Here we are going to discuss an important multiple candlestick combination patterns. It is named the dark cloud cover pattern. It is a major bearish reversal signal. Candlestick charts show different combinations synchronizing with important price action phases. We identify and interpret those patterns considering them as a potential symbol of typical price movement.
Such candlestick combinations are time-tested over many years. Famous technical analysts, market research associates and traders across the world then come up with any major conclusion.
These all are probability studies that help up with the most probable conclusion. Hence, the candlestick patterns give us a probable but potential price action move shortly. The Dark Cloud Cover pattern is a similar pattern that indicates a potential market downturn.
What is Dark Cloud Cover Candlestick Pattern?
Unlike the piercing patterns, the dark cloud cover suggests the onset of a major bearish phase. As the name suggests, these signals indicate a major market turnaround downwards, showing the potential bad days looming ahead.
This pattern is potentially bearish. We also find it to be a bearish reversal indicator. The candle formation shows sunny days but all of a sudden dark cloud covers the horizon and darkens the scenario.
Here the pattern shows a turnaround from a bullish market to a major bearish market ahead.
Significance of the Dark Cloud Cover Candlestick Pattern
The dark cloud cover pattern indicates a potential bearish reversal from the existing bullish trend. It is a top reversal signal. It consists of two consecutive candlesticks. The first candle is green reminding us of the existing uptrend. The second is a red candle that signifies the start of a new bearish downtrend.
There’s a strong psychological aspect reflected in this pattern. The first green/ white candle reminds us of the continuing trend where the bulls are still actively participating in the trade. Even the second candle opens with a gap up showing that the euphoria of the bulls is still there which is pushing the stock price continuously upwards.
Later the bears come back and push the stock down. So after the opening of the stock, though bulls tried to force the stock price upwards, the price starts coming down by a long way. This creates the stock to come down end in red. This starts a bearish phase. Bulls lose confidence and ultimately give in.
Features of Dark Cloud Cover Candlesticks
This pattern is a combination of multiple candlesticks.
There should be a continuing uptrend. therefore the first candle is a tall, large green candle indicating the bulls are in action and are in a dominant position.
The second candle is also big but red in color showing that bears have taken over and dominated. The second candlestick opens with a gap-up opening price. Then the price comes down sharply and crosses the midpoint of the previous green candle.
Though the second candlestick is in red and goes below the midpoint of the first candle, it fails to close below the body of the first candle.
In the best-case scenario, the first and the second candle should have no wick or very small wicks (shadow).
There is the third candle in this combination which is red and follows these two candlesticks. The third candle denotes the onset of the bearish trend. It is best if the third candle closes below the low of the first-day candle.
Psychology Behind Dark Cloud Cover
This candlestick pattern consists of a large bearish candle(red candle) forming a “Dark Cloud” over the bullish candlestick (green candle). As with the bearish engulfing earlier in the trading session, buyers pushed the price higher, but later in the session, sellers took over and pushed it lower price range. This signals the shift from buying to selling the stock which causes a price reversal to the downtrend which can be predicted by this pattern.
As Dark cloud cover is only useful for the traders if it appears during an uptrend or when there is a rise in stock price. As the price increase, there is an occurrence of a potential move to the downtrend where traders can short their long position in this case. If the price movement is unpredictable then the pattern has less effective as the price is likely to remain unpredictable after the pattern is seen.
How to Trade with Dark Cloud Cover Pattern?
The diagram above shows an example of a dark cloud cover pattern forming on the daily chart of Sun Pharma. The diagram shows all the necessary preconditions for a cloud cover to form.
Here, the first candle or the P1 candle is part of the continuing uptrend and the bulls are dominating.
The second candle or the P2 candle opens with a gap-up and closes down below the midpoint of the P1 candle indicating that the bears have taken over the bulls.
The third candle, the candlestick next to P2, is a red candle. That candle closed far below the low of the P2 candle, confirming trend reversal.
The larger the body of the P1 and P2 candles, the stronger will be the reversal.
The trader may sell/ create a short position on the stock on the third day, just below the price of the close of P2.
Trading stop loss
The stop loss would be placed just above the high of the P2 candlestick.
Also the larger the gap between the closing price of P1 and the opening price of P2, the stronger will be the reversal.
The dark cloud cover pattern doesn’t have any clear target. Therefore, the trader should continue with the existing sale / short position until the stop loss was breached or at the start of another uptrend. Else the trader may trail the stop loss and watch if the trailing stop loss was breached or not.
Following a Dark Cloud Cover pattern, a trader might look for a breakdown from a major support level as an indication that a downtrend is on the way.
Read more about: Types of Trading Indian Stock Market
Entry, Stoploss & Target using Dark Cloud Cover
Long traders may want to consider exiting towards the close of the bearish candle(red) or the next day (confirmation day) if the price continues to fall. At these points, traders could also enter short positions.
If you’re going short, your first stop loss should be above the bearish candle’s high. In this situation, the stop loss might be set immediately above the confirmation day high after the confirmation day. If the price continues to decline, traders would set a downside profit target or continue to trail their stop loss down.
Importance of the Dark Cloud Cover pattern
This combination of candlestick patterns is important for the traders as a signal for a reversal of the downtrend. The Dark cloud cover has more significance as a possible downtrend indicator if in the daily chart it forms with a higher time frame. Its importance gets much reduced if the time is shorter.
There is a bearish trend on the candlestick which in fact opens higher but it takes away more than half of the previous candlestick’s profits. The candle appears optimistic at first, but suddenly “Dark clouds” appear as the price moves downwards.
If the third candle in the sequence closes below the first candle’s low, the bearish indication of the dark cloud cover is enhanced. Price may decrease continuously for some time after that, without any substantial upward move.
Similar and opposite patterns
The bearish engulfing pattern is a somewhat similar pattern to dark cloud cover though their formations are different. But both are essentially bearish patterns and both show bearish trend reversals.
Read more: Bearish Engulfing Pattern
The dark cloud cover is just opposite the piercing pattern, both in the formation and in interpretation.
Candlestick chart patterns are known to generate false signals when all conditions are not met. It is, therefore, necessary to be aware of false signals. A trader must also see to the fact that all preconditions are rightly in place.
In addition, price action may become erratic due to market noise. Else, during the highly volatile market scenario, or in eventful choppy markets, such signals should be avoided. On such days, the price movements deviate from the expected path.
Points to note
As with all candlestick patterns, the validity of the Dark Cloud depends on the price action around it, indicators, where it appears within a trend, and key levels of resistance. This pattern occurs at the onset of the probable downtrend, which makes it appealing at the entry-level.
To reach the desired outcome, the pattern must occur within the trend. It must also occur at the peak of an upward trend.
Traders cannot trade solely based on this chart pattern. The trader must also get confirmed from other indicators. RSI should be in an overbought position or there is divergence in the MACD indicator.