Today's Trading Lesson From TradingMarkets

In this lesson, I'd like to share a candlestick pattern that I watch for quite frequently in my trading: the Evening Star formation.

By definition, the Evening Star is a formation that warns of a probable reversal of an uptrend.  The pattern is formed by a green (or white) candle, followed by an upward-gapping doji (of any color), followed by a red (or black) candle that moves into the real body of the first candle.  In a perfect world, there will be a gap between the second candle and the third as well as between the first and second candle. While this additional gap would give stronger credence to the reversal, the degree of penetration of the third candle into the first candle's real body is more important. The deeper the penetration, the more the likelihood of a reversal. The formation not only identifies a sell-signal, but also gives you a clear resistance level.  If price action takes out the high of the doji, the pattern is negated.

When trading, you must remember, first and foremost, that the stock market is not made up of paper and charts.  It is made up of people, and as such, you are trading emotions.  Charts, especially candlestick charts, help give a graphic presentation of the emotions behind the people trading.  In the Evening Star formation, the first green candlestick is filled with people jumping on a train, filled with excitement as their stock pushes higher and higher.  The second candlestick gaps up as more and more people want to jump on that train looking for even higher prices. Then, as the momentum slows and the stock price begins to slowly move lower, people begin to question their judgement.  A "warning flare" (the doji) has been shot.

On the third day, a few things occur.  The people that jumped on early in the game (the first green candlestick) begin to get nervous. Then, they begin to get nervous and bale out of their positions. People that have small losses start to hit the sell button before their losses get bigger. The momentum crowd has turned to the next hot stock, so the bids start to disappear. The degree to which people start selling can be seen in how far the third day's candle moves into the first day's candle. The stop for this formation is clearly the high of the second day (the doji), as the overhead supply is found in this candlestick. If new buyers are able to absorb the supply of stock from the sellers who bought on the day of the doji, the negative reversal implications of the Evening Star pattern would be negated.

The following are a few charts of stocks and indexes that I have played short in the past based on the Evening Star formation I found while scanning for plays.

At the risk of moans and groans from people who have seen me use this chart repeatedly in all of my recent commentaries, here's the NDX (Nasdaq 100 Index) daily chart. You can clearly see three Evening Star formations on this chart.

On the following chart of Ciena Corp. (CIEN), you can clearly see two Evening Star formations.

Here's one of my favorites, Hott Topic (HOTT).

And another favorite, but this time shown on a weekly chart.

The Evening Star formations on the following chart of J.P. Morgan Chase & Co (JPM) showed impending trend reversals well in advance of large moves down in the stock price.

The following two charts are of Juniper: Networks (JNPR). In just the short period of time I include here on the daily chart, there were three clear Evening Star formations, all of which led to very profitable trades.

Looking to a longer time frame, we turn to a weekly chart of Juniper

While you can probably identify more than just the three Evening Star formations I've pointed out on this chart, I think the two I've shown in red show us how weekly charts (and even monthly charts) can clue us in to trend reversals that have longer-term implications.  If you had been watching Juniper's weekly chart for signs of an imminent trend reversal after its extended uptrend, you would have seen the Evening Star.  Most importantly, you would have been ready to short the stock on any move back into the 215-240 area in October of 2000.  If you take time to pull up charts of most of the 1999-2000 "high-flyers," you'll see this formation appear time and time again.

For my final chart, I show a monthly of the Nasdaq Composite Index (COMPX).  I think the chart says it all...

Hopefully, I've been able to show enough examples of the Evening Star formation that you'll be able to quickly identify it when performing your nightly/weekly chart scans.  It truly is one of my favorite formations, and I took trades on all the stocks and indexes shown above once I identified the Evening Stars.  If you have any questions, please post a message on the "Market" section of the Message Boards or send a question via TradingMarkets, and I'll try to answer them in a future column.