High Probability Scenario- Signal followed by Gap up in Oversold condition
Candlestick signals depict change in investor psychology. This fact is mentioned several times in this website. We believe this is the most important concept behind charting the stock movement using candles. The formation of the candles, their size, color and location together act as an x-ray machine showing us the health of the market and the dynamics behind the price movement.
When a stock is in a downtrend, the sentiment is bearish. All news is considerd bad news. Any attempt at a rally is immediately followed by a selling spree. That is a function of human emotion. However there comes a point in the downtrend, where the supply is overcome by the demand. The sentiment which was bearish till then, is now ending and a new enthusiastic wave of buyers is coming in. The bears are tired at this point. The first sign that the bulls are coming in will be a formation of a candlestick buy signal. Conditions would already be oversold by now. What is needed to prove the candlestick signal validity? A confirmation by the bulls the following day.
If the bulls manage to close the price higher the next day, probabilities are high that the trend is reversed. However, if the stock gaps up following the signal and closes higher, it implies to the bears that the upward force is very strong. After all what does the gap up represent? It represents the fact that there is dramatic enthusiasm to buy the stock on the open. If that enthusiasm persists throughout the day, the bears will be very nervous and will start covering their short positions, thus leading to more upward pressure on the stock.
Candlestick traders should always watch for such opportunities. The chart for Barr Labs shows a Hammer Harami forming in an oversold area. The next day, the bulls gap up the stock and a profitable trend ensues from that point on.
Chart courtesy stockcharts.com