Bearish Candlestick Patterns Explained

By Chainika Thakar

In the dynamic world of trading, understanding the language of the markets is imperative and that includes the most valuable skills of the ability to read and interpret candlestick patterns. Among these, bearish candlestick patterns stand out as crucial indicators of potential price declines. In this all-encompassing guide, we embark on an enlightening journey through the world of bearish candlestick patterns.

From unravelling their underlying concepts to grasping their diverse types, we will delve into the techniques that empower traders to identify, interpret, and capitalise on these telltale indicators.

Whether you're a seasoned trader seeking to refine your skills or a newcomer looking for market mastery, this guide equips you with the essential insights into bearish candlestick patterns.

Some of the concepts covered in this blog are taken from this Quantra learning course on Candlestick Patterns based Automated Trading. You can take a Free Preview of the courses by clicking on the green-coloured Free Preview button.

This blog topic covers:

• What is a bearish candlestick pattern?
• Common types of bearish candlestick patterns
• Key factors to consider when identifying bearish patterns
• How do you read bearish candlestick patterns?
• What are bearish indicators?
• Trading Strategies for Bearish Candlestick Patterns
• Bearish vs bullish candlestick patterns
• Pros of using bearish candlestick patterns
• Challenges of using bearish candlestick patterns and how to overcome them?

What is a bearish candlestick pattern?

A bearish candlestick pattern is a visual representation of price movement on a trading chart that suggests a potential downward trend or price decline in an asset.

It's formed by the arrangement of the candle's open, close, high, and low prices, creating a specific pattern that indicates selling pressure and a possible shift in market sentiment towards pessimism. Traders use these patterns to anticipate and make informed decisions about potential market downturns.

Common types of bearish candlestick patterns

You might have heard of patterns like the Bearish Engulfing, Evening Star, and more – they each signal potential price drops. These patterns are like clues that traders analyse to make informed decisions.

Let us see some common types of bearish candlestick patterns below.

Bearish Engulfing Pattern

This occurs when a larger bearish candle fully engulfs the previous smaller bullish candle, suggesting a reversal from an uptrend to a potential downtrend.

You can see the same in the image below.

Evening Star Pattern

Comprising three candles, the evening star pattern starts with a bullish candle, followed by a small-bodied or doji candle, and then a larger bearish candle. It signifies a potential reversal.

Here is an image to get a clear idea about an evening star pattern.

Shooting Star Pattern

A single candle with a long upper wick and a small body, indicating an unsuccessful attempt by buyers to push prices higher. It's often seen at the end of an uptrend.

Dark Cloud Cover Pattern

Formed by two candles, this pattern starts with a bullish candle followed by a bearish candle that opens above the previous candle's high and closes below its midpoint, indicating potential selling pressure.

Hanging Man Pattern

Similar to the shooting star but appears at the end of a downtrend, the hanging man has a small body and a long lower wick, suggesting potential bullish reversal.

Key factors to consider when identifying bearish patterns

When identifying bearish candlestick patterns, several key factors play a pivotal role in accurate recognition and interpretation. These factors enhance your ability to distinguish potential price declines and make informed trading decisions.

Here are the key considerations:

Candle Body and Wick Characteristics

Examine the size and position of the candle's body and wick. Long upper wicks and small bodies often indicate selling pressure and potential downward movement.

Volume Analysis

Analyse the trading volume accompanying the pattern. Higher volume during a bearish pattern can strengthen the pattern's validity and potential impact and vice versa.

This can be seen in the image below.

The values on the x-axis can be any variable, such as earnings per share (EPS), revenue, cash flow etc. This kind of column bar graphs are often used to depict trading volume. Usually, the graph appears in a panel below a security's or an asset’s price chart.

Support and Resistance Levels

Consider the pattern's interaction with support and resistance levels. Patterns forming near these levels can have greater significance and impact.

By carefully observing these factors, you'll be better equipped to identify and confirm bearish patterns, leading to more confident trading decisions.

How do you read bearish candlestick patterns?

Reading bearish candlestick patterns involves analysing the visual formations on a price chart to understand potential downward price movements.

Here's a step-by-step guide on how to read bearish candlestick patterns:

Step 1: Identify the Pattern

Look for recognisable bearish patterns like Bearish Engulfing, Evening Star, Shooting Star, Dark Cloud Cover, and Hanging Man. These patterns consist of specific arrangements of candlesticks.

Step 2: Check the Trend

Consider the prevailing trend. Bearish patterns are more significant when they appear after an uptrend, suggesting a potential reversal.

Step 3: Examine Candle Characteristics

Focus on the candle's body and wick. A long upper wick and a small body indicate sellers' control and potential downward pressure.

Step 4: Confirm with Volume

Analyse trading volume accompanying the pattern. Higher volume in the bearish candle pattern adds weight to the pattern's significance and potential impact.

Step 5: Consider Support and Resistance

Look at the pattern's interaction with support and resistance levels. Patterns near these levels can have stronger implications.

Step 6: Additional Indicators

When identifying bearish candlestick patterns, it's valuable to confirm the signals with other technical indicators like Moving Averages, Relative Strength Index (RSI), and MACD (Moving Average Convergence/Divergence). These indicators provide additional insights into potential price declines and enhance the accuracy of your trading decisions.

Step 7: Distinguish False Signals

Keep in mind that not all patterns result in price declines. False signals can occur, especially in volatile markets, so additional confirmation is beneficial.

In order to bolster the reliability of bearish signals and mitigate the risk of false indications, traders can adopt a multifaceted approach to verification. This involves seeking convergence from multiple indicators and patterns that corroborate the bearish signal, particularly around significant support or resistance levels.

Moreover, observing higher trading volume during the pattern's emergence can provide broader market consensus, while consistency across various timeframes and the incorporation of supplementary indicators like trendlines or oscillators can fortify the bearish outlook. By waiting for confirmed price movement that aligns with the initial signal, traders can solidify their decisions with a more comprehensive perspective, ultimately leading to more informed and strategic trading outcomes.

Step 8: Make Informed Decisions

Based on your analysis of the pattern, trend, volume, and supporting indicators, you can make informed trading decisions. This might involve short-selling, setting stop-loss levels, and planning entry and exit points.

What are bearish indicators?

Bearish indicators are tools or signals in technical analysis that suggest a potential downward price movement in a financial asset. These indicators help traders anticipate and identify market trends that might result in price declines.

Here are some common bearish indicators:

Moving Averages

When a shorter-term moving average crosses below a longer-term moving average (like the 50-day crossing below the 200-day), it can signal a potential weakness in the prices and vice versa.

You can see an example of moving averages below.

A simple interpretation of the chart:

• If the SMA line cuts the closing price line from above, it could imply that the price is rising, and we have a bull trend. This is also known as a bullish crossover. The green stars marked in this chart are all instances of a bullish crossover.
• But if the SMA line cuts the closing price line from below, it implies that the price is decreasing and we have a bear trend. You can refer to this as the bearish crossover. The red stars marked in this chart are all instances of a bearish crossover.

Relative Strength Index (RSI)

An RSI value above 70 indicates overbought conditions, suggesting that a potential reversal or price decline might be imminent.

You can see both RSI and close lines in the graph below.

In the chart above, red lines indicate both 14 days RSI plot and the levels for RSI,

while the blue line indicates the close price of the cryptocurrency BTC/USD. As discussed above, at around 30 RSI plot is indicating oversold conditions and at around 70, the plot is indicating overbought conditions.

These overbought and oversold indications shouldn’t be interpreted as direct buy/sell signals. Though, they can be a part of the signal generating decision process.

Moving Average Convergence Divergence (MACD)

A bearish crossover between the MACD line and the signal line could indicate a shift towards downward momentum. A bearish crossover is a technical analysis signal that occurs when one indicator crosses below another indicator on a price chart, suggesting a potential downward movement in the asset's price. It often indicates a shift in market sentiment from bullish to bearish.

Moving Average Bearish Crossover is one of the examples. This is how moving average bearish crossover works-

• Indicators: A short-term moving average (e.g., 50-day) crosses below a longer-term moving average (e.g., 200-day).
• Interpretation: The crossover suggests that the asset's recent price performance is weakening compared to its historical performance. This could indicate a potential downtrend, and traders might consider this as a signal to enter short positions or take a more cautious approach.

This example illustrates how a bearish crossover, such as a moving average crossover, can be used as a technical indicator to anticipate potential price declines and adjust trading strategies accordingly.

You can see the MACD signal in the graph below and what it indicates.

In the graph above, when the blue line crosses above the orange line, long entry signals are generated.

In other words, when the MACD line crosses the signal line from above, a buy signal is generated.

Hence, buy when the MACD line > Signal line.

Volume

Increasing volume during a downtrend can signify stronger selling pressure and validate a bearish trend.

Example

Suppose a trader-1 buys 1000 shares of Apple, the trader-2 buys 1500 shares of Apple and  trader-3 sells 1000 shares of Apple to a trader other than 1st and 2nd traders above, in a period of one hour. Then, the total traded volume for that stock in that one hour is 3500 shares. Simply put, Volume traded is the sum of all completed trades.

Volume is analysed by technical analysts to confirm the price trends by backing a price trend with a volume trend. Similarly, volume helps to confirm price reversals in case the prices move aggressively upwards or downwards.

Bearish Divergence

The bearish divergence occurs when the price of an asset makes higher highs, but an indicator (like RSI or MACD) makes lower highs. It suggests weakening upward momentum and a potential reversal.

There are two types of divergence, that is regular divergence and hidden divergence.

Regular Bearish Divergence

In case of Regular Bearish Divergence:

• The Indicator shows Lower Highs
• Actual Market Price shows Higher Highs

Hidden Bearish Divergence

In case of Regular Bearish Divergence:

• The Indicator shows Higher Highs
• Actual Market Price shows Lower Highs

You can see both Regular Divergence and Hidden Divergences in the graph below.

In the graph above, you can see that a Regular Divergence makes for a reversal in the trend and thus, the price moves down +-/-350 pips.

Also, it is visible that a Hidden Divergence makes for a continuation in the trend, which makes the price go up 400 pips and it goes on.

Chart Patterns

Chart patterns like Head and Shoulders, Double Tops, and Rising Wedges can also act as bearish indicators when they break downward.

These indicators provide traders with additional insights to corroborate bearish signals derived from candlestick patterns or other forms of analysis. It's important to use a combination of indicators and analysis techniques to make well-informed trading decisions.

Trading Strategies for Bearish Candlestick Patterns

Trading strategies for bearish candlestick patterns involve using these patterns as signals to generate returns from trading decisions during potential price declines.

Here are some effective strategies:

Short-Selling Opportunities

Take advantage of bearish patterns by engaging in short-selling. Borrow the asset, sell it at the current market price, and aim to buy it back later at a lower price so that you can generate returns from the price drop.

Setting Stop-Loss and Take-Profit Levels

Determine specific price levels where you'll exit the trade to limit losses and secure maximum returns. This helps manage risk and prevents emotions from dictating your actions.

• Stop Loss – A stop-loss order limits an investor’s loss on a position in a security. It fires an order to square off the existing long or short position to avoid further losses and helps to take emotion out of trading decisions.
• Take Profit – Take-profit orders are used to automatically close out existing positions in order to lock in profits when there is a move in a favourable direction.

Confirmation with Indicators

Combine the bearish candlestick patterns with other indicators like Moving Averages or RSI to validate the signals. When multiple indicators align, it strengthens the likelihood of a price decline.

Using Trendlines and Channels

Draw trendlines and channels on your chart to identify potential entry and exit points. When a bearish pattern forms near a trendline or channel resistance, it enhances the reliability of the signal.

Scale-In Strategy

Instead of opening a full position at once, consider scaling in by entering the trade in multiple smaller parts. This allows you to manage risk and adjust your strategy as the trade progresses.

Bearish vs bullish candlestick patterns

Now, let us see how bearish candlestick patterns are different from the bullish candlestick patterns.

Keep in mind that while these general characteristics apply to many candlestick patterns, each trade is unique, and other factors like market conditions, timeframe, and additional technical analysis tools should also be considered when making trading decisions.

Pros of using bearish candlestick patterns

Using bearish candlestick patterns in trading offers several advantages for traders looking to make informed decisions during potential price declines:

• Early Warning Signs: Bearish patterns can provide early indications of potential downtrends, allowing traders to position themselves ahead of price declines and capture profit opportunities.
  
• Enhanced Risk Management: Recognising bearish patterns helps traders set appropriate stop-loss levels, minimising potential losses by exiting long positions before significant price drops occur.
  
• Versatility: Bearish patterns can be identified across various timeframes, making them suitable for day traders, swing traders, and long-term investors.
  
• Confirmation with Indicators: Combining bearish patterns with technical indicators provides stronger confirmation of potential price declines, improving the accuracy of trading decisions.
  
• Short-Selling Opportunities: Bearish patterns are particularly useful for traders interested in short-selling, where they can profit from falling prices by borrowing and selling assets.
  
• Flexibility in Bullish Markets: Even during overall bullish trends, bearish patterns can help traders identify potential price corrections or temporary reversals, allowing them to capitalise on short-term opportunities.
  
• Visual Clarity: Candlestick patterns offer a clear visual representation of market sentiment, making it easier for traders to interpret and act upon potential reversals.
  
• Effective Entry Points: Bearish patterns can guide traders to optimal entry points for short positions, increasing the potential for profitable trades.
  
• Use in Conjunction with Other Tools: Bearish patterns can be combined with other forms of technical analysis, such as trendlines, moving averages, and support/resistance levels, to refine trading strategies.
  
• Continuous Learning: Mastering the art of identifying and trading bearish patterns encourages continuous learning and improvement, enhancing overall trading skills.

By leveraging the advantages of bearish candlestick patterns, traders can gain a competitive edge in the market by making well-timed and informed trading decisions during potential price declines.

Challenges of using bearish candlestick patterns and how to overcome them?

By being aware of these challenges and applying the suggested strategies, traders can improve their ability to effectively use bearish candlestick patterns and navigate the complexities of the market.

Conclusion

In the ever-evolving landscape of trading, the mastery of understanding market dynamics is a prerequisite for success. Among the arsenal of skills at a trader's disposal, the art of reading and interpreting candlestick patterns holds unparalleled significance. Amidst these patterns, the bearish candlestick formations emerge as pivotal indicators, offering insights into potential price declines.

This comprehensive guide has embarked on an illuminating journey through the realm of bearish candlestick patterns.

Whether you're a seasoned trader refining your strategies or a newcomer aspiring for market mastery, this guide aims to equip you with the essential knowledge needed to navigate the intricate world of bearish candlestick patterns. Armed with these insights, you're poised to make more informed trading decisions, enhancing your ability to seize opportunities during the phase of bearish candlestick patterns.

If you wish to learn more about bearish candlestick patterns, you can enrol into our candlestick course. This course is designed to introduce the learners to patterns formed using candlesticks.

Also, the course gives insights on single and multiple candlestick patterns, how to combine them in your trading strategy, and the advantages and disadvantages of trading these candlestick patterns. Moreover, after completing this course, you can create, backtest, implement, live trade and analyse the performance of candlestick pattern-based trading strategies.

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