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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • Candlesticks – Dark Cloud Cover 0 comments
    Mar 30, 2014 10:33 AM

    At times, a bearish signal does not show up as a declining day or days; it can involve a two-day pattern with the second day opening higher.

    Such a pattern is the dark cloud cover, is also is called a bearish piercing lines pattern. This is shown in the illustration.

    There are several ways that this signals reversal. The first session is upward-moving and represents the end of the uptrend. The second day opens higher than the previous close, creating a gap. However, price moves downward to close lower, but within the range of the previous day's real body. This "piercing" aspect confirms that a reversal is most likely underway.

    In order for this signal to be valid, it has to show up during an uptrend. Without the uptrend, there is nothing to reverse, and traders interested in short-term trends have to be aware of the potential for sudden reversal at any time. The dark cloud cover is especially valuable if it is also confirmed by other signals. Momentum oscillators that show a weakening in the uptrend and crossover into negative territory often precede actual downtrends, so if the dark cloud cover happens at the same time as a weakening indicator, it is very strong. Consider tracking relative strength index (RSI), for example; this is one of the most reliable leading indicators.

    Another strong signal is found if the uptrend has also touched resistance or temporarily broken through. When price moves above resistance, one possible outcome is reversal, but you need some kind of signal to anticipate it. The dark cloud cover's second day is the alarm bell telling you that the breakout is not going to continue upward. The play at or near resistance is one of the most important placements for reversal signals. A breakout may signal a new and strong uptrend, or simply an attempt to move higher that will only fail and reverse.

    When dark cloud cover appears as the final step in a double top or head and shoulders, it also provides an exceptionally strong signal of a reversal and new downtrend. Look for a weakening in the trend itself as a final signal of lost momentum. When the angle of the upward movement begins evening out and then the dark cloud cover appears, expect price to turn south.

    While signals like dark cloud cover can show up after a very brief uptrend, and even foreshadow very short downtrends, longer trends make the signals more reliable. So the longer the preceding uptrend (especially if momentum has begun to weaken), the greater the significance of the dark cloud cover. However, even with a long trend underway, remember that no candlestick formation stands alone. Use candlesticks as a means for verifying what you see taking place in other signals.

    All candlestick indicators provide hints, especially reversal indicators. However, all need independent confirmation. Candlestick signals may also act as lead indicators, to be confirmed by other developments like tests of resistance or weakening momentum. Dark cloud cover is one of those difficult to spot but powerful indicators that, when confirmed, are decisive in what they reveal.

    To gain more perspective on insights to investing observations and specific analysis, I hope you will join me at ThomsettStocks.com where I publish many additional articles. I also maintain a virtual portfolio of stock at ThomsettStocks.com. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site to learn more.

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