Tired of guessing market direction? Candlestick setups might be your missing edge.
Candlestick patterns are a visual representation of the price movements that traders or investors can use to find possible trends or reversals in the market. Traders can also assess market sentiment and perform much more in-depth technical analysis thanks to these candlestick patterns, which helps them make much better trading decisions in the long run.
Why Candlesticks Matter in Options Trading
It’s key for options traders to note that candlestick patterns should be used alongside other technical indicators and fundamental analysis for the best results—they aren’t a foolproof system for better trading. Our guide will review everything you need about candlesticks and how to use them in your trading plan best.
What Makes a Candlestick Setup “Reliable”?
When used in the broader market context, candlestick patterns can be highly reliable, especially when paired with other technical indicators. It’s key to note that while they’re dependable for traders, candlestick patterns aren’t a foolproof way to navigate the markets.
- Consistency Across Multiple Timeframes—By viewing candlestick patterns across multiple timeframes, traders can improve their trading accuracy and risk management techniques. Traders can make more confident decisions when they see signals on higher timeframes align with signals on lower timeframes.
- High Probability of Follow-Through—Candlestick patterns will likely continue in the indicated direction after forming the initial pattern. You can see this in the most common candlestick patterns that traders see during their sessions, like the “Evening Star,” a bearish reversal, or a “Morning Star,” a bullish reversal.
- Works Well with Confirmation Signals or Indicators—Traders can pinpoint more accurate trade signals when using candlestick patterns and other indicators in combination with one another. This leads to improved accuracy and a better understanding of market sentiment.
- Spreads or Directional Plays—Candlestick patterns are great for helping traders set up spread or directional plays. For instance, these patterns can help traders identify entry points and set up profit targets or stop losses when using directional plays. In the case of spreads, traders can manage time decay more effectively and enhance their overall profitability thanks to candlestick patterns and the reliability of that technical indicator.
The Top 7 Most Reliable Candlestick Setups (for Options Traders)
Now, let’s examine the best candlestick patterns, which we consider the most reliable for options traders who want to nail down trend reversals or continuations in the markets correctly. We’ll address seven candlesticks and how they can point to market trend reversals or continuations. There’s even a pattern that involves market uncertainty that is worth knowing about!
1. Bullish Engulfing
Best for These Options Strategies: Long calls, bull call spreads, bull put spreads, and covered calls
A technical analysis candlestick pattern which signals potential trend reversals from a downtrend to an uptrend. It’s a great move when buying long calls or bull call spreads, which profit when the stock prices increase. In this pattern, buyers are overcoming the number of sellers, which could raise prices.
- Best Used In: Bullish markets / Bearish markets which are turning into bullish markets
The pattern formation is indicative of the name. There are two candles: a bullish candle that completely engulfs the body of the bearish candle that goes before it, the bullish candle will appear green or white on the chart, and the bearish candle will appear red.
2. Bearish Engulfing
Best for These Options Strategies: Buying Put Options, Shorting Call Options, and Bear Puts
The bearish engulfing signals potential trend reversals from an uptrend to a downtrend. This indicates a shift in the market sentiment where sellers are overcoming the number of buyers, resulting in lower prices. You’re going from a bullish market sentiment into more bearish territory. A strong downtrend signal could occur after a failed rally. It’s a valuable move for buying puts or initiating bear put spreads.
- Best Used In: Bearish markets / Bullish markets which are turning into bearish markets
The pattern for the bearish engulfing consists of two candles. The first is a bullish candle where the price is closer higher than it opened, and it’s followed by a larger bearish candle that completely covers the first bullish candle.
3. Morning Star
Best for These Options Strategies: Buying Call Options, Bull Call Spreads, Bull Put Spread, and Covered Calls
Unlike the Bullish Engulfing candlestick pattern, the Morning Star candlestick patterns are in a bullish reversal pattern, but three candles make up the pattern formation. This pattern suggests that bearish momentum could die, and buyers are beginning to reenter the markets. The Morning Star especially pairs well with long call entries after pullbacks. As with many of these patterns, it’s best to combine these with other technical indicators for the most accurate results.
- Best Used In: Bullish markets or markets that are trending upward
Let’s take a look at the formation of the Morning Star. It’s a 3-candle bottom reversal pattern. The first candle is a long, bearish candle, reflecting intense selling pressure and the continuation of the downtrend. The second candle is smaller, with a small gap between the high and the low of the first candle (this shows indecision of the downtrend). The third and last candle is a long, bullish one that closes above the midpoint of the first candle. This shows a renewed interest in buying from the investors, and that a potential reversal might be underway.
4. Evening Star
Best for These Options Strategies: Buying Put Options, Bear Call Spreads, Covered Calls with Bearish Bias, etc.
The evening star is a bearish reversal signal that can indicate a potential shift from a bullish (uptrending) market to a bearish or trending downward market. Like the Morning Star pattern, the Evening Star is made of three candles, all when out together, pointing toward the weakening of bullish momentum and a possible price decline on the horizon. In other words, the Evening Star is a top reversal pattern signaling upcoming weakness. They can best be used for buying puts or covered calls with a bearish bias.
- Best Used In: Bearish markets or bullish markets that are trending into bearish markets
Let’s discuss the formation of the pattern. The first candle is long and bullish, indicating a strong uptrend. The second candle is smaller, showing a slowdown of the bullish trend, a point where there is some indecision in the market. The third candle is a long, bearish one that ultimately confirms a trend reversal. The last candle is closest below the opening price and usually one gap down from the previous candle, where there was market indecision.
5. Hammer & Inverted Hammer
Best for These Options Strategies: Bull call spread, long call options, bull put spread, covered call, and “poor man’s covered call.”
Both candlestick patterns are bullish reversals, showing investors or traders that there will be a potential shift away from a downtrend to an uptrend. It’s a signal that buyers are beginning to overtake the sellers in a market. However, the sellers are still holding the price down, which could indicate a downward trend, which is finally losing its strength and coming to an end. Overall, the hammer or inverted hammer is a good sign of potential reversal after a downtrend, which makes them suitable for short-term bullish trades like credit put spreads.
- Best Used In: Bearish markets or bullish markets that are trending into bearish markets
Now, let’s talk about the formation of these patterns and how they get their names. A hammer has a small body at the top and a longer formation that’s twice as big as the body (the wick). On the other hand, unlike the hammer, the inverted hammer has a small body on the bottom, and its wick has little to no lower shadow.
6. Shooting Star
Best for These Options Strategies: Protective puts or bear debit spreads
Unlike the hammer or inverted hammer, this candlestick pattern is a bearish reversal pattern that signals exhaustion at the top of an uptrend. When traders see a Shooting Star, they can be sure there will be a significant shift from an uptrend to a downtrend. It’s an ideal candlestick for protective puts or bear debit spreads. The Shooting Star ultimately indicates that selling pressure is overwhelming the prices that the buyers drove up. The result is the price closing near its opening price.
- Best Used In: Bearish markets or bullish markets that are trending into bearish markets
The body of this candlestick pattern is smaller than most, and it’s located near the lower end of the candle itself. The wick, the longer upper shadow, is much longer than the body by about twice the length. On the other side, there’s very little or no shadow below the body. It suggests that the market is rejecting the higher prices and that a shift into a bearish pattern is imminent.
7. Doji (Especially After a Trend)
Best for These Options Strategies: Buying call options, bullish vertical spreads, buying put options, bearish vertical spreads,
The opening and closing prices of the trading period are nearly identical, which signals market indecision. The Doji candlestick signifies that there’s no considerable market movement during the trading session and that the market is equally balanced between buyers and sellers. A potential reversal is possible when the Doji candlestick is found after long trends. This pattern is suitable for combining with volume or support/resistance zones.
- Best Used In: Sideways markets
Regarding the formation of the Doji candlestick, it looks like a plus sign or a cross on the charts. It has a short body and long upper and lower “wicks,” which makes the entire shape indicative of market indecision by traders and investors. The shape of this candlestick shows that buyers and sellers are in a stalemate and that the opening and closing prices are virtually the same.
How to Use These Patterns in Real Options Trades
Now that you know the different candlestick setups on the charts, how do you incorporate them into your options trading sessions and decisions? We’ll address a few helpful tips and tricks for selecting the right timeframes and confirming these patterns with other technical indicators.
Timeframe Selection Tips
Traders will generally choose longer timeframes to focus on trend analysis or opt for shorter timeframes to make better decisions on entry or exit points for their trades.
- Daily, weekly, or monthly timeframes can be used to identify large-scale market movements successfully.
- Medium timeframes focusing on a few hours are best for swing traders as they balance signal frequency and clarity.
- If you’re dealing with shorter timeframes of 15 minutes or less, you’re trading mainly on entry and exit prices, which is an excellent method for scalpers and short-term traders.
Confirming With Other Technical Indicators
Remember the importance of combining what you see with the candlestick patterns with other indicators that can confirm the trends on the charts.
- Volume—A candlestick pattern with increased trading volume can indicate a firm conviction in the price move. It can add credibility to the pattern’s signal because of the higher amount of participation that the market is seeing. It’s the opposite when it comes to a decrease in trading volume.
- RSI—The Relative Strength Index can be used as a momentum indicator to evaluate overbought or oversold conditions. Combining RSI with candlesticks can increase the likelihood of a successful trade as it can filter out any false signals. The partnership of these indicators can lead to better risk management and better entry and exit points as well.
Trendlines refer to upward, downward, or sideways movements in the options market. In downtrends, look for bullish candlesticks (engulfing, hammer, or morning star) near the support area of the trendline. Look for bearish candlestick patterns like the shooting star near the trendline’s resistance in uptrends.
Common Mistakes to Avoid When Trading Candlestick Setups
What big mistakes do investors or traders make when using candlestick setups? We’ll touch on a few of these blunders below to give you a good idea of what to avoid to get the best outcome possible when working this indicator into your trading routine.
- Relying on Patterns Too Heavily—While candlestick patterns can be a helpful tool, they are somewhat useless when used in isolation without any other technical indicators. It’s always advised to pair candlesticks with other technicals to get confirmation of the patterns and trends you’re seeing.
- Ignoring Larger Trend Context or Support/Resistance—With candlestick patterns and other indicators for confirmation, traders should look at the broader market context for more clues on what’s occurring. It’s key to check any relevant market news for insights to bring these trends to life. If you begin ignoring the market context, you could get false signals with the candlesticks.
- Using Patterns on Illiquid Stocks or ETFs—This can be a rookie mistake for many traders. What’s the use in knowing about these candlesticks and using them for your trading strategy if you cannot quickly and easily buy or sell the options contracts you’re dealing with? Remember to choose relatively liquid options so you can easily enter and exit positions.
- Overtrading Based on “Weak” Patterns—Confirmation of these patterns is between relying on a strong pattern or basing your decisions on a weak pattern that could get you into trouble. You can dig deeper if you trade on this faulty pattern that other technical indicators don’t back up too strongly.
Bonus Tip—Combine Candlestick Patterns with Option Flow or Open Interest
Our bonus tip, where you’re using candlesticks along with open interest or options flow, can provide a comprehensive view of the market. It’s an approach that offers multiple layers of confirmation and can help traders pinpoint better entry and exit points as they trade options.
Candlestick Example With Option Flow and OI
Regarding multiple avenues of confirmation for the investors, we refer to how candlesticks can visually confirm market sentiment or potential price movements. Other indicators, like open interest or options flow, can offer a sound qualitative analysis that can strengthen the validity of the strategy you’re planning to use going forward.
- Bullish Engulfing Candlestick—This pattern appears after a downtrend and can signify a market sentiment shift that goes from an environment of selling to one of buying.
- Surge in Call OI—A surge in open interest indicates an uptick in bullish betting, which shows that traders are confident in rising prices.
Case Studies—Candlestick Setups in Action
Let’s look at a few candlestick patterns and how traders can use them in future sessions to inform their trading strategies.
Example 1—Bullish Engulfing + Long Call on AMD
- Pattern Spotted—This combination signals a potential shift from a downtrend to an uptrend in a stock or any other underlying asset. In this case, the publicly traded company is Advanced Micro Devices (AMD). The bullish engulfing pattern occurs after a downtrend where a larger bullish candlestick succeeds a smaller bearish candlestick.
- Entry and Strike Chosen—Because a new bullish pattern is emerging in the markets, the trader can take advantage of a long call on AMD stock, choosing their entry before the prices begin rising to get in for a reasonable price and then selecting a far out expiration date to take advantage of the long-term trend.
- Result After a Few Days—If everything that needed to happen to make the long call profitable happens, traders should be able to ride out the trade for a while. However, if this was a false signal or there’s an event that causes the markets to turn another direction, the trader could roll the long call into iron condor to capitalize on a sideways market, or they could close out the long call and buy a put option to make money on a price decline.
Example 2—Shooting Star + Protective Put on SPY
- Risk-Managed Hedge—When the Shooting Star candlestick appears after a strong uptrend, this can suggest bullish momentum weakening and that an emerging bearish trend is coming as sellers outpace the buyers.
- How It Played Out—A protective put on SPY can be a good way to lock in some of the gains you might have accrued with those investments over the long term. This can be helpful if there’s a market dip, as the Shooting Star suggests. Not only does the protective put limit losses, but it also allows the trades to maintain the ability to benefit from any future appreciation if SPY continues to rise.
Final Thoughts on Using Candlestick Setups in Options
Should you base your trading decisions on candlestick patterns alone? As with any indicators used in trading, cross-check your theories on where the markets and prices might go against other technical indicators. We advise anyone looking to incorporate these patterns into their trading routine to set aside time to test the candlesticks with paper trading simulators or any demo modes offered on their brokerage app.
Key Takeaways
- Candlestick patterns give powerful insight into price action.
- When paired with innovative options strategies, they help time trades with better accuracy.
- Always confirm patterns and consider the broader context.
- Try incorporating 1-2 patterns in your strategy this week to see how they perform.
