A way to map reversals, bullish or otherwise.
Last week, we looked at the ‘Doji’ formation , a particular candlestick pattern on stock movements. This week, we look at two other patterns, a ‘hammer’ and an ‘engulfing pattern’.
A hammer candlestick is a bullish reversal pattern. It forms when a security moves significantly lower after the opening, but rallies to close well above the intraday low. The resulting candlestick looks like a square lollipop, with a long stick. If this candlestick forms during an advance, then it is called a ‘Hanging Man’. We are not discussing this pattern here. For a classic hammer, the lower wick must be two times greater than the size of the body of the candle, and the body of the candle must be at the upper end of the trading range.
A bullish reversal pattern forms after a decline. In addition to a potential trend reversal, hammers can mark bottoms or support levels. After a decline, hammers signal a bullish revival. The low of the long lower shadow implies that sellers drove prices lower during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. While this may seem enough to act on, hammers require further bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. Such confirmation could come from a gap up a long white candlestick. Hammers are similar to selling climaxes, and heavy volume can serve to reinforce the validity of the reversal.
In this SBI weekly chart, a hammer appears after a downtrend trend , in the week ended March 13, 2009. In the following week, the stock makes a tentative move higher but really gathers momentum in the second week, doubling in 12 weeks.
ENGULFING PATTERN
An engulfing pattern is a reversal pattern that can be bearish or bullish, depending upon whether it appears at the end of an uptrend (bearish engulfing pattern) or a downtrend (bullish engulfing pattern). An engulfing pattern is seen when the body of a candle completely engulfs the previous day's body. The engulfing candle must completely "consume" the real body of the previous candle.
The power of the engulfing candle is increased by two factors, size of the candle and volume on the day it occurs. The bigger the engulfing candle and higher the volume, the more powerful the move.
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BULLISH ENGULFING
A bullish engulfing candle occurs after a significant downtrend. Note that the engulfing candle must encompass the real body of the previous candle, but need not surround the shadows. The engulfing candle is usually made on higher volumes compared to the previous day. The day opens below the close of the previous day, but then quickly rallies to close above the opening of the first day. This damages the spirits of the shorts and brings into question the bear trend, which prompts additional buying in the next few sessions.
BEARISH ENGULFING
A bearish engulfing candle occurs after a significant uptrend. On the day a bearish engulfing pattern is formed, trading opens at a level higher than the previous day’s closing and then quickly sinks to close below the opening level of the previous day. This torpedoes the spirits of the longs and brings into question the bull trend, which prompts additional selling in the coming days.
The engulfing pattern in the Infosys weekly chart appeared after a sustained bull run of eight months. The stock depreciated by about 30 per cent in the first six months and by about 50 per cent over 11 months.
The writer is director and head of research, Anagram Capital
