Candlestick patterns: The essential tool for trading indices

Stanislav Bernukhov

Senior Trading Specialist at AthenaAvo

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.

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In this guide:

  1. Basics of stock indices
  2. Types of popular stock indices
  3. Candlestick patterns for trading indices
  4. Pros and cons of candlestick patterns
  5. Ready to leverage candlestick patterns in index trading?

Ever wonder how trading tools like candlestick patterns are applied to trading various instruments? In this article, we take a closer look at how this tool is used specifically for trading indices.

Unlike other instruments, stock indices are known for their stability, rarely experiencing high volatility unless there are huge upheavals in the financial markets.

Yet, just like with other asset classes, candlestick patterns play a significant role in trading indices.

In this market guide, we discuss the top 5 candlestick patterns used for trading indices:

  • Bullish engulfing pattern
  • Bearish engulfing pattern
  • Doji candlestick pattern
  • Hammer (pin bar) pattern
  • Shooting star pattern

We also dive deep into their relevance when trading indices. But first, let’s understand some of the basics of trading indices. Let’s get started.

Basics of stock indices

Stock indices are typically popular among short-term buyers and sellers, from scalpers to active day traders and swing traders. Unlike stocks, indices can be traded around the clock, making them attractive for traders in the US and those in Asian and European time zones.

Stock indices represent the official stock markets across different world economies, such as Japan, Europe, the UK, and the United States. This means if you are a trader wanting to trade indices, you can choose ones that fit your time zone.

But first, let’s define what a stock index is.

A stock index is like a scoreboard that shows how well a specific group of stocks or securities is doing within a financial market. It gives you a glimpse of the performance of a particular market segment by tracking the price changes of the stocks within it. However, you can’t trade a stock index directly.

To track a stock index's performance, you can either trade stock index futures and options, also known as exchange-traded derivatives (ETDs), exchange-traded funds (ETFs) or contracts for differences (CFDs) for indices.

Every country with a developed stock market has its own stock index, though several large economies attract most of the global capital and trading volume. Let’s outline the most popular stock indices among traders:

S&P 500 index

The Standard & Poor's 500 Index includes 500 of the largest publicly-traded companies in the United States, covering a broad spectrum of industries. It is often considered one of the best indicators of the US stock market's performance. In the CFDs trading industry, it is known as the US500.

NASDAQ Composite index

The NASDAQ index is US-based. It includes thousands of companies and is known for its tech-heavy focus. It represents many technology and internet-based firms, not only in the US but worldwide. It is labeled USTEC as a CFD contract.

DAX index

The Deutscher Aktienindex, or DAX, is the primary stock market index for Germany. It tracks the performance of the 30 largest companies listed on the Frankfurt Stock Exchange. It is called DE30 as a CFD contract.

Nikkei 225 index

The Nikkei 225 is Japan's premier stock index, consisting of 225 companies listed on the Tokyo Stock Exchange. It's a key indicator of Japan's economic health and is marked as JP225 in a CFD listing.

Candlestick patterns for trading indices

Candlestick patterns are essential tools in the world of trading indices. As visual representations of market fluctuations, they can provide you with insightful information about potential price trends and reversals. These candlestick patterns can help you predict whether market sentiment is shifting from bullish to bearish or vice versa. In addition, they help in identifying key support and resistance levels, which can inform trading strategies.

Below, we dive into commonly used candlestick patterns such as the engulfing pattern, the doji, the hammer, and the shooting star. Each pattern provides unique insights into market dynamics and can be a powerful tool for your indices trading.

Engulfing candlestick pattern

The engulfing pattern is a popular candlestick pattern used in technical analysis to predict potential reversals in price trends. This pattern consists of two candles, and the pattern can either be a bullish candlestick pattern or a bearish candlestick pattern.

Bullish engulfing pattern

A bullish engulfing pattern is an indication of a reversal from a downtrend. The three main things you need to know about this pattern are:

  • The first candlestick of this bullish pattern is a bearish candlestick (downward candle). This bearish candlestick indicates that sellers are in control.
  • The second candlestick of this pattern is a bullish candlestick (upward candle) that completely engulfs or ‘swallows up’ the previous bearish candle. This means it opens below the low of the first candle and closes above the high of the first candle.
  • This pattern suggests a potential shift in market sentiment from bearish to bullish, as the buyers have now outnumbered the sellers in the marketplace. It may signal the end of a downtrend and the start of an uptrend.

The pattern’s usefulness depends on context. It’s better to use it if it reaches a certain support level, either static or dynamic . Static support is a fixed price level that previously served as support, while dynamic support could be a simple moving average.

Here’s an example of this bullish pattern for the NASDAQ index (USTEC), which occurred in July 2023. The price hit a dynamic support area (the combination of 20-day and 50-day moving averages), after which it reversed higher and continued to rise, indicating a strong bullish market.

an example of a strong bullish candlestick pattern

This is the bullish engulfing pattern for NASDAQ that appeared in July 2023, as seen on Tradingview.com. Bullish candlestick patterns for indices tend to lead to a price rebound if they appear near the strong support levels.

The bullish engulfing pattern for NASDAQ looks like this example: after the first bearish day, the market opened higher and closed substantially higher than the previous day’s close. Following this strong bullish signal, or bullish continuation pattern, you could open a position the day after the pattern’s completion.

bullish engulfing pattern for NASDAQ

A bullish engulfing continuation pattern for NASDAQ in July 2023, as seen on Tradingview.com. This type of pattern is one of many bullish candlestick patterns.

Bearish engulfing pattern

A bearish engulfing candlestick pattern is an indication of a reversal from an uptrend. The three main things you need to know about this pattern are:

  • The first candlestick of this pattern is a bullish (upward) candle, indicating that buyers are in control.
  • The second candlestick of this pattern is a bearish (downward) candle that completely engulfs or ‘swallows up’ the previous bullish candlestick. This means it opens above the high of the first candle and closes below the low of the first candle.
  • This pattern suggests a potential shift in market sentiment from bullish to bearish, as the sellers have outnumbered the buyers in the market. It may signal the end of an uptrend and the start of a downtrend.

Here’s an example of a bearish engulfing pattern for the Australian stock index AUS200, which occurred in July 2023. The price had initially risen above the dynamic resistance area (between 20-day and 50-day moving averages), but then dropped sharply from $7200 to $7000 due to a bearish pattern.

Example of bearish engulfing pattern

This is a bearish engulfing pattern for AUS200, July 2023, as seen on Tradingview.com.

Doji candlestick patterns

A doji is a candlestick pattern that suggests market uncertainty. It occurs when the opening prices and closing prices are very close or even identical, resulting in a small or non-existent candlestick body with long upper and lower wicks. Dojis can signal potential reversals or trend continuations, depending on their chart position.

For stock indices, it’s better to use the doji pattern on timeframes smaller than a daily chart, although the daily chart can still provide a number of useful candlestick patterns.

Let’s look at doji’s use on 4-hour charts.

For instance, a doji pattern was seen on the Nikkei index (JP225) in May 2023. After the appearance of several doji patterns, the market kept moving in the direction of the previous trend. So, in this case, the pattern indicates a continuation of a trend.

An example of a doji candlestick pattern

Doji candlestick pattern for JP225, May 2023, as seen on Tradingview.com.

Hammer candlestick pattern

The hammer pattern is a sign of a bullish reversal. It’s characterized by a small body near the top of the candlestick and a long lower wick. The hammer often appears after a downtrend and suggests that buyers are starting to gain control, and possibly signaling an uptrend (bullish) reversal. The hammer pattern is often called a “pin bar”, and is commonly used in trading stocks and indices to identify a bullish reversal pattern.

For instance, a hammer pattern showed up in the Hang Seng index (HK50) after a dip in August 2023. After the price hit a new low at around $19000, buyers took control and closed the day with a slight increase, forming the hammer pattern.

On the contrary, an inverted hammer is a bearish candlestick pattern, which appears on the top of the trend. The inverted hammer indicates that sellers are about to take control and push the trend downwards.

Hammer candlestick pattern

Hammer candlestick pattern showing a bullish reversal pattern for HK50, August 2023, as seen on Tradingview.com.

Shooting star pattern

The shooting star pattern is a sign of a bearish trend reversal. It looks like an upside down hammer with a small body near the bottom of the candlestick and a long upper wick. This pattern can indicate that sellers are taking control and that an increasing selling pressure would shift the price downwards.

In September 2023, this pattern was seen in the UK100 index (FTSE100). After the price reached a new peak, sellers outnumbered buyers and closed the day in a red, forming a shooting star pattern. Following this, the price consistently dropped several days in a row.

shooting star pattern of the UK100 index

Shooting star candlestick pattern for UK100 index in September 2023, as seen on Tradingview.com.

Dark cloud cover candlestick pattern

Another candlestick pattern quite common for trading individual stocks, but also applicable for indices, is the dark cloud cover pattern. Essentially, it is a bearish reversal pattern. This pattern is a variation of a ‘bull trap’, the control suddenly shifts from buyers to sellers, and buyers have to capitulate.

The dark cloud cover pattern represents a bearish reversal in the price action. In this scenario, a downward candle (usually black or red) opens above the last price before closing of the preceding upward candle (typically white or green) and subsequently closes below the midpoint of the upward candle. Below is an example of what a bearish reversal looks like.

example of a dark cloud cover pattern with a downward reversal

Appearance of a dark cloud cover pattern with a bearish reversal for the HK50 index, June 19 2023, as seen on Tradingview.com.

The pattern looks similar to the engulfing pattern, but the red candlestick doesn’t close below the closing price of a previous candlestick (as with the engulfing pattern) but just closes below the 50% level of a previous candlestick. It becomes enough to create selling pressure and shift the price action lower.

Pros and cons of candlestick patterns

Candlestick patterns, one of the most utilized chart patterns among traders, offer valuable insights into possible market direction. However, like all trading tools, they come with their own set of pros and cons. Here we look at the advantages and disadvantages of candlestick patterns to help you better understand their role in forecasting market trends.

Advantages of trading with candlestick patterns

  • Candlestick patterns are relatively easy to use and can be mastered by beginner traders. With practice, almost anyone can learn to recognize the ‘engulfing pattern’ or ‘pin bar’.
  • Candlestick patterns don’t look too far into historical data: their focus on the present moment makes them useful for timing entry and exit points.
  • All trading terminals have candlestick patterns available, so no matter what platform you use, you will still have access to candlestick charts.

Disadvantages of trading with candlestick patterns

  • The opening and closing price of daily candlesticks may vary across different brokers. That’s why traders can sometimes recognize the entry point with one broker and miss this signal with another.
  • Candlestick patterns don’t provide market context: they should be used in combination with other technical tools, such as support and resistance areas. As such, they should only be used as supplementary tools and not the main decision-making mechanism.
  • The simplicity of candlestick patterns may be deceptive; sometimes strong trends produce a lot of false reversal candlestick patterns, and so traders should learn how to filter them.

Frequently asked questions

The most profitable models built with candlestick patterns are probably those indicating price reversals: engulfing patterns, pin bars, shooting stars. However, much depends on the context. A trader should have reliable tools for identifying the price areas where the trend can reverse.

Candlestick patterns are timeframe-dependent: the smaller the timeframe, the more statistical noise a trader will get. The most reliable timeframes for candlestick pattern analysis are daily and hour-to-hour charts. Their reliability should be assessed in combination with other tools, but usually, they give correct entry and exit points and in most cases could provide a decent hit rate.

It’s suggested to use other tools and indicators to create and formulate a trading idea. A candlestick pattern may help in timing the entry point for this idea, but relying solely on candlestick patterns for your trading decisions, without further technical and fundamental analysis, is not recommended.

A candlestick chart is a type of financial chart that displays the high, low, opening, and closing prices of a security for a specific period. This chart is widely used in technical analysis to study price patterns and trends.

The main component of the candlestick chart is the candlestick, which consists of a body and wicks, also known as shadows. The body of the candlestick represents the range between the opening prices and closing prices. If the last price before closing is higher than the opening price, the body is usually filled or colored, indicating a bullish period. Conversely, if the opening price is higher than the last price before closing, the body is generally hollow or a different color, indicating a bearish period. The wicks represent the range of price movement beyond the opening and closing prices.

Reading candlestick charts involves recognizing bullish and bearish patterns that signal potential future price movements. Bullish patterns indicate that prices may rise, while bearish patterns suggest prices may fall. For instance, a commonly recognized bullish pattern is the 'bullish engulfing' pattern, where a small bearish candle is followed by a large bullish one, suggesting a potential reversal of the downtrend.

By using candlestick charts, investors have a better chance at interpreting the complex relationship among opening price, closing price, highs, and lows. These charts offer a great deal of information about the emotional state of traders and potential reversals in the market. They can be used in all timeframes, from those looking for long-term investments to those who use swing trading or day trading. The power of candlestick charts is that they can visually show bullish and bearish forces at work.

A bullish candle, often illustrated on a candlestick chart, is typically represented by a green or white color, signifying that the closing price was higher than the opening. This suggests an upward price movement. On the other hand, a bearish candle is typically represented by a black or red candlestick. This color is used to indicate that the last price before closing was lower than the opening price, suggesting a downward price movement. The most common colors seen on candlestick charts are white for bullish and black for bearish. A bullish candle can be used to identify trend reversals from a previously bearish market to a bullish one. In summary, a red or bearish candle indicates a price decrease, while a bullish candle, usually green or white, signifies a price increase.

A candlestick chart can be a powerful tool for trading. By studying historical data and recognizing bullish and bearish patterns, you can make informed predictions about potential price movements, helping to guide trading decisions.

The shooting star pattern consists of just one candlestick of a small body and large wick and represents a fast change of price action. Whereas the morning star pattern is a combination of three candlesticks, with a small reversal third candlestick in the middle and two big candlesticks on either side. The evening star, similar to the morning star, comprises three candlesticks. However, the evening star denotes a bearish reversal pattern in contrast to the bullish reversal pattern signified by the morning star.

The first candlestick of the evening star pattern is a long bullish one, followed by a small-bodied candle that opens above the preceding one, and finally, a large bearish candle that penetrates into the territory of the first candle. Thus, the morning star and evening star are both more complex patterns and may be used for spotting long-term reversals.

The three-candle rule refers to a three-candlestick pattern on a candlestick chart. This rule is used to predict a potential trend reversal in the market when studying the candlestick chart. Other candlestick patterns also contain three candlesticks: for example, ’three white soldiers’, ‘morning star’, and ‘three black crows pattern’. Some patterns are known as continuation patterns (‘three white soldiers’ and ‘three black rows’), while others, like the three-candle rule, are reversal patterns.

Here’s how the three candlestick pattern rule works: the second candlestick in a sequence has a smaller body than the first one, indicating that momentum is slowing and price action has stopped. The third candlestick indicates movement in the opposite direction and usually closes above the close of the second candlestick for the bullish reversal, or below the close of the second candlestick for the bearish reversal.

Ready to leverage candlestick patterns in index trading?

In conclusion, candlestick patterns serve as an invaluable tool for trading indices. These patterns can be applied to trading any asset class providing a basic foundation for decision-making. Although they do not delve into deep historical analysis, they are effective at highlighting short-term shifts in sentiment between buyers and sellers.

However, it's crucial to remember that candlestick patterns aren't a standalone trading signal. Traders should always apply them in the context of the existing market structure. For instance, tracking reversal candlestick patterns is particularly beneficial near crucial support or resistance zones.

AthenaAvo offers multiple account types suitable for trading indices. The rule of thumb is to choose a swap-free account for swing or position trading and any other type of account for day trading.

Now that you understand the importance and application of candlestick patterns, it's time to put your knowledge into practice. Ready to capitalize on the many benefits of using candlestick patterns in your trading strategy? Start trading indices with AthenaAvo today.

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.