The Hindu Business Line : Candlestick reversal patterns

There are certain candlestick patterns that give an early indication that a prevalent trend has run its course and is beginning to lose strength. Dark Cloud Cover pattern (DCC) and piercing patterns belong to this class. A DCC pattern is formed with two candles. The first candle is white and the second is black, forming the ‘dark cloud’ that hovers ominously, threatening the prevalent up trend. Needless to add, the DCC pattern occurs near the top of an uptrend.

The second candle in the DCC pattern gaps upward and then moves down, some way within the body of the first white candle but it does not cover the first candle entirely. If it did so, it would then get labelled as a bearish engulfing candle. The extent of penetration within the body of the first candle determines the strength of the pattern. When the second candle moves more that half-way within the body of the first , it implies that a trend reversal is imminent. Dark clouds (second black candle) that move less that half-way within the first candle can turn out to be a false alarm or minor halts within an up trend.

Dark Cloud Cover pattern

Refer the chart of Canara Bank which illustrates DCC pattern. In late September 2008, the stock encountered resistance at around Rs 230 and the uptrend was arrested with the formation of a dark cloud cover pattern. The stock reversed direction following this trend. The piercing pattern is the inverse of the DCC pattern. While the latter occurs towards the end of an up-trend, piercing patterns occur towards the end of a down trend and signal the possibility of a trend reversal from that juncture. This pattern is made up of two candles too. The first candle should be a long black candle as it would be part of the downtrend. The second candle would gap downward and then move higher well within the body of the second. Again, the extent of the penetration determines the strength of the pattern.

Piercing pattern

Refer to the chart of Reliance Infrastructure for piercing patterns. It isevident that the stock’s downtrend was arrested in early July 2008 when a piercing pattern was formed. When the stock’s decline resumed two months later, another piercing pattern was formed in late October 2008 that arrested this leg of the down-move.

A penetration that exceeds 50 per cent of the first candle’s body should be a more reliable signal of a trend reversal.

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