Candlestick Patterns: The Dark Cloud Cover Reversal

[RichardCox 10]

Candlestick Patterns: The Dark Cloud Cover Reversal

 

One of the oldest sayings in financial market trading is that it is “best to buy low, and sell high.” But while this is a relatively easy idea to understand, it is much easier said than done. This is because if can be very difficult in some cases to identify situations where market momentum is truly changing. A trend, by its very nature, is a circumstantial event that requires a significant amount of market momentum to generate. This is why experienced traders are well-accustomed with the constant “head fakes” and false reversals that are seen on a regular basis.

 

Needless to say, the ability to accurately buy low and sell high can be extremely profitable. So it makes sense for traders to have many tools in their arsenal that will allow these situations to be spotted as they unfold. Here, we will look at the Dark Cloud Cover, which is a Japanese candlestick formation that signals “trouble is on the wake” and that the bullish momentum needed to maintain an uptrend is starting to leave the market.

 

Candlestick Pattern Dimensions

 

The Dark Cloud Cover differs from patterns like the Doji or Evening Star in that it is a more decisive move that signals potential trend reversal. Dojis and Evening Stars are more an indicator of market indecision, and this can be seen when we look at the way the Dark Cloud Cover starts to separate from the trend.

 

 

In the illustration above, we can see that the “cloud cover” is a bearish candle that follows a bullish candle as part of an uptrend. The highest high actually surpasses what was seen in the previous bullish candle. Price moves like this can be thought of as a “bull trap” because it can be easy to mistake this activity as a new higher high that is needed to support the uptrend. Closing activity in the period is the key here, however. When we see a negative close that falls below 50% of the bullish candle body, warning signals should start to flare up for those in long positions. If the next candle is also bearish, our Dark Cloud Cover pattern is confirmed and it makes sense to start thinking about shorting the asset.

 

Pattern Rationale

 

The supportive logic behind the pattern is that in any uptrend, traders should be looking for reasons to be bearish rather than bullish. This might seem counterintuitive but the fact is that in any uptrend, by definition, most of the upside has already been seen. There is nothing wrong with being in a long position in an uptrend as long as all of the central criteria supporting that trend are still being met. But once we start to see evidence of stalling, risk-to-reward clearly starts to favor playing the downside.

 

When we look at candlestick patterns, there are varying degrees for how this type of situation might play itself out. On one end, we have patterns like the Doji and Evening Stars mentioned above. On the other end of the spectrum, we have patterns like the Bearish Engulfing pattern, where a much more decisive move is being made (ie. the bearish pattern completely ”engulfs” the bullish candle that came before it). There are significant differences in the criteria that make up each of these patterns. But the main signals here are clear: the prior uptrend is starting to run out of steam, and the potential for reversal is becoming much more likely. The Dark Cloud Cover falls into this category, somewhere in the middle given the size of the reversal candle.

 

Combining With Ichimoku Analysis

 

Since the Dark Cloud Cover is a Japanese candlestick formation, it is not entirely uncommon to see the pattern paired with Ichimoku chart analysis. For this reason, it is a good idea to have some sense of when bearish Ichimoku signals are being sent. This way, it becomes easier to spot a confluence of events that support a reversal position.

 

The Ichimoku Kinko Hyo is an indicator that looks much more complicated than it actually is. I am not going to cover all the basics in this article, as I have done this in another article. Here, we will be looking at the downward cross in the Chikou Span, as this is the indicator’s warning signal for lower prices going forward. This stance could be viewed as somewhat ironic because the Chikou Span component is actually a price plot that lags 26-periods behind the latest closing price on your chart:

 

 

As far as general rules, prices are viewed as entering a downtrend when the Chikou Span is located below the closing prices on your chart’s candlestick bodies. In the chart above, this line is marked in green and we can see when the price activity starts to grow in downside momentum. This is the first indication that any bullish uptrend is likely to end, and signals like these become especially powerful when seen in conjunction with candlestick patterns like the Dark Cloud Cover. In this example, the Tenkan Sen starts to move lower while prices fall below the Kijun Sen.

 

For technical traders, a situation like this marks a confluence of events that supports short positions. At the very least, it should be a warning signal to those holding long positions that the initial uptrend has run its course. Once a short position is established, Ichimoku analysis can also be useful for setting stop loss areas. Since this would be a sell scenario, the upper and lower lines in the Senkou Span should be viewed as primary and secondary resistance levels. If prices were to cross above these areas, it would usually be a good idea to close out the position.

 

Conclusion: Candlestick Patterns and Ichimoku Analysis Can Be Used to Spot Reversals

 

When we combine all of these ideas, it can become much easier to visualize situations where market momentum has reached an exhaustion point and an uptrend is ready to give back some of its gains -- if not complete in an all-out price reversal. This is mostly useful for those traders that are willing to push back against the majority of the market’s momentum and capitalize on situations where buying low and selling high is more feasible. No single indicator should be viewed in isolation and candlestick patterns are often combined with Ichimoku analysis as a means for identifying agreement in the available signals.

 

The Dark Cloud Cover is one of the earliest indicators in this type of scenario. To spot this pattern, you will need to watch for individual candlestick formations as they are still unfolding. This takes a good degree of patience and specificity but if you are able to locate areas like these, there is a very good chance that you will be getting a jump on the rest of the market. The second part of the process is to confirm the validity of these patterns using an external indicator. When using the Ichimoku Kinko Hyo, remain cognizant of any crossovers in the Chikou Span. This could be your best signal that the “dark cloud” is actually a thunderstorm ready to end the previous uptrend.