The piercing candlestick pattern belongs to the multiple candlestick patterns where we use a specific combination of candlesticks to determine the trend and project the next course of price movements.
We assume that after a downtrend, this combination of candlesticks gives us a trading signal. A two-day or maybe a two-period consecutive set of candlesticks form a specific pattern. This pattern consists of two consecutive candlesticks, first a bearish candlestick and a bullish candlestick immediately after that.
We generally consider the green candle as the bullish candle. And the red candle is the bearish candle. there are the older schools of thought, that considered the black candle as the bearish candle and the white candle as the bullish candle.
Before moving further let us see what it looks like in a diagram.
As in the diagram above, we can see two candlesticks in two successive periods. The first one is the red candlestick and the next candlestick is green. Red being the bearish candle (as per presumption), is the first candle that shows that the stock was in selling mode.
The next candle is green which shows bullishness. From earlier discussions, we know that when the price of a stock closes at a higher price than the opening price, the candle becomes green and the stock shows bullishness for that period of time.
The piercing line is a bullish trend reversal line. Therefore it can be presumed that the reveal occurs after a downtrend. This also signifies that the candles before the red candle would be red also.
Characteristics of the Piercing Candlestick Pattern
The piercing pattern is a bullish trend reversal pattern. Therefore this pattern can not be seen in a bullish trend. This is a trend reversal signal. Hence the previous trend has to be bearish before this pattern occurs.
This is essentially a two candlesticks pattern. we will discuss it after viewing the following image.
In the diagram shown above, we can see two consecutive candles, first the red and then the green. The opening period candle, P1 is a bearish candle. Both of these two candles have comparatively large bodies.
The opening price of the first candle is above the closing price of that candle. That shows the price closed in negative territory and the candle is bearish.
The second candle (P2 candle) opens with a gap down. The gap down signifies that the opening price of the P2 candle is far below the closing of the P1 candle. That is the price on the second day opened far below the closing price of the first day.
We can understand it from the fact that the green candle started far below the bottom of the first candle.
The second candle closes after crossing the half-length of the first candle.
We call this P2 candle, which is a bullish candle. From the diagram above, it can be seen that the bullish candle has gone above the 50% length of the first candle and then closes above it.
Key takeaways from Piercing candlestick patterns
It is evident from the diagram above there are a few takeaways. We can call them the key factors.
The key factors are as follows.
The first candle should be a part of a downward trend. The downward trend is supposed to end at the P1 candle.
The body of both the P1 and P2 candles must have large bodies.
The P2 candle should open at a gap-down price.
The length of the body of the P2 candle must be more than 50% of the length of the body of the P1 candle, the first candle.
A new short-term trend starts after the second candle. That is why this pattern is considered a bullish trend reversal.
Why do we call this Piercing line pattern?
In technical analysis, the piercing pattern signals are known to be a potential signal for a bullish reversal. The typical formation in the strictest sense can be rarely seen. But a similar pattern can be seen after a long downtrend.
The pattern after a long downtrend denotes a bullish reversal. The bullish reversal shows a typically forecast about only five days out.
The second candle which forms the piercing pattern opens with a gap-down opening. This is a must condition for this formation to happen.
The second candle shows the come of bulls that overpower the bears and pushes the candle upwards to close way up in the green zone.
The typical two big consecutive candles are also unique for this piercing line candlestick pattern. However, there are other conditions also that must be satisfied for this formation to form.
The size of candlesticks is important in piercing pattern
The diagram above shows the candle size. They must have large bodies. The large body of a candle can be seen when the gap between the opening price and the closing price is big. This also indicates that both the buyers and sellers were active all through the day.
High trading volume
High trading volume occurs when both the buyers and sellers are active. This also means that there is a tussle going on between the bulls and the bears on those two days, i.e. on the days of P1 and P2.
Because of the reason that on both the days the bulls and bears were very active, hence we get large candles.
Bears win on day one
Since the first candle was part of a long downtrend, the P1 candle is red. The bears win that day. Though the bulls were very active, the candle ends in red.
Bulls win on day two
The bulls were dominated by the bears on the first day. That continues even during the opening of the second day. Bears, active on day one, start the day with a gap down of the opening price to continue the prevalent downtrend.
But then the bulls return with vengeance. They act fast and overpower the bears by just whisking them off their ground. That starts the reversal of the existing downtrend.
The bulls win ultimately and take the price further up, closing the day after crossing the midpoint of the previous day’s candle.
How to use the piercing line candlestick formation?
The piercing line candlestick pattern works best when there is an existing downtrend. In the figure above, we can see that the long downtrend continued, even after small pullback rallies.
At the very end of that downtrend, we can find a pair of large candles. Both the candles have big bodies. The first one is red and the second one is green.
After the second candle closed, a new bullish trend started. Here the piercing pattern satisfies all the conditions. Therefore, we can see a big bullish reversal of the trend.
Size of the Second Candlestick pattern
The size of the second candle matters most. This candle tells us the bulls have returned and taken control of the stock. Therefore the second candle or the P2 candle must fulfil all the preconditions to form this pattern.
The second candle should go well over the mid-point of the length of the body of the first candle.
The secondly must also end in the green zone indicating a bullish reversal of the earlier downtrend.
The bullish reversal in the terms of candlestick pattern
The action of bulls is the indicative feature of the second candle. Till the first candle, all were well for the bears. They were active and happily taking the stock down. From the second candle bulls win and start to take the market upwards.
This piercing candlestick pattern is a typical setup. If all other conditions are present, this pattern shows us a clear bullish reversal of the trend. When this pattern occurs, the RSI, MACD and other technical indicators also show bullish divergence. Thus a trader can have a prior conviction on his trade outcome.
Trade setup for piercing candlestick pattern
When a trader can find the piercing candlestick pattern, the trader must confirm whether all other conditions are already there.
So, the trader must wait for the second-day trade to be completed. The green candle of the second day must cover the midpoint of the first-day candle.
On that particular stock chart, the second day should open with a gap down price.
The trader should wait until the high of the first candlestick is succeeded by the previous bearish candle.
For an ideal trade setup of piercing patterns, this must be seen on the stock chart.
Trade entry point: The trader should enter the stock on the third day, at or near the high of the second candlestick.
The trade stop loss: The stop loss should be the low of the previous bearish candle.
The exit point: The trader should wait for an exit from the stock if the stop loss is decisively breached. Else the trader can carry forward with a trailing stop loss for an early exit.
Otherwise, the trader may exit at the next signal for a downtrend.
The most suitable time frame
This piercing candlestick pattern suits the swing traders the most. The success rate is quite high for traders who operate at longer time frames.
This pattern suits the traders who trade using daily charts and weekly charts.
It is best to get trade confirmation from other technical indicators before entering the trade.
Trade example of piercing candlestick pattern
Now let us find a true example in a stock chart.
This is a daily chart of Sun Pharmaceuticals Industries Limited.
The chart shows us that SUN (symbol of Sun Pharma) was under a long bearish trend.
At the end of the bearish trend, there is a large red bearish candlestick followed by a large green candle. Let us consider that the red candle is P1 and the green candle is P2.
The P2 candle started with a gap down open and then went further below, showing the strength of the bears still active in the trade.
The P2 candle closed above the midpoint of the P1 candle. This move started the bullish reversal trend. After P2, the bullish trend continued.
A trader will enter the stock on the third day above the closing price of P2. The stop loss would be just below the low of P1.
When the uptrend starts, the trader can continue to hold the stock bought on day three, till the stop loss is triggered. Or continue holding the stock with a trailing stop loss. Else the trader remains on the stock till another downtrend occurs.
Importance of Market Volume in Candlestick pattern
The volume on P1 and P2 days is very important. Unless we have a large real body of candles on p1 and P2, the pattern will not have a true effect. The large candles may also mean great trading volume.
It is an automatic condition that when both bulls and bears are highly active, the volume would be large. On P1 the volume will be large when bears win over the bulls. On the other hand, on the day of P2, there will also be a large trading volume. But the bulls will win at the end and start the bullish reversal.
Limitations of piercing candlestick patterns
The ideal condition of the piercing line pattern rarely happens. The piercing line pattern has to occur at the end of a long downtrend. With that, the other conditions have to be met also. All these conditions are ideal conditions and can be rarely found.
Therefore, it becomes necessary to get confirmation from other indicators. Indicators like RSI, and MACD are helpful in such cases. Say when there is divergence in RSI and MACD, and the piercing pattern appears after a bearish candle, we can be more convinced to take a trade entry into the stock.
We can also find modifications to this strategy. One such strategy can be found here. The researcher here has taken the trades on different currency pairs over a long time period, using daily charts. For the successful implementation of the strategy, the researcher used 10 consecutive pips to form a successful trading model using the piercing line candlestick pattern. The details of the trading model can be found on the link mentioned above.