A trader must be aware of reversal signals appearing on chart as it enables him to lock in profits or position himself early in a trade. Today we are going to discuss one such reversal signal that appears frequently on the chart. The signal I am talking about is- Dark cloud cover candlestick pattern.
This pattern is bearish opposite of Piercing pattern which we have already discussed in an earlier post.
Let's get started.
What is Dark cloud cover candlestick pattern?
A Dark cloud cover pattern is a bearish reversal candlestick pattern that frequently appears at the top of an uptrend or before a correction in an uptrend.
It is a two candle pattern that signals a bullish momentum exhaustion and is most effective after a sustained rally or at a key resistance level. As the name suggests, it represents a 'dark cloud', a bearish candle descending over a previous green candle. More of it in the identification part in the next paragraph.
How to identify the Dark cloud cover pattern?
Identifying a Dark cloud cover is easy once you understand the morphology of candles involved in the pattern.
The first candle of the pattern is a big bullish candle (green or white). This must form within an established uptrend, indicating the control of bulls in the market.
The second candle has a gap up opening, ideally above the high or at least above close of the previous candle. This initial gap indicates continued buying pressure at the open. However, shortly after this gap up, the price starts falling forming a bearish candle. This bearish candle (second candle of the pattern) must close below the mid-point (50% level) of the actual body of the first candle.
If the second candle doesn't close below the 50% mark of the first candle, the pattern is not a valid Dark cloud cover. It is called a bearish thrusting line.
Dark cloud cover Vs Piercing pattern
Dark cloud cover is mirror image or opposite of Piercing line pattern. While Dark cloud cover is a bearish reversal signal, Piercing pattern is a bullish reversal sign. I have written a separate post on Piercing pattern that you can go through to have a better idea about this pattern.
The image below shows the difference between the two patterns.
How to confirm the Dark cloud cover pattern?
While candlesticks and candlestick patterns give important clue regarding sentiments and change in change in momentum in a stock, trading them alone in isolation is risky. That is why smart traders look for confluence of signals- multiple signals agreeing with one another, before taking a trade.
Here is how you can confirm the Dark cloud cover pattern with other signals.
The Volume confirmation-
Volume validates price action. In context of Dark cloud cover pattern, high trading volume should accompany the second candle of the pattern. This indicates that either buyers are exiting their positions or sellers are taking a short position early.
The Resistance confirmation-
The pattern becomes more reliable when the gap up of the second candle hits a known key resistance zone, trendline, or a Moving average and fails to break it through.
The Third candle confirmation-
Once you have identified the pattern, wait for the next candle to form. If the third candle opens lower and continues to go down, the pattern and reversal is confirmed.
The RSI Confirmation-
If the price makes a new high while the pattern is formed but the RSI does not, it indicates a weakening momentum. A RSI divergence or a RSI failure swing at the point of formation of pattern adds reliability to the pattern.
The Bollinger band confirmation-
Price stretched outside the upper band of the Bollinger band while the second candle starts and coming back inside afterwards is another signal you should watch out for while validating the pattern.
How to trade the Dark cloud cover pattern?
Once you have correctly identified the pattern and confirmed it through various signals, you have to plan your entry and exit. Here is a standard trading strategy to trade Dark cloud cover pattern.
Entry-
You can have two kinds of entry while trading a Dark cloud cover.
Aggressive entry- In this kind of entry you enter a short position at the close of the second candle itself. While this entry provides early entry with a favourable risk-reward ratio, the tradeoff is a higher rate of failed trades.
Conservative entry- In this kind of entry, you wait for the third candle and enter a short position once the third candle breaks below the low of the second candle. This adds another layer of confirmation, enhancing the success rate of trade, however, this also lessens your risk-reward ratio as you have to place wider stop-loss.
Exit-
Once you have entered a trade using Dark cloud cover pattern, place your stop-loss slightly above the high of second candle. Price breaking this high means that the reversal has failed.
Once trade goes in your expected direction you can take profit at next support level or use a risk reward ratio of 1:2 or trail your stop-loss to maximize your gains.
How reliable is Dark cloud cover pattern?
While Dark cloud cover pattern is a classic reversal pattern, it is not infallible.
A Dark cloud cover pattern in a choppy sideways market is often a noise that generates false reversal signal, however, the accuracy increases in a trending market. To be reliable, it must appear in an uptrend.
The body sizes of the candle is another thing to note to increase the accuracy of the pattern. The longer the real bodies of the both candles, the more significant the reversal. Small bodies indicate indecision rather than a decisive shift.
Statistical backtesting suggests that while the pattern does predict reversals, it often leads to a short term pullback rather than full trend change. Therefore, it is best used as a signal to exit long positions or to initiate short-term swing trades, rather than betting on a full trend change.
Comparing it with other reversal patterns, it has been noticed that the Bearish Engulfing and Evening star patterns give better success rates while trading reversals.
The Bottom line-
The Dark Cloud Cover pattern is a potent warning signal for traders, that signals a probable shift in market sentiment from bullish to bearish.
While it is an effective tool for identifying exhaustion in an uptrend, it should always be used after confirming it with other signals or indicators.. By combining this pattern with confirming indicators—such as volume, key resistance levels, and RSI divergence—traders can filter out market noise and significantly improve their success rate.
Whether you use it to timely exit a long position or to initiate a strategic short trade, disciplined execution with proper stop-losses remains important. As with all technical analysis, treat the Dark Cloud Cover not as a guarantee, but as a probability enhancer that, when mastered, adds a critical edge to your trading arsenal.
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