HARAMI:  THIS CANDLE CAN HELP NURTURE YOUR PROFITS

Major reversal candlesticks include: doji, hammer, hangman, bearish and bullish engulfing, piercing, dark cloud cover and star.

When you see any of these on a daily chart following an up or downtrend of more than six days, you should immediately ask yourself if the Minor trend is about to reverse direction. Because of their importance, all swing traders should be able to readily identify these candles. Day traders should also learn how to spot them in intraday charts, such as the 5-minute or 60-minute, as these candles often have great significance in those time frames as well.

In addition to the major reversal candles, there are several other candles all swing traders should be able to identify and integrate into their decision-making. In this week's "Inside The Black Box" installment we will explore harami, the "pregnant" candle. The ability to recognize this "intermediate strength" trend change signal will help you nurture your profits.

The harami candle can occur both after an uptrend or downtrend. To keep this discussion clear, however, for the sake of today's example I will assume a stock is in an uptrend. Immediately preceding the harami candle, there should be a large, real body clear candle. When this candle occurs, the bulls appear to be fully in the driver's seat.

The next day, however, a small real body candle appears within the larger real body. This is the harami candle. In my experience, the signal is more powerful if the second day's candle is near the middle of the trading range of the first. When the two candles are grouped together, you can imagine that the first candle is like a mother and the second candle the child that emerges from its belly. That is where the name harami, or pregnant, comes from. Here is an example of a harami candle:

Experts tend to disagree about whether the harami day needs to be of the opposite color from the large, clear candle day. Clearly, the reversal signal is more potent if it is the opposite color, as this color change shows that the advance has stalled. The bears are now on strong ground and are engaged in a struggle for power with the bulls. The upper and lower shadows can be of any size, and theoretically could even go above the real body of the clear candle day. In practice, however, the harami day's shadows are often small and are typically contained well within the real body of the previous day's candle.

Always look carefully at the next day's candle -- the one that follows the harami candle. Sometimes harami merely signifies that the stock is entering a period of consolidation (meaning that the shares will trade sideways). If, however, the stock you're examining plummets the day after the harami candle takes place, then there is an increased likelihood that the shares have put in a Minor top.

In the historical chart of Activision (ATVI) below I have circled a good example of the harami candle. On the day before the harami appeared, a long white candle capped a rally that took the stock from below $13 to north of $16 in just 15 trading days. (It's important to note that at fifteen trading days, the Minor uptrend was very mature and was ripe for reversal.) On the day of the long white candle, the stock penetrated the upper Bollinger band, showing ATVI was overbought. Volume, however, was much weaker than at the first high, which also took place at $16 several days before.

This bearish divergence can also be seen in the CCI indicator, which made a significantly lower peak than it had on the first high. The harami candle brought ATVI back within the Bollinger band. At this point, holders of this stock should have been alert that the trend was potentially changing. Defensive action should have been taken to protect profits. The next day, the stock attempted a probe north of $16, but left a large upper shadow and closed sharply down. In fact, it closed even lower than the day of the large white candle, more than reversing that day's entire gain. An MACD sell signal followed, and that signal remains in force. The shares are still well below the level of the harami day (and even the day after it).

While the harami candle is considered less potent than many of the key reversal candles I mentioned above, it nevertheless has substantial predictive power. If it occurs in a stock in which you have a position, then you should be alert to a change in trend from up to sideways, or even up to down. (If the stock is in a downtrend, then the harami candle can also warn of an impending period of sideways trading, or perhaps even an uptrend.) So, the next time you observe the harami candle, I'd urge you to take heed, as it can provide you with a valuable tool to help you protect your profits.

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