DARK CLOUD COVER CANDLESTICK

DARK CLOUD COVER WARNS OF IMPENDING MINOR TOPS
In the last several installments of this "Inside the Black Box" section we have explored several key reversal candlesticks: the doji, hammer/hangman and bearish/bullish engulfing. When seen on a daily chart, these candles often mark the beginning of a Minor trend reversal (the trend that typically lasts from approximately six to fifteen days). Swing traders, I have argued, need to be able to unhesitatingly recognize these candles when they occur.

The candlestick I want to now explore is called "Dark Cloud Cover." It is a close relative of the bearish engulfing, but is not quite as negative in its implications. Still, the appearance of this candle should be a warning to the swing trader to protect profits in a position. It also suggests that you should watch a stock as a possible short candidate in the trading days ahead.

The Dark Cloud Cover candle occurs after a strong uptrend. A series of ascending candles is ultimately "capped" by a final strong white candle. At this point, the stock or index seems technically healthy and the bulls may be lulled into a sense of false complacency.

On the day of the dark cloud cover, the stock opens above the previous day's high. For a true dark cloud cover to emerge, therefore, the stock should gap above the upper shadow of the previous white "capping" candle. At the opening bell on this trading day, it seems like the uptrend will continue.

As the day wears on, however, the bears wrest control. On the dark cloud cover day, the stock closes at least halfway into the previous white "capping" candle. The larger the penetration of the previous candle (that is, the closer this candle is to being a bearish engulfing), the more powerful the signal. Swing traders should pay particular attention to a dark cloud cover candle if it occurs at an important resistance area and if the end-of-day volume is strong. Below you will find an example of a Dark Cloud Cover candle:

The historical chart of Hot Topic (HOTT) below -- from Thursday, November 6th, 2003 -- provides us with a good example of a dark cloud cover candle. In early October, HOTT bottomed near $22.50. It bounced off of important support on a reversal day that saw a bullish engulfing candle emerge. After that, the stock entered into a 10-day minor uptrend that brought the shares to a high of $29.31. That uptrend ended with a bearish engulfing candlestick.

Hot Topic then retraced to a low of $25.72, bouncing off a rising 20-day moving average. After that, the stock then retested a previous resistance area (its old high). On the circled dark cloud cover day, HOTT looked like it wanted to break out of a small base, but the stock was turned back by round-number resistance at $30. 

A swing trader with this position should have noted that on the day this candle occurred, the charts were showing bearish divergence in a number of momentum indicators. Bearish divergence occurs when price hits a new high, but a momentum indicator makes a lower peak. Note that RSI, MACD and stochastics all gave a consistent message on the dark cloud cover day.

At this point, the swing trader should have protected profits by putting a nearby stop loss on the shares, perhaps below the lower shadow of the dark cloud cover day. Should traders have initiated short positions in the stock at that time? I would say "no." The stock was, and still is, above a rising 30-day moving average. The four-day moving average is just penetrating down through the nine. When the Dark Cloud Cover occurred, there was still too much bullish force for the stock to decline strongly. On the other hand, for swing traders that held long positions in the stock, a failure to set a tight stop would have led to a deterioration of profits.

While the Dark Cloud Cover is not as potent a reversal candle as bearish engulfing, its appearance in the chart should be respected. Look for other indicators, such as bearish momentum divergence, to confirm the message that this candle communicates.

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