Keep an eye out for these two chart set-ups
In today’s Profit Watch:
• Check out these strangely named chart patterns
• How ‘crows’ and ‘soldiers’ signal a new trend
• Plus: How to trade these reversal set-ups
We’ve talked about chart patterns made up of a lot of candlesticks representing a fair bit of time during which the pattern forms…
You know, like head and shoulders, flags and pennants and double or triple tops and bottoms.
Some of these are reversal patterns, i.e. they suggest a reversal in the trend. Others are continuation patterns, pointing to the trend resuming after a bit of sideways action.
As I say, a lot of these patterns are formed over fairly lengthy time periods, as we build up a picture of what the price action is telling us… and where we think the market could be heading.
But there are other patterns that are formed of far fewer candlesticks. And because of how they appear within the whole market context, they can be very telling about where price could be heading.
If you ever manage to get hold of any of Steve Nison’s books (he’s really the guy who took Japanese candlestick charting and made it popular with traders in the West), then they’re worth studying. You’ll find plenty of these interesting little patterns within those pages.
But let me give you two examples to give you a taste of what I’m talking about.
The three black crows
Although it occurs fairly infrequently, this is an pretty powerful pattern and one to watch for. I’ll show you what it looks like and then you’ll be able to spot it.
Close your eyes just for a moment. Imagine three black crows sitting at the top of a tall tree far in the distance. That’s kind of what this pattern looks like (with a bit of imagination!) To be honest, I’m not sure why it was given this name (I didn’t choose it!)
Anyhow, it’s an interesting formation – a bearish one and one that comes after a significant uptrend. In other words, price has been going up… but then along comes this pattern that screams “watch out!”
The formation is most successful if the first crow – or bearish candlestick – closes below the previous candle’s real body.
Two more consecutive long-bodied, bearish candles then follow.
With each of these candles, it appears as though the bulls are trying to regain their dominance as the candle opens higher than the close of the previous candle.
By the end of each session, however, the sellers regain control and price drops to a new closing low.
Here is what the three black crows candlestick pattern looks like:
IMPORTANT: The lower wicks on three black crows are small relative to the body and in some cases there aren’t any lower wicks at all. Three black crows can be seen as a complete pattern. But it’s worth watching carefully how the next candle after the third black crow behaves. Don’t forget, there has already been heavy selling pressure, so the market could be oversold and due a bit of a pull-back. Ideally what we want is a continuation of the selling – which could lead to a far bigger move lower.
How to trade the three black crows
In the trading example below, you can see that price is advancing to the upside and gaps higher.
The gap is followed by the formation of the three black crows pattern. This should alert you to the possibility of a reversal and continuation play.
So how to play it?
We place a sell limit order below the low of the third bearish candle in the pattern with a protective stop placed above the high of the first candle in the pattern.
The initial profit objective for this trade is twice our initial risk. You could either bank all your profits at that level – or reduce risk, taking some off the table and leaving the rest to run for a bigger move.
Now as I said earlier, the three black crows is an infrequent pattern. But it’s easy to spot and can be a very powerful candle formation.
As we saw, the three black crows pattern is a sign of a potential bearish change in trend. If we spot one, we’re looking to profit from falling prices or shorting…
The opposing bullish pattern is called ‘the three white soldiers’ – and as you’ll see, it works in a similar way – only this time you’re looking to buy the market as a trend reverses.
Let’s take a look at it…
The three white soldiers
Close your eyes. Imagine three soldiers, dressed in white, at the bottom of a hill in the distance…
Oh, whatever! Again, I didn’t choose the name.
Anyway, it’s another interesting formation – a bullish one and one that comes after a significant downtrend. In other words, price has been going down… but then along comes this pattern that signals a potential move higher.
The three white soldiers pattern is most effective when it forms after a substantial downtrend and develops from a period of sideways action or consolidation.
When price posts a decline followed by consolidation, the emergence of three white soldiers signals a high probability that price will move higher.
The first of the three white soldiers is a reversal candle. So we’ve had a down trend, and maybe some consolidation (sideways trading), and then the market starts to move higher.
The second candle should open within the body of day one, usually in the upper half, as per above.
By the end of the second candle, the market should close near its high. In other words, the upper wick should be very short or even better, not there at all. This indicates strong buying into the close of the session.
And then you get the same sort of action on the third day.
So how do we go about trading them?
How to trade the three white soldiers
When we observe the three white soldiers pattern after a significant decline or emerging from a period of consolidation, you can look to place a buy stop order above the high of the third candle in the pattern. (A “buy stop” is an order that is only triggered if price moves up to a higher level.)
You’d look to put your protective stop below the low of the first candle in the formation – perhaps even below the most recent swing low. And you can aim for a target of perhaps twice your initial risk. Although if I was doing a trade based on this, I’d assess support and resistance levels on the chart and bring that into my target analysis.
Remember, the main premise of technical analysis (charting) is that history tends to repeat.
Not necessarily exactly. But price often follows patterns that have happened before. And often those patterns happen again. That’s an opportunity to make money.
It’s the whole premise of Guy Cohen’s analysis and trading strategies. His software scans the charts for repeating patterns and then shows you how to trade them. In other words he does most of the work for you…