The main idea that technical analysis is one of the most effective ways to analyse the markets is based on the assumption that price movements can predict the future. Although the premise may seem wrong in practice, it can be used as a starting point to analyse price behaviour and determine which side will prevail.
Are Price Patterns Predictive?
Since technical analysis is based on price patterns appearing repetitively over time, one would think the more frequently those occur, the more predictive they would be. However, research proves the opposite.
So, the above assumption does not only seem to be wrong, but it is wrong if, and only if, the predictive nature of the patterns has low probabilities of indicating a future direction.
This makes successful pattern analysis as easy as identifying repetitive price patterns that have led to a trend continuation or reversal with a high success rate over time.
How Reliable Are Short-Term Candlestick Patterns?
Although all investors are familiar with long-term patterns such as the triangle, the head and shoulders and others, the most reliable way of using candlestick patterns for intraday trading are short-term patterns, which are known as such.
The most popular candlestick patterns are the single-line Doji candle, the three-line evening and morning stars, and the standard and inverted hammer. Although traders often use them successfully, statistically speaking, not all make the best-performing candlestick patterns list. The only one that does is the evening star.
Over 100 candlestick patterns are working in all types of markets. Some are known, but most are not, as they often have hard to memorise names, such as the Tasuki Gap. Others are way more memorable, like the Abandoned baby.
Out of all the candlestick patterns, there are three highly performing candlestick patterns scoring 84%, 78% and 72% in their predictability, and frankly, they’re not so commonly known.
The Top 3 Candlestick Patterns
Three-line Bearish Strike (84% Predictability Score)
The three-line bearish strike is the least frequent candlestick pattern, appearing only 85 times out of 4.7 million daily samples. As its name suggests, it is a bearish pattern, however, and surprisingly, it scores 84% as a bullish reversal instead.
Opposite to what the name suggests, the bearish three-line strike is a bullish four-candlestick reversal pattern. Recognising the pattern on the charts is relatively easy as it only requires three bearish candlesticks, followed by an engulfing fourth candle in the upside direction.
It is therefore easy to identify. However, it needs to be in the right place to be reliable. For example, after an extended bearish market that hints at a reversal, even in the short-term. Or at the end of consolidation patterns, such as the triangle, or as the handle of a cup and handle pattern.
The idea is to open a trade at the close of the bullish day and let it run at least the true range of the bullish day, i.e. if the bullish day opened at $1.13 and closed at $1.135, the exit should be at least 50 pips.
Three Black Crows (78% Predictability Score)
The three black crows is also a bearish reversal pattern quite similar to the three-line strike pattern explained above as it is also made up of three consecutive bearish candlesticks. However, it does not require confirmation with a bullish day following. Think of it as a three-line striker pattern without confirmation.
A significant difference between the two candlestick patterns is where they appear. The three black crows candlestick pattern performs better when it appears at tops and after the top is in. It is a reversal pattern, but, in a sense, it appears after the tipping point, suggesting a continuation of the reversal and confirming the downtrend. It is not recommended to use it in downtrends.
Another significant difference is that despite being bearish, the three black crows pattern offers short, not long trading opportunities, contrary to the three-line strike. This makes sense when keeping in mind that it is supposed to perform better when it appears after tops and not when it registers local lows as in the three-line strike case.
Just remember, in the three black crows candlestick pattern, each candlestick must post a new low, close below its preceding close and stay below its preceding candlestick’s top.
The best entry is to wait for a short-term 38%-50% retracement on the third candlestick and short. When it comes to the exit, traders could use at least the full top-to-bottom range of the candlestick pattern.
Evening Star (72% Predictability Score)
The evening star is a bearish three-candlestick reversal pattern that appears at tops. However, it performs better when that top appears in a bullish retracement of a downtrend and not in a bullish trend.
As its name suggests, the candlestick consists of a ‘star’ which is nothing more than a Doji candlestick, and two candlesticks, one on its left and one on its right. The ‘evening’ refers to the pattern’s declining nature as the evening is the time the sun sets down.
The evening star is considered a bearish reversal once the bottom of the bearish candlestick breaks. If the bottom is close to the bullish candlestick’s open, the chances of an elongated bearish trend increase, but it usually takes time to develop or end.
As a rule of thumb, the bearish day must register a close below the midpoint of the bullish day. The closer to the bottom, the better, with an engulfed bullish day hinting at a faster and stronger reversal.
Traders can trade it with or without a pullback, but the usual open is at the bearish candlestick’s close. The exit is at least at 50% of the upward movement of the downward trend low.
Tips for Trading Candlestick Patterns
Each candlestick pattern, regardless of its predictability score and gain characteristics, must be treated carefully and cautiously as new incoming price data could always impact their reliability. Although they have some predictive nature, this will likely decimate in lower timeframes than the daily and threaten your portfolio.
Understanding candlestick pattern is not only about recognising them. It is more about context: where does the pattern appear; is there any other pattern appearing before or emerging after it; is the reward this offers good; did you identify all the criteria to trade it, are questions you should always ask yourselves before entering any of the three highly predictive candlestick patterns.