In last week’s episode of how to day trade using price action, you gained an understanding about how the pricing of securities worked through my simplified and silly examples. We also had a look at the “Big Green Candle” and you learned what it really means when you see one of those big green candles. I believe it is important to for you understand the mechanics behind the candles in your chart. Usually the Big Green Candles are found in strong uptrends, and they signal a continuation of the trend.
I didn’t go through the “Big Red Candles”, but I know you are pretty smart, so you probably already figured out that Big Red Candles are the opposite to Big Green Candles. In other words the Big Red Candles are big bearish candles found in a down trend. They can also be find right at levels of support, when big strong moves are required for a break out. Same thing with Big green candles – they are often found at levels of resistance, and the big green candle represents the strong demand that is needed to break through the resistance.
These are also continuation candles, meaning that they indicate a continuation of the trend. In an uptrend you want to see bullish candles, and in a bearish trend you want to see bearish candles. Makes sense, right?
There are also reversal candles, that signal an imminent reversal in the trend. Today I will go through a basic reversal candlestick pattern. This is simply called the “Reversal candle”. I will go through examples in an uptrend, and there are four main variations of this pattern.
This pattern is formed over two candles, but that doesn’t mean that you are only going to look for these two candles. You’ll also need to take the candles before that into consideration. Always when you trade patterns, and price action in general, you cannot just isolate a few candles and look at only those candles.
It’s just like when you’re reading a book – you cannot just read a word here and there, you need to read and understand the whole sequence of words in order to get anything meaningful out of it.
So when you’re reading price action, you’ll need to consider the whole chart. Has the stock been in an uptrend or downtrend, is it moving sideways, is it erratic and chopping around, and so on.
So the definition of a Reversal Candle is that the candle opens, makes a high, but closes below the open, and closes below the close of the previous candle.
There are also variations of this reversal pattern;
The first variation is the “Outside Reversal Candle”. “Outside” means that the highest high of the candle is higher than the previous candle’s highest high.
Then we have the “Key reversal”, which means that the candle opens lower than the previous candle’s close, moves higher and then closes below the open, and also below the previous candle’s close.
And then finally the “Outside Key Reversal” – the candle opens lower than the previous close, makes a new highest high, and then closes below the open and below the previous candle’s close.
The same principles apply in downtrends, but you’ll need to replace the highs and lows, with lows and highs, right?
So an “outside key reversal” in a downtrend opens higher than the previous close, moves lower than the previous candle’s low, it closes above the open, and thereby also above the previous candle’s close.
Like I mentioned in another episode in this price action day trading series, the market always tests where it has been before – so the outside key reversal is a final test of that price level – of that previous high or low, just before the market starts heading in the opposite direction.
It’s a good candlestick pattern.
Alright, and remember you cannot just look at the two candles of the pattern to be successful with this.
If you have sideways, erratic, choppy price action it doesn’t make sense looking for the reversal patterns. The market needs to be in a trend, it needs to have “predictable” swings higher and higher, two three swings that you can clearly see.
Then as we approach a potential top of a swing, the price action starts to arch over, you can start looking for reversal patterns. Then you are likely to catch the top of the swing, and be able to successfully trade short. If you’re in a downtrend and get a reversal pattern at the bottom of a down swing, you trade long.
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