Module 2   Technical AnalysisChapter 10

Multiple Candlestick Patterns (Part 3)

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The morning star and the evening star are the last two candlestick patterns we will be studying.

Before we understand the morning star pattern, we need to understand two common price behaviors –gap up opening and gap down opening. Gaps (a general term used to indicate both gap up and gap down) are a common price behavior.  A gap on a daily chart happens when the stock closes at one price but opens on the following day at a different price.

M2Ch10-title

10.1 – The Gaps

Gap up opening – A gap up opening indicates buyer’s enthusiasm. Buyers are willing to buy stocks at a price higher than the previous day’s close. Hence, because of enthusiastic buyer’s outlook, the stock (or the index) opens directly above the previous day’s close. For example consider the closing price of ABC Ltd was Rs.100 on Monday. After the market closes on Monday assume ABC Ltd announces their quarterly results. The numbers are so good that on Tuesday morning the buyers are willing to buy the stock at any price. This enthusiasm would lead to stock price jumping to Rs.104 directly. This means though there was no trading activity between Rs.100 and Rs.104, yet the stock jumped to Rs.104. This is called a gap up opening.  Gap up opening portrays bullish sentiment.

In the following image the green arrows points to a gap up openings.

M2-Ch10-chart1

Gap down opening – Similar to gap up opening, a gap down opening shows the enthusiasm of the bears. The bears are so eager to sell, that they are willing to sell at a price lower than the previous day’s close. In the example stated above, if the quarterly results were bad, the sellers would want to get rid of the stock and hence the market on Tuesday could open directly at Rs.95 instead of Rs.100. In this case, though there was no trading activity between Rs.100 and Rs.95 yet the stock plummeted to Rs.95. Gap down opening portrays bearish sentiment. In the following image the green arrows points to a gap down opening.

M2-Ch10-chart2

10.2 – The Morning Star

The morning star is a bullish candlestick pattern which evolves over a three day period. It is a downtrend reversal pattern. The pattern is formed by combining 3 consecutive candlesticks. The morning star appears at the bottom end of a down trend. In the chart below the morning star is encircled.

M2-Ch10-chart3

The morning star pattern involves 3 candlesticks sequenced in a particular order. The pattern is encircled in the chart above. The thought process behind the morning star is as follow:

  1. Market is in a downtrend placing the bears in absolute control. Market makes successive new lows during this period
  2. On day 1 of the pattern (P1), as expected the market makes a new low and forms a long red candle. The large red candle shows selling acceleration
  3. On day 2 of the pattern (P2) the bears show dominance with a gap down opening. This reaffirms the position of the bears
  4. After the gap down opening, nothing much happens during the day (P2) resulting in either a doji or a spinning top. Note the presence of doji/spinning top represents indecision in the market
  5. The occurrence of a doji/spinning sets in a bit of restlessness within the bears, as they would have otherwise expected another down day especially in the backdrop of a promising gap down opening
  6. On the third day of the pattern (P3) the market/stock opens with a gap up followed by a blue candle which manages to close above P1’s red candle opening
  7. In the absence of P2’s doji/spinning top it would have appeared as though P1 and P3 formed a bullish engulfing pattern
  8. P3 is where all the action unfolds. On the gap up opening itself the bears would have been a bit jittery. Encouraged by the gap up opening buying persists through the day, so much so that it manages to recover all the losses of P1
  9. The expectation is that the bullishness on P3 is likely to continue over the next few trading sessions and hence one should look at buying opportunities in the market

Unlike the single and two candlestick patterns, both the risk taker and the risk averse trader can initiate the trade on P3 itself. Waiting for a confirmation on the 4th day may not be necessary while trading based on a morning star pattern.

The long trade setup for a morning star would be as follows:

  1. Initiate a long trade at the close of P3 (around 3:20PM) after ensuring that P1, P2, and P3 together form a morning star
  2. To validate the formation of a morning star on P3 the following conditions should satisfy:
    1. P1 should be a red candle
    2. With a gap down opening, P2 should be either a doji or a spinning top
    3. P3 opening should be a gap up, plus the current market price at 3:20 PM should be higher than the opening of P1
  3. The lowest low in the pattern would act as a stop loss for the trade

10.3 – The evening star

The evening star is the last candlestick pattern that we would learn in this module.

The evening star is a bearish equivalent of the morning star. The evening star appears at the top end of an uptrend. Like the morning star, the evening star is a three candle formation and evolves over three trading sessions.

M2-Ch10-chart4

 

The reasons to go short on an evening star are as follows:

  1. The market is in an uptrend placing the bulls in absolute control
  2. During an uptrend the market/stock makes new highs
  3. On the first day of the pattern (P1), as expected the market opens high, makes a new high and closes near the high point of the day. The long blue candle formed on day 1 (P1) shows buying acceleration
  4. On the 2nd day of the pattern (P2) the market opens with a gap reconfirming the bull’s stance in the market. However after the encouraging open the market/stock does not move and closes by forming a doji/spinning top. The closing on P2 sets in a bit of panic for bulls
  5. On the 3rd day of the pattern (P3), the market opens gap down and progresses into a red candle. The long red candle indicates that the sellers are taking control. The price action on P3 sets the bulls in panic
  6. The expectation is that the bulls will continue to panic and hence the bearishness will continue over the next few trading session. Therefore one should look at shorting opportunities

The trade setup for an evening star is as follows:

  1. Short the stock on P3, around the close of 3:20 PM after validating that P1 to P3 form an evening star
  2. To validate the evening star formation on day 3, one has to evaluate the following:
    1. P1 should be a blue candle
    2. P2 should be a doji or a spinning top with a gap up opening
    3. P3 should be a red candle with a gap down opening. The current market price at 3:20PM on P3 should be lower than the opening price of P1
  3. Both risk taker and risk averse can initiate the trade on P3
  4. The stop loss for the trade will be the highest high of P1, P2, and P3.

10.4 – Summarizing the entry and exit for candlestick patterns

Before we conclude this chapter let us summarize the entry and stop loss for both long and short trades. Remember during the study of candlesticks we have not dealt with the trade exit (aka targets). We will do so in the next chapter.

Risk taker – The risk taker enters the trade on the last day of the pattern formation around the closing price (3:20 PM). The trader should validate the pattern rules and if the rules are validated; then the opportunity qualifies as a trade.

Risk averse – The risk averse trader will initiate the trade after he identifies a confirmation on the following day. For a long trade the colour of candle should be blue and for a short trade the color of the candle should be red.

As a rule of thumb, higher the number of days involved in a pattern the better it is to initiate the trade on the same day.

The stoploss for a long trade is the lowest low of the pattern. The stoploss for a short trade is the highest high of the pattern.

10.5 – What next?

We have looked at 16 candlestick patterns, and is that all you may wonder?.

No, not really. There are many candlestick patterns and I could go on explaining these patterns but that would defeat the ultimate goal.

The ultimate goal is to understand and recognize the fact that candlesticks are a way of thinking about the markets. You need not know all the patterns.

Think about car driving, once you learn how to drive a car, it does not matter which car you drive. Driving a Honda is pretty much the same as driving a Hyundai or Ford. Driving comes naturally irrespective of which car you are driving. Likewise once you train your mind to read the thought process behind a candlestick it does not matter which pattern you see. You will exactly know how to react and how to set up a trade based on the chart that you are seeing. Of course in order to reach this stage, you will have to go through the rigor of learning and trading the standard patterns.

So my advice to you would be to know the patterns that we have discussed here. They are some of the most frequent and profitable patterns to trade on the Indian markets. As you progress, start developing trades based on the thought process behind the actions of the bulls and the bears. This, over time is probably the best approach to study candlesticks.


Key takeaways from this chapter

  1. Star formation occurs over three trading sessions. The candle of P2 is usually a doji or a spinning top
  2. If there is a doji on P2 in a star pattern, it is called a doji star (morning doji star, evening doji star) else it is just called the star pattern (morning star, evening star)
  3. Morning star is a bullish pattern which occurs at the bottom end of the trend. The idea is to go long on P3 with the lowest low of the pattern being the stop loss for the trade
  4. Evening star is a bearish pattern, which occurs at the top end of an up trend. The idea is to go short on P3, with the highest high of the pattern acting as a stop loss
  5. The star formation evolves over a 3 days period, hence both the risk averse and risk taker are advised to initiate the trade on P3
  6. Candlesticks portray the traders thought process. One should nurture this thought process as he dwells deeper into the candlestick study

559 comments

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  1. Nitesh sharma says:

    Hi Karthik
    Is this a Morning Star ?

    • Karthik Rangappa says:

      Yes Sir, you can treat this as a morning star. However I would have been happier if the prior trend (down trend in this case) was a bit more pronounced and the 3rd day candle a bit longer. But I guess with some about of flexibility, we can consider this as a morning star. If I were trading based on this, I would expose very little capital on this trade simply because of the two point I just mentioned.

      • Nitesh Sharma says:

        Hi karthik
        My Knowledge is very less infront of you , so if you say sir to me it looks lil bad pls call me Nitesh only . 😀

      • Sachin Kanchan says:

        You might want to update the pdfs. While reading I found some mistakes that are corrected here on the Website.
        A new mistake I came across is: “The long red candle indicates that the *buyers* are taking control. The price action on P3 sets the bulls in panic”.
        Should be – “*sellers* are taking control”
        btw, nice explanation. Thanks heaps.

      • Hemant says:

        I’m a little bit confused. In the image mentioned above in the comment you said that the pattern is a morning star. But the closing of P3 is less than the opening of P1. So how it could be a morning star?

        • Karthik Rangappa says:

          Sorry, I seem to have missed the closing bit. Nevertheless, as I have mentioned earlier, you need to have some amount of flexibility. Finding textbook definitions is not easy in real market situations.

      • Rakesh Hansalia says:

        My question is based on chart what Nitesh’s posted in above comment.

        1) Suppose if second day candle(P2) were formed as doji having BLUE short body then still we can consider as a morning start pattern ?
        2) Let’s assume conditions for P1 and P2 are satisfied then body color (blue or red ) of doji (for P2) does really matters in morning or evening start pattern ?

    • rohit.kumar4000 says:

      prior to your morningstar didn’t you see the bullish engulfing clear cut signal

  2. Gautham ks says:

    Hi Karthik
    what if a stock has complied with all the other requirements for an evening star,
    i.e —- prior trend is an clear uptrend ,
    day 1 is a long blue candle
    day 2 has a gap up
    day 2 closses as a doji/spinning top
    buy day 3 IS NOT A GAP DOWN opening….. still closes below or very near to day 1 opening.

    How important is the Gap up and gap down?

    • Karthik Rangappa says:

      I would treat this on a case to case basis. If such a pattern appears and all other checklist items comply i.e volume, S&R, Risk Reward Ratio etc…I would go ahead and trade this confidently on the merits of an evening star.

  3. jagadeesh says:

    Hello Sir,
    I am now comfortably able to trade single candlestick patterns and that increased my success ratio quite well these days. But coming to multiple candlestick patterns, 3 out of 5 trades that i take on multiple candlestick patterns are failing. Is that because i didn’t train my eyes and brain enough to identify them correctly?? Also, does the volume in the P2 and P3 must be higher than the volume in P1 to consider it as a valid pattern??
    Thanks in advance..

    • Karthik Rangappa says:

      Good to that you are comfortable with single candlestick patterns Jagadeesh. With regard to multiple candlestick pattern, please ensure the day you are taking an action i.e either buying or selling the volume should be above average. Also, one of the main things people miss is to validate the prior trend. So please make sure you are factoring this as well.

      • jagadeesh says:

        Yeah im not missing those two checklist points sir. I think i need to train myself in identifying support and resistance levels properly. The thing is, with the appearance of a candlestick pattern, i am totally biasing myself towards the trade direction and searching for the support around that area to support my decision. When the trade ended in loss, im realizing that area is not a major level.. 😀
        I think i need to change this behaviour. 🙂

  4. Ashwin says:

    Hi Karthik, First comment is to thank you for helping all of us with this. I have read through all the candle sticks over and over agin, but your explanations are state of the art.
    My question for these kind of patterns is, why can’t a risk lover can take the position at start of the day itself. Why would we wait for the confirmation till EOD. The same for the peircing and other patterns too. I am a bit confused here.

    • jagadeesh says:

      Hi Ashwin,
      Because you cannot cosider the pattern as valid until it completely appears on the chart. I think the main difference between the risk lover and the risk adverse is the former doesn’t need a follow through after the pattern appeared and the risk adverse guy need a follow through after the candle formation. But both these guys need a completed candlestick patter to appear on the screen which happens at the close of the day.

    • Karthik Rangappa says:

      Thanks Ashwin.

      Even for risk takers it would be prudent to wait for a confirmation. Think about it, the whole of candlestick patterns is actually based on price action and the markets reaction to it. We should give time for the price action to pan out. Hence for both risk takers risk averse traders it would make sense to wait proportionately (wrt to risk they want to take) ..before initiating a position.

      • Ashwin says:

        Thanks again Karthik! I completely understand and appreciate your statement ”Reaction of the market to the price action”,but sometimes due to market volatility and external factors affecting the market as a whole, there wont be any confirmation in the next day,it might become counterproductive for the risk lover,who has initiated the call only at 3.20 PM ,to get a loss the next. So, I am only trying to understand how early any breakouts like this can be capitalized.
        I have got the essence of both your point and the candle stick pattern, so may be with time and experience I might be able to answer it.

        • Karthik Rangappa says:

          Absolutely, with time, experience, and the knowledge you have gained you will develop your own techniques of identifying markets. In fact in the long run this manifests as your edge as a trader 🙂

          • manishdjk21 says:

            What kind of discipline you’re referring to. like being able to constantly monitor the stock price during the day, keeping your news channel on for any update news or any other livewire news online? I really want to know this because, I’ll tell you something about myself. After working for 6 years in corporate world I Ieft my job in 2014, since then I have been looking for a job but no luck. Now I’ve started to think about making trading as my full time career. Thants why learning TA so that I can make money everyday. My first goal is to earn an avg income of 1 thousand daily by investing 10000 and doing margin trading. please share your thoughts on the same.

          • Karthik Rangappa says:

            Many people quite their mainstream job to get into trading full time. The problem with this is, moment you put targets like Rs.1000/- per day then you are subconsciously adding a layer of stress on yourself, and when in stress, you cannot make rational decisions which is very crucial while trading. Frankly, the approach you are taking to markets is not correct. You will eventually come under a lot of stress and will find it very hard to benefit from markets. This may sound discouraging, but this is what happens to most of the people in your situation. How ever hard it is maybe, get a full time job, stabilize, and then trade without any sort of pressure (like making 1000 per day). This is when you will really start benefiting from markets.

          • manishdjk21 says:

            Hi Karthik,
            Thanks for the advise. On the contrary what I’ve experience in the past that it is very difficult and inefficient to do your day job in the office and place your trade, because once a person have placed the trade, then he/she tends to distract from his office work in order to keep a track on the trade and this creates a situation of see-saw where the attention is divided, which not good either. I did search for jobs a lot in the past two years, but no luck as of yet. That’s why I thought why not do trading full time, of course after getting a good understanding giving a time period of 3-6 months.

          • Karthik Rangappa says:

            True, juggling a full time job and trading gets distracting. But I do know people who manage this well….common trait across all these traders are that they place longer term trades. Something like a 1 week futures position or even equity position.

            Good luck and I hope you have thought through this well.

          • ZQ0852 says:

            Dear sir,
            Adding to the MANISH’s query (below), Is it possible to make money in market on daily basis and run your house, means Is it possible to generate a salary type income from trading.
            Regards

          • Karthik Rangappa says:

            I’ll be frank. Its tough.

            Have a steady source of income like a salary and trade with capital that does not hurt your family needs. When you trade this way, the stress to make a fixed amount via trading is reduced, which means you can afford to be highly selective and trade only when you are thoroughly convinced.

            Place your family first, markets next.

            Good luck.

  5. Harshad Salvi says:

    Hi Nitesh,
    How did you manage to copy the chart of “LT” from icharts?

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