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Principles of Technical Analysis: The Evening Star Formation

In technical analysis, Japanese candlesticks can be applied to help anticipate the market's next move.

One important candlestick pattern is the "Evening Star" formation.

When correctly spotted, this bearish formation can signal a potential trend reversal. But the pattern is a very subtle one and for its implications to be valid three conditions must be fulfilled. Otherwise, as a trader you can take the wrong action.

The Evening Star pattern occurs during a sustained uptrend. But, as I say in my book, 21 Candlesticks Every Trader Should Know, "If you see the Evening Star, a top is often not very far."

You can recognize an Evening Star formation because it appears as a group of three distinct candles.

On the first day, a candle with a long white real body occurs. Everything looks normal and the bulls seem to be in control.

But on the second day, a star candle occurs. This candle has a small body and often contains a large upper shadow. The large upper shadow indicates the probe into higher ground could not be sustained. As a result, a potential reversal is signaled.

The star candle can be either black (bearish) or white (bullish). But, for the formation to be valid, the candle must gap above and close higher than the previous day's candle.

The occurrence of the star shows the bulls and bears are in a tug of war, but neither side is winning. After a sustained uptrend, those who want to take profits have come into balance with those who want to buy the stock.

On the third day, a candle with a black body emerges. This candle is largely in line with the real body of the candle that occurs on day one. The more in line it is, the more powerful the reversal signal.

If there is a gap between the second and third candles, the pattern is that much more decisive. However, unlike the required gap between the first and second candles, a gap between the second and third candles is unusual and not a requirement of the pattern.

Since the third day affirms the potentially bearish implications of the pattern, no further confirmation is needed. The pattern is complete. Traders should strongly consider taking immediate action by liquidating long positions or going short.

The daily chart of the S&P 500 provides a good example of one Evening Star formation and two that look like, but in fact aren't, true evening stars.


 

The first pattern (labeled A) occurred in early to mid February. On the first day, a reasonably large white candle formed. On the second day, a bearish Evening Star candle occurred; however, it did not gap above or close higher than the previous day. On the third day, prices closed well back into levels on the first day.

While this pattern appears to be an Evening Star, it is not a true Evening Star formation because the middle star candle did not gap above the first day's candle. It is important for traders to be able to recognize this subtlety.

#-ad_banner_2-#Following a sustained uptrend, a confirmed Evening Star pattern (labeled B) occurred in mid-April. This pattern is marked by the appearance of a white real body candle on the first day. The next day, a star candle appears. Note how this candle (unlike the first example) closes just above the previous day's high. On the third day, a candle with a long black real body emerges. This candle is largely in line with the candle that appears on the first day of the pattern. The Evening Star formation is now confirmed.

Following the appearance of this candle, the S&P fell slightly.

The pattern labeled C again looks like an evening star but is not since the star candle on the second day does not gap above or close higher than the first day's candle.

Still, the appearance of two Evening Star-like formations in such a short time period, combined with the break of the intermediate uptrend line make me cautious. This caution will be reinforced if the S&P can not hold its first level of support near 1180. Meanwhile, I will keep scanning the night skies to see if any more stars appear; I suggest that you keep a look out, too.

This article was originally sent to subscribers of Dr. Pasternak's "Double-Digit Trading" service on May 3, 2010. The charts and stocks that are mentioned are used to illustrate how an investor can learn to use technical analysis to identify Evening Star formations, and they should be used for educational purposes only.

If you want to learn more about using technical analysis in your portfolio, we recommend Principles of Technical Analysis: Double Top Formations Explained and The Six Biggest Mistakes Technical Traders Make.