THE PIERCING CANDLE: A POTENT REVERSAL SIGNAL

The dark cloud cover and piercing candles are like bookends. Whereas the dark cloud cover warns that an uptrend might be coming to an end and is thus a signal to take profits on long trades, a piercing candle intimates that a downtrend may be about to reverse and shorts should be covered.

The first thing to look for to spot the piercing pattern is an existing downtrend. With daily candles, the piercing pattern will often end a minor downtrend (a downtrend that lasts between six and fifteen trading days). The day before the piercing candle appears, the daily candle should have a fairly large dark real body, signifying a strong down day. Here is an example of the piercing candle:

In the classic piercing pattern, the next day's candle gaps below the lower shadow, or previous day's low. I find with stocks (in comparison to commodities), however, that the gap is very often below the previous day's close, but not less than the previous day's low.

On the piercing day, the candle comes back into and closes at least halfway into the real body of day one. If it does not come at least halfway back, then the candle is not a piercing candle and needs to be called by a different name. (The candle is "on-neck" if it closes at day one's low, "in-neck" if it closes slightly back into day one's real body, and "thrusting" if it closes substantially into the real body, but less than halfway.) In addition, the second day's candle cannot totally make up the ground lost in day one, otherwise it would be a bullish engulfing.

Here are a few other points on the piercing candle. The closer it is to being a bullish engulfing candle, the more positive it is, and thus the greater the possibility of a reversal. Second, take particular note of the piercing candle if it occurs at an important support level. Third, if volume is strong on the piercing day, then the candle gains added significance.

The circled candles, which occurred in late September in the Lexar Media (LEXR) chart below, provide us with a perfect illustration of the piercing pattern. In mid-September Lexar peaked outside the Bollinger band, forming a bearish long-legged doji. This was then followed by a hangman candle. The stock stayed aloft for several days and then fell rapidly to a low of $16.80, a sell-off of almost 20% from the high. This minor downtrend took ten trading days and was climaxed by a fairly large negative real body candle with a small lower shadow.

The piercing candle gapped below the previous day's low, but not the lower shadow. As I mentioned above, this is a common occurrence with stocks. By the end of the day, LEXR closed well back into day one's real body. Within five trading days, the stock was at a new high, peaking at $22.25 and rewarding the alert swing trader with a very substantial gain.

Note that the piercing candle occurred at important support from two standpoints. First, it came just at the rising 30-day moving average, which often defines the trend. Second, $16.80 was a previous zone of support. Stochastics and ADX both gave buy signals almost immediately, confirming the piercing candle and indicating that the stock was off to the races. OBV had also remained above its own moving average, a sign of strength.

The piercing candle is a less powerful signal than the doji or bullish engulfing. Nevertheless, it is potent. Make a mental note to include it in your analysis the next time it occurs in a stock you own or are watching.

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