Everything You Need to Know About the Dark Cloud Cover Candlestick

In this article, we will discuss

• What is the Dark Cloud Cover Pattern?
• Interpreting the Two Candles in the Dark Cloud Cover
• Key Characteristics of the Dark Cloud Candle
• Dark Cloud Cover Pattern: Occurrence and Frequencyy
• Trading the Dark Cloud Cover
• Limitations of the Dark Cloud Cover Pattern
• Conclusion

For any trader who wants to capitalise on short-term price changes in the market, technical analysis is crucial. In addition to studying technical indicators, you must also become familiar with candlestick patterns, which can give you crucial insights into price trends like consolidation, continuation and reversals. Some candlestick patterns indicate a bullish reversal, while others may signal a bearish change in the market.

The dark cloud cover pattern is one such indicator that can warn you of a potential bearish reversal in the markets, so you can prepare to enter a short position or close a long position. Let us take a closer look at what this candlestick pattern is, how it looks, what it means and how you can place a trade when you see this pattern appear.

What is the Dark Cloud Cover Pattern?

This is a Japanese candlestick pattern that can signal a possible bearish reversal in the market. It is a two-candle pattern that is formed over two different trading sessions or time frames at the end of a long-term bullish run. To better identify the dark cloud cover pattern, you need to know the physical attributes of these two candles. Here is how each candle in this pattern appears:

• The First Candle:

This is a bullish candle that occurs as a part of the prevailing uptrend. The candle is typically tall, with a long real body and perhaps distinct wicks. Sometimes, if the opening or closing price merges with the low or high price, this candle may not have either or both wicks.

• The Second Candle:

It is the second candle that really confirms the formation of the dark cloud cover. It is a bearish candle that opens above the highest point of the preceding bullish candle. This leads to a gap up between the previous and the current trading session. Furthermore, the second bearish candle closes well below the midpoint of the previous day’s green candle.

This is how the dark cloud cover candle pattern looks at first glance. It is not enough to merely have a green candle followed by a red one. On day 2, there must be a gap up and the closing price should be below 50% of the candle formed on day 1. These two distinct features can help you establish the formation of the dark cloud cover with some degree of certainty.

Interpreting the Two Candles in the Dark Cloud Cover

You now know how the red candle and the green candle in the dark cloud cover look. But what do they mean? Let us decode this aspect of the pattern, so you can interpret the candles better and understand how to trade this reversal pattern if you notice it has formed.

• The First Bullish Candle:

The first bullish candle is simply an indicator of the existing uptrend. Here, buyers remain in control of the market, so the price closes higher than it opened. When you notice this candle form on the chart, you may not have any clue that it is the beginning of a potential dark cloud cover pattern.

• The Second Bearish Candle:

The second red candle is what makes the dark cloud cover candlestick pattern noticeable. The gap up may be a sign that when the market opens, the buyers are still strong. This is what leads to an opening price that is above the previous day’s closing price.

However, the sellers quickly start to dominate the market and drive the price downward steeply — so much so that it drops below the midpoint of the previous day’s bullish candle. By the end of this trading session, the sellers gain control of the market and cause the price to close well below the opening level.

Key Characteristics of the Dark Cloud Candle

In a fast-paced trading environment, finding and confirming this pattern may be difficult. You may mistakenly look at any combination of a green candle followed by a red candle and tag it as this pattern. However, to avoid this costly mistake, you need to look for a set of five key characteristics unique to the dark cloud cover. They include the following features:

• A Prevailing Upward Trend

The first important feature to verify is the prevailing trend, which must be bullish. A dark cloud cover only occurs at the end of an uptrend. So, if you notice this pattern in the middle of a downtrend, that may not signify a bearish reversal at all.

• A Bullish Candle on Day 1

Once you have confirmed that the prevailing trend is bullish, you need to ensure that a bullish candle forms on the first trading day/session. At first glance, this candle may simply look like a continuation of the prevailing bullish trend.

• A Gap Up on the Next Day

When the market opens on the next trading day, the first thing you will notice is a gap up, where the opening price jumps a few points above the previous day’s closing price. This may give the impression that the buyers are still in control and driving the price upward.

• A Bearish Candle on Day 2

The formation of a bearish or red candle in the second trading session is the most important giveaway that you may be looking at a dark cloud cover pattern. As this session progresses, the price steadily falls and closes well below the opening price, leading to a red candle.

• Day 2 Closing Price Below 50% of the First Candle

Another important sign to watch out for is the level at which the red candle closes. For a pattern to be called a dark cloud cover, the closing price should be below the midpoint of the previous green candle. This means the sellers have gained enough control to push the price down significantly.

Dark Cloud Cover Pattern: Occurrence and Frequency

Since this pattern indicates an incoming downtrend, it typically occurs at the end of a prevailing uptrend. The second bearish candle in the pattern may indicate the beginning of a downtrend after the current bullish market. However, to ensure that this is not a false signal, you can wait for another trading session to confirm the formation of another red candle.

As for its frequency, the dark cloud cover pattern is fairly common. It may appear more frequently in volatile markets, but many of these may be false signals. In stable and trending markets, however, this pattern may be less common. That said, if it does appear during a trending market, it is less likely to be a false signal. To ensure that you are not misled by such false signals, you need to also use technical indicators like moving averages, RSI, volume indicators and MACD.

Trading the Dark Cloud Cover

When you notice this reversal pattern on the price chart, you can either exit a current long position you hold or initiate a new short position in the market. Let us take a closer look at how each of these scenarios works.

• Scenario 1: Closing an Existing Long Position

If you are already long in the market, you can consider closing your position when you notice a dark cloud cover candle because it may be a sign that the prices will fall. The ideal price at which you can exit the long position would be at the closing point of the bearish candle.

For instance, say you entered the market and purchased a stock at Rs. 100. Now, suppose that the dark cloud cover you notice has the following price points:

• Green candle: Opens at Rs. 110 and closes at Rs. 114
• Red candle: Opens at Rs. 115, has a high of Rs. 116 and closes at Rs. 111

In this case, you can exit your long position at Rs. 111, thus earning a profit of Rs. 11 per share.

• Scenario 2: Opening a New Short Position

When a dark cloud cover forms, it also presents an opportunity to open a new short trade in the market. For this new trade, you can set the entry, stop-loss and target price points as outlined below.

• Entry price:

The entry price for a short trade initiated after you notice this reversal pattern is typically the closing price of the bearish candle. So, in the hypothetical example we’re discussing, you would initiate your short trade at Rs. 111.

• Stop-loss:

Since this pattern can sometimes offer false signals, it is important to be prepared for a rebound after the reversal. You can set a reasonable stop-loss limit to restrict the downside in case of a false signal. The stop-loss price should ideally be just above the highest price in the bearish candle. In our example, that would be just above Rs. 116. You can set the stop-loss price a few ticks above this limit, say at Rs. 116.50 or Rs. 117.

• Target price:

There are two ways to set a target price for your short trade. One way is to identify a support level just below your point of entry. So, for instance, say you entered the trade at Rs. 111 and the immediate support level below that point is Rs. 105. In this case, your target price or take-profit level would be Rs. 105.

Alternatively, you can also use any risk-reward ratio you are comfortable with to set a target price for exiting the short trade. In this scenario, the maximum risk you are taking is defined by your stop-loss, which is set at Rs. 117. This means a maximum possible risk or loss of Rs. 6 (from your entry at Rs. 111 to the stop-loss at Rs. 117). Now, if your preferred risk-reward ratio is 1:2, you can set the target price at Rs. 12 (i.e. two times) below the entry point. This will give you a take-profit level of Rs. 99.

Limitations of the Dark Cloud Cover Pattern

Now that you know how to set the different price points for any trade based on this reversal pattern, you may be eager to spot and trade this pattern. However, before you do that, you need to be aware of the limitations or risks that this pattern carries. Check out these important details below:

• False Signals

The dark cloud cover may occasionally produce false signals about impending bearish reversals. To avoid trading based on such false signals, you need to combine your candlestick chart analysis with further technical analysis and look at different technical indicators to confirm a possible bearish reversal.

• Lagging Indicator

This reversal pattern often only reveals a bearish trend after it has begun. This minor lag may not be significant for most traders, but if you want to stay ahead of the market, the lag may be an issue for you.

• Less Reliable in Volatile Markets

In highly volatile markets, prices fluctuate wildly even when there is no established market sentiment. So, you may notice the pattern forming in such volatile markets even if there is no apparent shift from a bullish to a bearish mood in the market.

Conclusion

Like all candlestick patterns, this one may also occasionally produce false signals. To confirm how reliable this pattern is, you can rely on other indicators used in technical analysis to check how strong the bearish sentiment is. For instance, you could look for appropriate moving average crossovers, RSI values and Bollinger Bands, among other indicators. Once the reversal is confirmed, ensure that you set the required stop-loss limits for any trade you implement in the market.

To identify and use the dark cloud cover pattern for your trades, you need to have real-time access to candlestick charts. The new-gen Samco trading app — with its seamless integration of TradingView charts — can help you with this. To access the various types of charts available on the TradingView platform free of cost from the comfort of your smartphone, you only need to sign up for the Samco demat and trading account and log into the Samco trading app, where you can view these candlestick charts and more live from the markets.

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