Multiple Candlestick Patterns (Part 4)

 

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 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. 

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 XYZ Ltd was BDT 100 on Monday. After the market closes on Monday assume XYZ 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 BDT 104 directly. This means though there was no trading activity between BDT 100 and BDT 104, yet the stock jumped to BDT 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.  

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 BDT 95 instead of BDT 100. In this case, though there was no trading activity between BDT 100 and BDT 95 yet the stock plummeted to BDT 95. Gap down opening portrays bearish sentiment. In the following image the green arrows points to a gap down opening.

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 composed of three consecutive candlesticks. At the bottom of a downward trend, the morning star arrives. In the following chart, the morning star is circled.

 

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 the second day of the pattern (P2), the bears demonstrate their authority with a gap-down opening. This strengthens the bears' viewpoint.
  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. When a doji or spinning top shows up, it makes the bears a little nervous because they would have expected another down day, especially after a good 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

  10. Unlike the single and two candlestick patterns, both the risk taker and the risk averse trader can initiate the trade on P3 itself.

 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.

 

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. The market opens with a gap on the second day of the pattern (P2), which confirms the bulls' position in the market. But after a promising start, the market or stock doesn't move and ends with a doji or spinning top. The closing on P2 makes bulls a little scared.
  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

 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.

Risk taker – The risk taker enters the trade on the last day of the pattern formation around the closing price. 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 start the trade after he finds confirmation the next day. If you want to buy, the candle should be blue, and if you want to sell, 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.