Candlestick patterns in context

Nobody gets hit at the café "Under the Hammer". The name is just a name, and the real information lies in who sits at which table. Candlestick patterns are the same: hammer, morning star or engulfing are labels that are easy to remember and just as easy to abuse. In this lesson you will learn to recognise them, but above all you will understand when they can be trusted.

What you will learn

• how to define the key candlestick patterns with numbers so that they do not depend on the eye,
• three questions about context that decide whether a pattern matters,
• why confirmation can matter more than the pattern itself.

The key patterns

All of them build on what you learned in lesson 3: body, wicks, colour. Here are a few classics, each with a numerical definition so that two people judge it the same way.

• Hammer: a small body in the upper part of the range, a lower wick at least twice as long as the body, almost no upper wick. Appears after a decline. Sellers pushed price low but buyers bounced it back.
• Shooting star: the mirror image of the hammer: a small body at the bottom, an upper wick at least twice as long as the body. Appears after a rise. Buyers pushed price high but sellers pushed it back.
• Bullish engulfing: after a bearish candle comes a bullish one whose body fully covers the body of the previous one. The market changed its mind with force. The opposite is bearish engulfing.
• Harami: the second candle has a body that fits inside the body of the first. It is a pause in momentum, not yet a change of direction.
• Morning star: three candles after a decline: a long bearish one, a small candle with a tiny body (hesitation), a long bullish one closing deep inside the body of the first. The opposite is the evening star.
• Doji: open and close almost equal. Hesitation, a draw.

Three questions about context

Before a pattern deserves your attention, ask three questions:

1. Where? A hammer at the support from lesson 2 is a story about the rejection of lower prices. The same hammer in the middle of a sideways channel is chance.
2. After what? A hammer after a clear decline makes sense, because something is being stopped. A hammer after three quiet days has nothing to stop.
3. With what confirmation? A pattern with higher volume (lesson 4) and with a following candle that closes in its direction is more credible than a pattern in a vacuum.

If the answer to all three is "I don't know", you have a pretty drawing, not a signal.

Confirmation

A single candle is a hypothesis, the next one is evidence. When after a hammer at support the next session closes above the hammer's high, the hypothesis "buyers are regaining control" gets support. When it closes below the hammer's low, the hypothesis fails, and you know it immediately, because you have a ready point where you were wrong. That is one of the most valuable features of a well-defined pattern: it tells you by itself where its invalidation is.

Chart example: Alphabet (GOOGL), daily chart

Alphabet is so liquid that patterns on its chart are not the work of a few individual orders. Open the daily chart for the last year, mark several of the most important support and resistance zones (lesson 2), and then look near them for the patterns from this lesson: hammers, engulfing candles, stars.

For every pattern you find, answer the three context questions and write down what the next candle did and where price was after five sessions. The result may surprise you: many "pretty" patterns mean nothing at all, and those that do mean something almost always sit at important levels.

A private record instead of other people's promises

The best way to find out whether a pattern works for you is to measure what a researcher would, only on a small scale. Record every pattern you meet in a spreadsheet in five fields: date, pattern name, whether it sits at an important level (yes or no), relative volume and the change in price after five sessions. After twenty cases you will have your own honest statistics, drawn not from other people's textbooks but from the charts you look at. Usually two things become visible: context makes a big difference, and a sample of twenty is still too small to announce conclusions.

How it fails

• A modest edge. Research on the effectiveness of candlestick patterns gives mixed results: where an edge exists at all, it tends to be small and unstable over time. Do not treat patterns as a money machine.
• Noise without a filter. On a chart with hundreds of candles there will be plenty of patterns. Most mean nothing. Without a context filter you will see signals everywhere.
• Subjectivity. An "almost hammer" is not a hammer. Stick to the numerical definitions.
• A self-fulfilling name. The better a pattern sounds, the easier it is to believe that it works. Check with numbers, not with names.

Check yourself

1. How would you define a hammer numerically?
2. Under what condition does a candlestick pattern matter at all?
3. How does bullish engulfing differ from harami?
4. Why wait for confirmation from the next candle?

Next lesson

Lesson 6. Trendlines and channels: a single straight line can say more than three indicators, but only if you draw it honestly. I will show you how not to fool yourself and why the chart scale changes the whole story of one of the biggest rallies of recent years.

Educational material, not investment advice.