Let me first start off by saying I am not an expert in candlestick charting. Sure, I’ve read a ton of books on the subject, including the granddaddy of them all “Japanese Candlestick Charting Technique,” by Steve Nisson. I have also closely studied the different and colorfully named patterns shown in those books.
Patterns such as the “Three Black Crows,” the “Dark Cloud Cover,” and the “Bukakke,” but at some point they all just seem like a Rorschach test. I’m not good with concepts in which I don’t understand or relate to the underlying mechanics, and that’s how most candlestick patterns seem like to me.
One of the patterns I do relate to and have written about before is the reversal hammer. The other one is a pattern that I like and have traded numerous times as well, and was reminded of when my friend NYC Trader pointed it out to me yesterday; the Morning Star Reversal pattern.
There are a number of rules on how to determine and trade this pattern, and reams of statistical data on its success rate, all of which I will read for you right now…..Zzzzzzzzz!!!!
Instead let me show you what I look for in the pattern and the ways I have traded it in the past.
In the chart of $AIR above you will see the most important factor when determining a morning star reversal pattern; a definite and extended down trend preceding it. How extended is up to interpretation, and though it sounds perhaps too subjective, I have just found that if it visually jumps out at you, it’s probably valid.
The pattern starts with a large red down bar, and the key here is that you want to see a spike on volume on that bar. It’s an indication after an extended downtrend that the last remaining longs have thrown in the towel and sold. The next bar of the pattern is designed to confirm this.
The second bar is a doji, and preferably a tight range doji opposed to a gravestone or dragonfly doji. The thought behind this, for me at least, is that it shows after the large down red bar, buyers and sellers are in perfect equilibrium. This action is key to setting the stage for the last bar of the pattern which determines if it is a true reversal or just a pause in the direction of the previous trend.
With the last bar we want to see a strong green body that closes right around the level of the top of the first red bar. The more symmetrical the pattern the more valid it is.
Volume does not have to be as large on this green bar as it was on that first red bar or even the doji, although if it is that’s a plus. It is really just price action we want to see on this bar because the next one is the “action” bar.
You would buy the next bar as it breaks above the high of the first red bar on a daily chart if you are swinging it, or drill down to the 5-min chart to find a good entry if day trading it. You definitely want to see more volume on this bar than the previous one.
The morning star reversal pattern works across all different time frames and a good variation on it for day trading is to wait to see if an inside consolidation bar forms after the third bar. This gives you a tighter range and a better risk reward to work off of, although you might miss the trade if the bar doesn’t form.
So to recap:
1. Established downtrend.
2. Large red bar with volume spike.
3. Tight range doji.
4. Large green bar finishing near the top of first red bar.
5. Look for symmetry in the pattern.
6. Buy the break of the first bar high.
7. Strongest if formed at a support level.
8. Optional to wait for “fourth” inside consolidation bar.
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