What is dark cloud cover?
Dark Cloud Cover is a bearish inversion candlestick pattern where a descending candle (usually black or red) opens above the closure of the previous candle (usually white or green), then closes below the middle of the rising candle.
The diagram is significant because it shows a change in the dynamics from upward to downward. The pattern is created by an upward candle followed by a downward candle. Traders expect the price to continue to fall on the next (third) candle. This is called confirmation.
Key points to remember
- Dark Cloud Cover is a candlestick model that shows a downward change in momentum following an increase in prices.
- The pattern is composed of a bearish candle which opens above but closes below the middle of the previous bullish candle.
- The two candles should be relatively large, showing strong participation from traders and investors. When the pattern occurs with small candles, it is usually less important.
- Traders generally see if the candle following the bearish candle also shows a price drop. A further drop in prices following the bearish candle is called confirmation.
Understanding Dark Cloud Cover
The Dark Cloud Cover motif involves a large black candle forming a “dark cloud” on the previous candle. As with a engulfing bearish model, buyers push the price higher at the opening, but sellers take over later in the session and push the price significantly lower. This shift from buying to selling indicates that a downward price reversal could occur.
Most traders consider the Dark Cloud Cover model useful only if it occurs as a result of an upward trend or an overall rise in prices. As prices rise, the trend becomes more important to mark a potential downward trend. If the price action is jerky, the pattern is less significant because the price is likely to remain jerky after the pattern.
The five criteria for the Dark Cloud Cover model are:
- An existing upward trend.
- A bullish candle (bullish) in this bullish trend.
- A gap the next day.
- The upward gap turns into a bearish (bearish) candle.
- The bearish candle closes below the midpoint of the previous bullish candle.
The Dark Cloud Cover motif is further characterized by white and black candlesticks which have long real bodies and relatively short or non-existent shadows. These attributes suggest that the decline was both very decisive and significant in terms of price movement. Traders can also look for confirmation in the form of a bearish candle depending on the model. The price should go down after the dark cloud cover, so if not, the pattern may fail.
Closing the candle can be used to exit long positions. Alternatively, traders can exit the next day if the price continues to fall (confirmed pattern). If you enter short at the close of the bearish candle or the following period, a stop loss can be placed above the top of the bearish candle. There is no profit target for a dark cloud cover model. Traders use other methods or candlestick patterns to determine when to exit a short trade based on Dark Cloud Cover.
Traders can use the Dark Cloud Cover model in conjunction with other forms of technical analysis. For example, traders can look for a Relative Strength Index (RSI) greater than 70, which confirms that the security is overbought. A trader can also seek a breakdown from a key support level following a dark cloud cover pattern as a signal that a downward trend may occur.
Example of dark cloud cover
The following graphic shows an example of the dark cloud coverage model in the short-term ETN VelocityShares Daily 2X VIX (TVIX):
In this example, the dark cloud cover occurs when the third bullish candle is followed by a bearish candle which opens higher and closes below the middle of the last bullish candle. The model successfully predicted a drop in the next session, where the price fell by almost 7%. This session confirmed.
Traders who were long could consider exiting towards the end of the bearish candle or the next day (confirmation day) when the price continued to fall. Traders could also take short positions at these times.
If you enter short, the initial stop loss could be placed above the top of the bearish candle. After the confirmation day, the stop loss could be lowered just above the highest confirmation day in this case. Traders would then set a downside profit target, or continue to follow their stop loss down if the price continues to fall.