2 Candlestick Reversal Trading Strategy

As a fan of price action trading, this candlestick reversal trading strategy using two candlesticks in the pattern is a simple one to trade.  The prerequisite to trading this pattern is to know what a bearish and bullish candlestick pattern looks like.

If you know this pattern and study the candlestick charts on your trading platform, you will see that some major price reversals have occurred when this pattern has formed.

Let’s take a look at a few charts and then discuss why this candlestick pattern is a decent one to look for in terms of trading reversals.  You can use price bars as opposed to candlestick charts however candlesticks are much easier to see these types of trading patterns.

BULLISH 2 CANDLESTICK REVERSAL PATTERN

For a bullish reversal, we first need to see price in a downtrend.  You can also use this pattern as a reversal off of support and resistance in a ranging environment.

• the first candlestick must always be red(bearish) and the second candlestick must always be green (bullish).
• when you see the 2 candlestick reversal pattern in a downtrend, there’s a chance that the downtrend may be ending. Look for it around support levels.
• when you see this pattern in a minor downswing (trading price retracements/pullbacks) in an uptrending market, you can use it as a continuation pattern

Some traders may have been considered with the consolidation and pullback that happens right after the trade begins.  As long as lows are being held and there is no strong momentum move against the potentially developing uptrend, let the price action evolve.

BEARISH 2 CANDLESTICK REVERSAL PATTERN

This is the exact opposite of the bullish reversal pattern.  We need to see price in an uptrend or coming into potential resistance inside of a trading range.

• the first candlestick must green (bullish) and the 2nd candlestick must be red (bearish)
• when you see the 2 candlestick reversal pattern in an uptrend, there’s a chance that uptrend may be ending. Look for it around resistance levels.
• when you see this pattern in a minor upswing in a major downtrend market, you can use it as a continuation pattern and its a good opportunity to sell.

As you can see, this strategy is not a bullish engulfing or bearish engulfing Japanese candlestick pattern.  You can certainly look for those but understand that your risk management on those may be a little different.

Reversal Candlestick Strategy Trading Rules

Long Trades

1. place a buy stop pending order 2-3 pips above the high of the 2nd candlestick when it has finally closed.
2. place you stop loss at least 5 pips below the low of the 2nd candlestick.
3. Use previous swing highs as your take profit target levels and trail stop your profitable trades using this trailing stop technique where you place it a few pips behind each new trough that form as price moves higher until your take profit target level is hit or market reverses and takes you out with a profit.

Short Trades

1. Place sell stop pending order 2-3 pips below the low of the 2nd candlestick.
2. Place your stop loss 5 pips above the high of the 2nd candlestick.
3. Use previous swing low as your take profit target levels and trail stop your profitable trading behind each new lower peak that forms as price continues to move lower until your take profit target level is hit or market reverses and takes you out with a profit.

Why Can These Patterns Work?

When we have smaller candlesticks next to a larger one as we do in this strategy, it’s almost like we are trading a doji chart pattern.

What we have is something called “price compression” which simply means we’ve gone from a volatile trading environment to low volatility.  While many traders are looking to trade engulfing patterns, you are trading a pattern that is not so obvious.

In the bullish reversal example, traders see price heading down and to many, the green candlestick is simply a minor pullback in price.  The small shadow that pokes below the previous candlestick is not deep enough to trigger sell stops for continuation traders and the retrace of 50% of the previous candlestick alerts astute traders that there is weakness at this point.

Once your trade triggers, those traders that are short or wanting to get short, have to reverse their line of thinking.  To these traders, this small candlestick is the same as a doji and they think it’s just a small pause in price.

If a trader is short, they must exit and there exit will add fuel to your position.

You may want to investigate the double top trading strategy and see if this candlestick reversal trading strategy can increase your edge.

Wrap This Up

1. Don’t get this pattern confused with the Bullish or Bearish Pin Bar formation. A pin bar has a very long tail but with this 2 candlestick pattern, the tail is very short.
2. The closing price of the 2nd candlestick must almost equal the high for a bullish setup and in the case of a bearish setup, the closing price must almost equal the low.
3. The 2nd candlestick must not go past the range of the 1st candlestick by 50%.  Any further and we may lose some of the momentum when other traders jump in

As with every trading strategy on this website, make sure you fully test it.