Use This Simple Three Candlestick Pattern to Find Bottoms in Stock Prices

In this era of algorithm-driven financial markets, stock prices can be volatile and extreme. Often a stock price overreaction (steep sell-off) can present a compelling buying opportunity. Unfortunately, this tends to materialize in the “rearview mirror” well after prices recover. A simple three-candlestick pattern known as the market structure low (MSL) can be applied during these situations to better spot a potential buying opportunity complete with a built-in buy and stop-loss trigger.

Japanese Candlesticks

Originated by Japanese rice traders, they plotted four price points composed of the 1^st trade (opening price), the last trade price (closing price), the highest price and lowest price on a graph to provide a snapshot summary for specific incremental periods of time. The plots resembled candlesticks composed of a body representing the opening and closing prices and the wicks on either side representing the highs and lows.

 

Bullish candles were colored green since the closing price was higher than the opening price. Bearish candles were colored red indicating the closing price lower than the opening price. By plotting these candlesticks next to each other on a chart, traders were able to identify price patterns and develop methods to game trends and reversals.    

The Market Structure Low  (MSL) Pattern

Using a candlestick chart for any stock, the market structure low (MSL) pattern enables users to identify potential price bottoms along with the buy trigger and a stop-loss price level. One candlestick alone doesn’t provide much information. However, a series of continuous candles enables us to gauge price trends and reversals. The MSL pattern is a reversal pattern that forms after a sell-off, thereby enabling traders to catch the bounce or find a pullback entry on an uptrend. There are three steps to trading this pattern.

Step One: Four or More Consecutive Lower (Candlestick) Lows

To produce a meaningful price bottom reversal, it must first build panic with successive selling action. This can be spotted with four or more successive candlesticks each making a lower low indicated by the lower wicks (also referred to as tails).

Step Two: Lowest Low Candlestick

Eventually, a final lowest low candlestick will form indicated by the lowest point of the wick. The candle that forms this lowest low is the MSL candle. The low price of this candle acts as a stop-loss trigger if the price falls back under this level. When counting the candles in real-time, each lower candlestick has the potential to be the lowest low until a higher low candle forms. This takes us to step three, the higher low.

Step Three: Higher Low

This is the most important candle also known as the MSL Trigger candle. Once this candle closes, it’s important to mark the price of the lowest low on the preceding MSL candle, then mark the high of the MSL Trigger candle. From this point forward, the stop-loss is set under the low of the MSL Candle and the buy signal trigger above the MSL Trigger candle high price.

Best Use Applications

Spotting price bottoms using MSL triggers can be useful during panic sell-offs to profit from price recovery. They can also enable opportune entry levels to enter a position on a pullback within a general uptrend, rather than chase an entry at the highs. As a defensive measure, it can be used to take a stop-loss on temporary “dead cat” bounces on a down-trending stock.

Recap

In summary, the three-candlestick count starts with the lower low candle that precedes the lowest low candle followed by a higher low candle. These three-candlesticks (numbered 1, 2, and 3 in the illustration) shape the bottoming process complete with the stop-loss under the lowest point and a buy trigger above the MSL Trigger candle high. It sounds more complex than it is at first. However, this basic pattern is effective for both intra-day trading or longer-term positions. Adding more charting indicators that measure price momentum on multiple time frames can forecast price trajectories and spot key price inflection points days to weeks ahead of time. In future articles, we will explore these indicators along with strategies that can refine the accuracy and improve the probabilities of price action patterns. As with any trading or investing decisions, always consult with a professional before taking the plunge.