What Is Dark Cloud Cover?
Dark cloud cover is a Japanese candlestick charting pattern that aids technical traders in identifying the exhaustion of bullish price action. Classified as a bearish reversal pattern, dark cloud cover is commonly seen as a signal of an exhausted uptrend, or the end of bearish trend retracement.
Depending upon the pattern's location within the context of a trending or consolidating market, it can serve as an indicator of long-term market reversal or bearish trend continuation.
The formation can be implemented on many different financial products or time frames. Typically, it's used on the daily time frame, but it can be utilised on an intraday or long-term basis.
Constructing Dark Cloud Cover
In order for the dark cloud cover charting pattern to exist, the following elements and conditions must be present and satisfied:
- Consecutive candlesticks: Two consecutive candlesticks are necessary to construct the formation.
- Positive candlestick: The initial candlestick in the formation is an obvious bullish candle. This means that the close is located definitively above the open, and the body of the candle is white or the designated positive color.
- Negative candlestick: The second candlestick in the series serves as the dark cloud referenced in the pattern's name. The dark cloud is a large negative candle, meaning that its close is decisively below its open. The body of the candlestick appears black or the designated negative color.
- Open and close of the dark cloud (negative candlestick): Two key requisites of the negative candlestick must be satisfied in order for the pattern to occur. First, its opening price must be located above the high of the initial positive candlestick, the result of a pricing gap created through aggressive buying. Then, the close must be below the midpoint of the first candlestick's body, signifying a rejection of the gap up in price.
- Confirmation: Confirmation of the pattern occurs when a subsequent negative candlestick is formed, with its body extending below the low value of the second candlestick. Confirmation is a crucial aspect of the chart pattern. It's a signal that bearish sentiment has taken definitive control of the market, not that sellers have merely reacted to the pricing gap.
Applications Of Dark Cloud Cover
The predictive value of dark cloud cover depends upon several unique characteristics of the pattern itself. First, the size of the negative candlestick plays a key role in determining the probability of selling pressure becoming the dominant form of price action. As the negative candle overlaps more of the initial candle's body, the strength of the selling is deemed stronger and the probability of confirmation becomes larger.
Also, the location of the pattern within the context of the overall market state lends validity to the chance of a directional move. For instance, if the pattern forms during the retracement of a strong downtrend, then the possibility of the trend extending becomes very real.
However, in the event that the dark cloud cover formation occurs at the extreme top of a buying trend, then the possibility of market reversal comes into play. In this scenario, the pattern is viewed as sign of bearish intervention. Rejection of the previous gap up in pricing, coupled with confirmation, can be a precursor to a longer-term change in market direction.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…