; weekly candlestick chart; 29 May 2000 - 10 September 2001 with annotations

We’ve seen this chart already: we used it when we were looking at the Hammer pattern (Figure 3-4). We came to the conclusion that Candles B, C, D and G were the Hammers, and that the others didn’t qualify.

We can now embellish on this and say that E and F qualify as Hanging Man candlesticks, as they’re both Hammer-shaped, but seen in a rising market. We can also safely say that while Hanging Man candlesticks don’t generally provide strong signals, in this case they did.

What about A and H? Argue amongst yourselves! If anything they’re Hanging Man candles, as they’re seen just off the highs.

Hanging Man summary

A Hanging Man candlestick is the same shape as a Hammer, but is seen during a rising market.

I’m sure you’ll agree with me that after finding out all about this pattern it’s a bit of an anticlimax. What a great name, summoning up the most bearish of bear thoughts! In reality it can be a good warning signal that the sellers are stirring after a period of domination by the bulls, but it’s not often the horrid disaster that its name might suggest!