Dark Cloud Cover Definition and Example

Dark Cloud Cover Definition and Example

What Is the Dark Cloud Cover?

Dark Cloud Cover is a bearish reversal candlestick pattern where a down candle (typically black or red) opens above the close of the prior up candle (typically white or green), and then closes below the midpoint of the up candle.

The pattern is significant as it shows a shift in the momentum from the upside to the downside. The pattern is created by an up candle followed by a down candle. Traders look for the price to continue lower on the next (third) candle. This is called confirmation.

Image by Julie Bang © Investopedia 2020

Key Takeaways Dark Cloud Cover is a candlestick pattern that shows a shift in momentum to the downside following a price rise.

The pattern is composed of a bearish candle that opens above but then closes below the midpoint of the prior bullish candle.

Both candles should be relatively large, showing strong participation by traders and investors. When the pattern occurs with small candles it is typically less significant.

Traders typically see if the candle following the bearish candle also shows declining prices. A further price decline following the bearish candle is called confirmation.

Understanding Dark Cloud Cover

The Dark Cloud Cover pattern involves a large black candle forming a “dark cloud” over the preceding up candle. As with a bearish engulfing pattern, buyers push the price higher at the open, but sellers take over later in the session and push the price sharply lower. This shift from buying to selling indicates that a price reversal to the downside could be forthcoming.

Most traders consider the Dark Cloud Cover pattern useful only if it occurs following an uptrend or an overall rise in price. As prices rise, the pattern becomes more important for marking a potential move to the downside. If the price action is choppy the pattern is less significant since the price is likely to remain choppy after the pattern.

The five criteria for the Dark Cloud Cover pattern are:

An existing bullish uptrend. An up (bullish) candle within that uptrend. A gap up on the following day. The gap up turns into a down (bearish) candle. The bearish candle closes below the midpoint of the previous bullish candle.

The Dark Cloud Cover pattern is further characterized by white and black candlesticks that have long real bodies and relatively short or non-existent shadows. These attributes suggest that the move lower was both highly decisive and significant in terms of price movement. Traders might also look for a confirmation in the form of a bearish candle following the pattern. The price is expected to decline following the Dark Cloud Cover, so if it doesn’t that indicates the pattern may fail.

The close of the bearish candle may be used to exit long positions. Alternatively, traders may exit the following day if the price continues to decline (pattern confirmed). If entering short on the close of the bearish candle, or the next period, a stop loss can be placed above the high of the bearish candle. There is no profit target for a Dark Cloud Cover pattern. Traders utilize other methods or candlestick patterns for determining when to exit a short trade based on Dark Cloud Cover.

Traders may use the Dark Cloud Cover pattern in conjunction with other forms of technical analysis. For example, traders might look for a relative strength index (RSI) greater than 70, which provides a confirmation that the security is overbought. A trader may also look for a breakdown from a key support level following a Dark Cloud Cover pattern as a signal that a downtrend may be forthcoming.

Example of Dark Cloud Cover

The following chart shows an example of the Dark Cloud Cover pattern in the VelocityShares Daily 2X VIX Short Term ETN (TVIX):

Dark Cloud Cover Pattern. StockCharts.com

In this example, the Dark Cloud Cover occurs when the third bullish candle is followed by a bearish candle that opens higher and closes below the midpoint of the last bullish candle. The pattern successfully predicted a downturn in the following session where the price moved nearly seven percent lower. That session provided confirmation.

Traders who were long could consider exiting near the close of the bearish candle or on the following day (confirmation day) when the price continued dropping. Traders could also enter short positions at these junctures as well.

If entering short, the initial stop loss could be placed above the high of the bearish candle. Following the confirmation day, the stop loss could be dropped to just above the confirmation day high in this case. Traders would then establish a downside profit target, or continue to trail their stop loss down if the price continues to fall.

Three Inside Up

What Are Three Inside Up/Down?

Three inside up and three inside down are three-candle reversal patterns that appear on candlestick charts. The pattern requires three candles to form in a specific sequence, showing that the current trend has lost momentum and a move in the other direction might be starting.

Key Takeaways The three inside up pattern is a bullish reversal pattern composed of a large down candle, a smaller up candle contained within the prior candle, and then another up candle that closes above the close of the second candle.

The three inside down pattern is a bearish reversal pattern composed of a large up candle, a smaller down candle contained within the prior candle, and then another down candle that closes below the close of the second candle.

These patterns are short-term in nature, and may not always result in a significant or even minor trend change.

Consider using these patterns within the context of an overall trend. For example, use the three inside up during a pullback in an overall uptrend.

Understanding the Three Inside Up/Down Candlestick Patterns

The up version of the pattern is bullish, indicating the price move lower may be ending and a move higher is starting. Here are the characteristics of the pattern.

The market is in a downtrend or a move lower. The first candle is a black (down) candle with a large real body. The second candle is a white (up) candle with a small real body that opens and closes within the real body of the first candle. The third candle is a white (up) candle that closes above the close of the second candle.

Three Inside Up.

The down version of the pattern is bearish. It shows the price move higher is ending and the price is starting to move lower. Here are the characteristics of the pattern.

The market is in an uptrend or a move higher. The first candle is a white candle with a large real body. The second candle is a black candle with a small real body that opens and closes within the real body of the first candle. The third candle is a black candle that closes below the close of the second candle.

The three inside patterns are essentially harami patterns that are followed by a final confirmation candle, which many traders wait for with the harami anyway.

Three Inside Down.

Three Inside & Trader Psychology

Three Inside Up

The downtrend continues on the first candle with a large sell-off posting new lows. This discourages buyers, while sellers grow confident.

The second candle opens within the prior candle’s trading range. Rather than following through to the downside, it closes higher than the prior close and the current open. This price action raises a red flag, which some short-term short sellers may use an opportunity to exit.

The third candle completes a bullish reversal, trapping remaining short-sellers and attracting those who are interested in establishing a long position.

Three Inside Down

The uptrend continues on the first candle, with a large rally posting new highs. The second candle opens within the prior candle’s trading range and closes below the prior close and current open. This causes concern for the buyers, who may start selling their long positions.

The third candle completes a bearish reversal, where more long positions are forced to consider selling and short-sellers may jump in to take advantage of the falling price.

Trading the Three Inside Up/Down Candlestick Pattern

The pattern doesn’t need to be traded. It can simply be used as an alert that the short-term price direction may be changing.

For those that do wish to trade it, a long position can be entered near the end of the day on the third candle, or on the following open for a bullish three inside up. A stop loss can be placed below the low of the third, second, or first candle. This depends on how much risk the trader is willing to take on.

For a bearish three inside down, a trader could enter short near the end of the day on the third candle, or at the open the following day. A stop loss can be placed above the third, second, or first candle high.

These patterns do not have profit targets. Therefore, it’s best to utilize another method for deciding when to take profits, should they develop. This could include using a trailing stop loss, exiting at a predetermined risk/reward ratio, or using technical indicators or other candlestick patterns to signal an exit.

These patterns can appear quite often and will not always signify that the price is set to trend in a new direction.

The pattern is fairly common, and therefore not always reliable. The pattern is also short-term in nature, so while it may occasionally result in significant trend changes, it may bring about only a small to medium-sized move in the new direction. Following the pattern, the price may not follow through in the direction expected at all, and may instead reverse course once again, in the direction of the original trend.

Trading in the same direction as the long-term trend may help improve the performance of the pattern. Therefore, during an overall uptrend, consider looking for the three inside up during a pullback. This could signal that the pullback is over and the uptrend is resuming.

During a downtrend, look for the three inside down following a small move higher. This could signal the move higher is over and the downtrend is resuming.

Example of Three Inside Up/Down Candlestick Patterns

The following Facebook Inc. chart shows an example of a three inside down pattern that fails. It appears during a strong price rise, but the third candle is relatively small and doesn’t show a lot of selling conviction. The next day the price quickly resumes trading to the upside in alignment with the broader trend.

Image by Sabrina Jiang © Investopedia 2021

The next two examples occur during an overall price rise and occur during pullbacks against that rise. Once the pattern occurs, the price begins to move higher again, although not necessarily right away. In both cases, the price pauses after the pattern before moving up. Therefore, it would have been prudent to have a stop loss placed below the entire pattern in order not to be prematurely stopped out on a long position.

Understanding the ‘Hanging Man’ Candlestick Pattern

The hanging man is a type of candlestick pattern. Candlesticks displays the high, low, opening and closing prices for a security for a specific time frame. Candlesticks reflect the impact of investor' emotions on security prices and are used by some technical traders to determine when to enter and exit trades.

The term “hanging man” refers to the candle’s shape, as well as what the appearance of this pattern infers. The hanging man represents a potential reversal in an uptrend. While selling an asset solely based on a hanging man pattern is a risky proposition, many believe it’s a key piece of evidence that market sentiment is beginning to turn. The strength in the uptrend is no longer there.

The Hanging Man Explained

The hanging man occurs when two main criteria are present:

The asset has been in an uptrend.

The candle has a small real body (distance between open and close) and a long lower shadow. There is little to no upper shadow.

Given these two criteria, when a hanging man forms in an uptrend, it indicates that buyers have lost their strength. While demand has been pushing the stock price higher, on this day, there was significant selling. While buyers managed to bring the price back to near the open, the initial sell-off is an indication that a growing number of investors think the price has peaked. For believers in candlestick trading, the pattern provides an opportunity to sell existing long positions or even go short in anticipation of a price decline.

The hanging man is characterized by a small “body” on top of a long lower shadow. The shadow underneath should be at least twice the length of the body.

Image by Julie Bang © Investopedia 2019

The chart below shows two hanging man patterns in Facebook, Inc. (FB) stock, both which led to at least short-term moves lower in the price. The long-term direction of the asset was unaffected, as hanging man patterns are only useful for gauging short-term momentum and price changes.

Even though traders often count on candlestick formations to detect the movement of individual stocks, it is also appropriate to look for candlestick patterns in indexes, such as the S&P 500 or Dow Jones Industrial Average. Candlesticks can be also be used to monitor momentum and price action in other asset classes, including currencies or futures.

Distinguishing Features

If it’s an actual hanging man pattern, the lower shadow is at least two times as long as the body. In other words, traders want to see that long lower shadow to verify that sellers stepped in aggressively at some point during the formation of that candle.

Thomas Bulkowski’s “Encyclopedia of Candlestick Charts” suggests that, the longer the lower shadow, the more meaningful the pattern becomes. Using historical market data, he studied some 20,000 hanging man shapes. In most cases, those with elongated shadows outperformed those with shorter ones. Some traders will also look for strong trading volume. Bulkowski’s research supports this view. Of the many candlesticks he analyzed, those with heavier trading volume were better predictors of the price moving lower than those with lower volume.

Another distinguishing feature is the presence of a confirmation candle the day after a hanging man appears. Since the hanging man hints at a price drop, the signal should be confirmed by a price drop the next day. That may come by way of a gap lower or the price simply moving down the next day (lower close than the hanging man close). According to Bulkowski, such occurrences foreshadow a further pricing reversal up to 70% of the time.

It’s worth noting that the color of the hanging man’s real body isn’t of concern. All that matters is that the real body is relatively small compared with the lower shadow.

Trading the Hanging Man

The hanging man patterns that have above average volume, long lower shadows and are followed by a selling day have the best chance of resulting in the price moving lower. Therefore, it follows that these are ideal patterns to trade off of.

Upon seeing such a pattern, consider initiating a short trade near the close of the down day following the hanging man. A more aggressive strategy is to take a trade near the closing price of the hanging man or near the open of the next candle. Place a stop-loss order above the high of the hanging man candle. The following chart shows the possible entries, as well as the stop-loss location.

One of the problems with candlesticks is that they don’t provide price targets. Therefore, stay in the trade while the downward momentum remains intact, but get out when the price starts to rise again. Hanging man patterns are only short-term reversal signals.

A Question of Reliability

If looking for any hanging man, the pattern is only a mild predictor of a reversal. Look for specific characteristics, and it becomes a much better predictor. Bulkowski is among those who feel the hanging man formation is, in and of itself, undependable. According to his analysis, the upward price trend actually continues a slight majority of the time when the hanging man appears on a chart.

However, there are things to look for that increase the chances of the price falling after a hanging man. These include above average volume, longer lower shadows and selling on the following day. By looking for hanging man candlestick patterns with all these characteristics, it becomes a better predictor of the price moving lower. Stick to trading only these strong types of patterns.

Hanging Man vs. Shooting Stars and Hammers

There are two other similar candlestick patterns. This can lead to some confusion.

The hanging man appears near the top of an uptrend, and so do shooting stars. The difference is that the small real body of a hanging man is near the top of the entire candlestick, and it has a long lower shadow. A shooting star as a small real body near the bottom of the candlestick, with a long upper shadow. Basically, a shooting star is a hanging man flipped upside down. In both cases, the shadows should be at least two times the height of the real body. Both indicate a potential slide lower in price.

The hanging man and the hammer are both candlestick patterns that indicate trend reversal. The only difference between the two is the nature of the trend in which they appear. If the pattern appears in a chart with an upward trend indicating a bearish reversal, it is called the hanging man. If it appears in a downward trend indicating a bullish reversal, it is a hammer. Apart from this key difference, the patterns and their components are identical.

The Bottom Line

Hanging men occur frequently. If you highlight them all on a chart, you will find that most are poor predictors of a price move lower. Look for increased volume, a sell-off the next day, and longer lower shadows, and the pattern becomes more reliable. Utilize a stop loss above the hanging man high if you are going to trade it.