Today we're going to take a look at the shooting star candlestick pattern and see how it behaves out there in the wild.
Background: What Are Candlesticks?
Candlestick charts are graphs that show the price of a security as it rises and falls throughout a day of trading.
Each candle consists of a colored body and two black shadows. These elements communicate four pieces of information: the opening and closing prices of the security, and the daily high and low.
On a green or white candle, the top of the body corresponds to the day's opening price, and the bottom corresponds to the closing price. On a red or black candle, it's precisely the opposite. Consequently, the color of the body indicates whether the security ultimately rose in value or fell over the course of the day.
The two lines that extend above and below the body are called "shadows" or "wicks." They indicate the highest and lowest points that the price reached during the day. If a candle lacks either an upper or lower shadow, this means that the day's opening or closing price was also its high or low.
Multiple candlestick charts, representing several successive days of trading, form "patterns" which analysts use to try to predict future price movements.
This rest of this article presupposes a basic familiarity with candlestick patterns. If you're learning about them for the first time, we suggest checking out some of the introductory articles on Investopedia.
Before starting in on this breakdown, you'll want to have read (and understood) at least the following:
The Plight of the Intermediate Learner
Articles like the ones linked above provide a great base for traders who are just starting out. They comprehensively cover the theory of candlestick patterns. And make no mistake, it's important to study that stuff.
But theory is different from practice. You can memorize the 25 most common candlesticks and feel like you've learned something, but that doesn't necessarily mean you'll know what to do when you encounter them out in the wild.
Most of the real-world examples of candlestick patterns on investing sites and in textbooks are fairly cursory. Moreover, their authors often stack the decks by picking examples that are unusually clear-cut.
They'll highlight the pattern they want to illustrate: "As a bullish continuation pattern, the rising three methods suggest that the current uptrend will continue. Now might be a good time to add to your long positions." And in their example, of course the uptrend does continue.
Real-world patterns are rarely that clear when you look at them in context. For instance, what if the rising three methods pattern was preceded by other, less optimistic patterns that suggest the uptrend might not have much life left in it? Which pattern "wins"?
Take this chart.
This chart shows stock prices from 05/10/2000 to 08/09/2000.
Imagine that you're a short-term trader looking at this chart after close of trading on August 9th.
Obviously, this stock is in an uptrend. But how likely is that to continue? Is the stock about to go up, down, or stabilize?
What should you actually do?
As part of an ongoing series, we're going to look at some of the most common candlestick patterns as they evolve. Instead of taking a retrospective look, like the examples in most intro-level articles, we'll advance day-by-day, showing you what a short-term trader would have seen at the time. (But not a day trader—if you're engaging in that level of minute-by-minute analysis, you're too advanced for this article.)
Let's take a closer look at this chart—which, incidentally, is for Starbucks's stock. If it makes things a little more vivid for you, as we go over their stock movements, feel free to picture blenders churning out frothy caramel Frappuccinos and cargo ships pulling into port, full of sacks of coffee beans from Indonesia.
The Sudden Appearance of a Shooting Star
First of all, we need to simplify this chart. For our purposes, we want to focus on the final fifth or so—that uptrend that began in early August. We want to figure out if it will continue.
In general, this pattern is decisive and optimistic. Most of these candlesticks have fairly short shadows relative to their bodies (particularly candles 4-6), meaning the price hasn't been fluctuating very much. There's not a red candle among them. It's clear that the bulls are in control, without much price uncertainty.
But what's that candle at the end?
The most recent candle has a short real body, a long upper shadow, and a nearly absent lower shadow. If you've read the articles linked above, you'll recognize it. When a candle like this occurs in an uptrend, you're looking at a shooting star.
A Bad Sign, Except When It's Not
It doesn't look quite like the diagrams, does it? Actually, according to the strictest definitions, this isn't a true shooting star. The upper shadow isn't quite double the length of the real body, and it does possess a very minimal lower shadow.
But it isn't usually a good idea to get hung up on technicalities. It's close enough that we should pay attention to it. And as you know, the shooting star often indicates a bearish reversal.
Often. But not always.
It's hard to interpret here. After all, the preceding uptrend looks awfully strong. A lot stronger than this little candle, which isn't very impressive. It's tough to believe that it could forecast a total reversal.
This is one of those "less clear in context" situations.
Let's say you decide to follow conventional wisdom and wait for a confirmation candle. If the price drops the next day, you figure, the shooting star will be confirmed and you'll know it's time to sell or go short.
Unfortunately, the next candle is a bit of a mess.
Arguably, it's another shooting star, although the opening and closing prices are so close that it's almost a gravestone doji. It's giving us decidedly mixed signals.
On one hand, per the advice you've read, you were looking for a red candle or one that gapped downwards—certainly one with highs and lows below the previous day's. That's not what this is at all. Its highs rise significantly above the first day's, and it closes somewhere near the middle of the first candle's body.
That's not the decisive confirmation you were looking for. Maybe we're not about to enter a downtrend.
On the other hand, you remember reading that although the doji is generally an ambiguous pattern, it can itself also forecast a reversal. So maybe we are.
You're not sure what to do.
This is the pitfall of watching for the signs that appear in your textbooks. Real patterns are almost never that obvious. (And when they are, you can bet that every other trader will pick up on it too—and the ensuing rush may then reintroduce unpredictability.)
Here's where it helps to think about what causes both the shooting star and the doji. With their long shadows, they both indicate price volatility. When a shooting star appears, it means that the price rose to unexpected heights ... and then, for whatever reason, failed to stay there, dropping significantly before the close.
The gravestone doji tells a similar story. Again, the price rises dramatically. Again the bulls prove unable to keep it there.
What does this mean? Uncertainty. This is something that happens when no one is quite sure what the stock is really worth. Neither the bears nor the bulls are firmly in control, and no one knows where the price will go next.
That includes us. But what we do know is that we can discount the previous uptrend. It's over. This pattern indicates that the momentum and certainty that previously carried this stock upwards have been lost.
If the price starts to rise again, it would arguably be fair to class it as a new, separate uptrend instead of a continuation of the old one. Taken together, it'll look like one movement ... but in fact there was a moment of discontinuity when it could have moved in either direction.
To put it another way, there's no proof right now that the bears have gained control, but there's no evidence that the bulls are going to retain it, either.
At this point, in the face of this instability, you might consider taking a calculated risk and shorting this stock. That's up to you—but if you're still holding a long position, think about whether you really want to bet on a stock that could fairly be described as "uncertain."
Let's advance the clock more one day.
Finally, here's that clear confirmation candle we were waiting for. You might recognize this as the hanging man.
Although its open and close aren't much below the previous two candles', the price continues to fluctuate—in the opposite direction, now. Only very brave and optimistic traders will remain bullish on this stock in the short term.
At this point many people will be selling or shorting. Anybody who's holding onto their shares is playing a longer game and probably isn't worrying about the day-to-day fluctuations of the market the way we are.
The price continues to fall.
It's always possible for a downturn like this to be an anomalous blip, but in this case, it isn't.
The price, at least in the short-to-medium term, does not recover. Several months pass before it bounces back to the highs it reached (briefly) on August 10.
The Right Moment to Act
When we take a step back like that, it becomes clear that the stock never really stopped trending upwards, and the dip forecast by those three fateful candlesticks was only a momentary slowdown.
If you were a long-term investor, holding onto your shares would have been the right choice. On the other hand, for a short-term trader, it would have been a serious mistake.
Let's assume you did the right thing, i.e. you sold off your shares and possibly went short. You're pretty happy with yourself. (And you deserve to be.)
Here's a question for you. What was the ideal time for you to make your move?
That is: at what point did you have enough information to make an informed choice, without showing up late to the party?
Was it after the appearance of that ominous red candle?
Nope. The first two signs were ambiguous, but the third candle was a blaring alarm that almost nobody would have ignored.
As a trader, you want to stay ahead of the curve. If you'd waited that long, you'd have been rushing to sell or short at the same time as everybody else.
How about after the first shooting star appeared?
No. This sign just wasn't clear. In isolation, single candlesticks are rarely predictive. In this instance, if you'd taken it as a sign of an impending downturn and acted accordingly, it would have worked out for you, but your success would have been pure luck. Get in the habit of acting that impulsively and eventually you'll be burned.
The time to act was after the appearance of the second candle.
Together, the two shooting stars were a clear warning. They were an indication that, although the stock wasn't guaranteed to go down, it probably wasn't a smart choice to bet your money on it continuing to go up.
This two-candle pattern isn't that hard to interpret. Two ambiguous candles, one right after the other—it's no surprise that it signified the disruption of the prevailing trend.
To a trader who's used to thinking about the motives and mechanisms that underlie the day-to-day movements of stocks, the uncertainty communicated by those disproportionately long wicks will stick out immediately. But if you're hung up on watching out for the exact patterns you've seen in your textbook, you might miss it, even though it's staring you in the face.
It's worth memorizing those big-name patterns so that you recognize them when they appear. But remember to apply a little common sense as well.
That's all for today. Join us next week when we look at another superficially simple reversal pattern, the three white soldiers (and its bearish counterpart, the three black crows).