Morning star pattern holds an important place in technical analysis. It forms after a continuous downtrend in the stock prices. It is a reversal pattern indicating the reversal in ongoing bearish trend. It is a bullish candlestick pattern.
Morning star is a term which indicates light after darkness. After the ‘darkness’ of price fall ends, there is light, means prices are likely to rise in coming days. The name of this pattern is inspired from the planet Mercury in our solar system. Mercury is known as a morning star.
Formation of Morning Star Pattern
Morning star pattern forms after a significant price fall. It is a three candlestick pattern. You would need to see the fourth green candlestick of follow up buying as a confirmation signal of expected stock price rise.
The morning star pattern starts forming with first big bearish red candlestick indicating significant sell off in the markets.
Next trading day, prices open lower with a gap down from the previous day closing price. After completing its trading range for the day, the prices again close lower than the previous day closing.
That day of trading may make a green or red candlestick. The colour of the candlestick is not of much significance although green candlestick is more favourable. This candlestick is a small body candlestick with shadows on both sides. This tells us that some buying is emerging at lower levels although sellers are also equally strong.
On third day of trading, the prices open higher with a gap up from the previous day closing. Buyers or the bulls take the control of prices and the sellers or the bears start giving up. In the end, the price closes significantly higher making a big green candlestick (third candlestick). The closing may be almost near or above the opening price of first bearish candlestick.
This completes the morning star pattern. If follow up buying continues the next trading day or the 4th trading day, the pattern gets confirmed. Otherwise the pattern may be a false signal. See a failed pattern in below image where there was no follow up buying on 4th day of trading.
Gaps we mentioned are very important for the pattern to be more favourable. There should be gap on both sides of the second trading day candlestick in the morning star pattern.
How To Trade The Morning Star Pattern
When the pattern is confirmed, the trader may find opportunities to create long positions or start buying the concerned stock. The prices are expected to move higher for the short term. Targets for the up move are towards the higher resistance levels.
The lowest price touched by the stock (swing low) in morning star pattern becomes your stop loss for the trade. Keep your stop loss just below that price level.
You can buy the stock on the day of formation of third candlestick itself, just before the market close. Better, you can buy the stock on next trading day. The drawback of the morning star pattern is that your stop loss for the trade becomes very deep due to gap ups. The decision to buy on the fourth day, after the confirmation, can give you a better entry level. However, the further gap up opening on fourth day may also result in missing the trade. But, you can definitely get the better entry if you wait for few days in that case. You can see in the above charts that sometimes prices showed some retracements for better entry after gap up moves.
Keep your risk reward ratio favourable while taking this trade. Start buying near the support level or the stop loss. Don’t just jump into the trade at any available price in a hurry. Wait for the prices to come down to go long. Markets give opportunities to buy at lower level.