FALLING CROWN, RAMS HEAD and ADDITIVE CANDLE PATTERNS

Some Favorite Candle Patterns at Undergroundtrader.com

Russell Arthur Lockhart, Ph.D.

            Most traders have at least a passing familiarity with candlestick patterns and most charting programs now include candle charting as a standard feature. What is less clear is the degree to which candle patterns are actually used by traders in trading. In  my informal surveys over the years, I have never found more than 10% of any sample to report using candle patterns in trading. What is more certain, is that new research into candle patterns seems harder to find than traders who will admit to using candlesticks in active trading. My previous note introduced TOPS, FOPS, Sunshine and Through the Floor patterns. Here I want to introduce the Falling Crown, the Rams Head, and to illustrate the principle of the Additive Candle pattern.

The Falling Crown. As the name suggests, the Falling Crown is a pattern that warns a declining market lies ahead. The pattern is composed of a sequence of five consecutive periods in which there is a specific relationship between the period highs: high, lower high, highest high, lower high, higher high. The lows as well as the body aspects do not enter into the definition. Figure 1 illustrates the basic pattern. The nominal trigger for the Falling Crown is the first close below the high of the fifth period. This would be the point of the first short-side entry. The pattern is a contextual leading indicator and for this reason many other entry signaling methods would be appropriate as well. The pattern is hard to see in the flux of trading, particularly on intraday periods, so it is recommended that a scanning tool programmed to find Falling Crown candidates be employed. Figure 2 is a chart showing a recent Falling Crown pattern unfolding in the daily Dow Transports. I employ the ”Rule of Three” to project a nominal time frame in which the pattern should unfold. This takes the form both of anticipating a three-wave process as well as a nominal 3*5 = 15 periods for completion. These are rules of thumb obviously but they serve as handy guides.

Rams Head. The Rams Head is a five consecutive period pattern with the following relationship between the lows: low, higher low, lowest low, higher low, lower low. It is a leading indicator for a rising market. Figure 3 shows the Rams Head pattern. In this case, the trigger for a long-side entry is a close above the high of the fifth candle. The same time frame and wave expectations described for the Falling Crown apply as well to the Rams Head pattern. Figure 4 shows a recent daily Rams Heads in Goggle (GOOG) and the first four sessions following the completion of the pattern.

Additive Candles. Another approach to patterns based on multiple candles is what I call “additive” candles. Almost all candle pattern analysis is based on the relationship between discrete candles. The principle of additive candles follows from the idea that successive periods of same-bodied candles are forming what may be considered a “super” candle, one that keeps “adding” to its bullish body until a bearish bodied candle appears (and vice versa for the bearish sequence). One of the reasons for the low popularity of candle trading may be the impression that candle stick patterns fail too frequently. For example, a bullish candle is followed by a bearish engulfing candle. The trade goes short, only to find that the next move is strongly higher. Very often what has happened is that the bearish engulfing candle is occurring in the context of an additive candle and that from this perspective the actual pattern is more harami than bearish engulfing. Consider Figure 5 as a way of making this point more clearly. Here we see a bearish dark cloud cover pattern. This pattern is a leading indicator for a market decline. As can be clearly seen, however, the next period is clearly bullish with a higher high and a higher close. The dark cloud cover has “failed.” Now this will happen with any method of course. But with the principle of additive candles we can literally “see” why the patterns fails. First, look at a longer view of this same failure in Figure 6. Note that the bearish engulfing candle occurred following a pair of bullish candles. An additive candle is formed when 2 or more candles with the same body type (bullish or bearish) occur consecutively. This triggers the construction of an additive candle chart where only additive candles will be plotted. Such a chart is shown in Figure 7.

This is an additive candle chart for the monthly candle data for the period from June 2003 through trading on April 8, 2005. Now, whether one uses such a chart for longer term trading, or for understanding the longer term candle dynamics, it is clear that the longer term additive pattern is still bullish. A minor cloud pattern failed to close below the body midpoint of the prior additive candle. This is bullish behavior. The current harami pattern features a new market high (in March 2005), but as with all harami (meaning “pregnant”) patterns, what this gives birth to is uncertain. However, failure to make a new closing high following a new high is nominally a bearish warning, as would be a monthly close below the body midpoint of the prior additive candle (at 1176.05). This value is “hidden” in the regular chart and can only be gleaned from the additive candle chart. Experience shows that knowledge of body points in the additive candle chart can be of decisive value in understanding market behavior.