DARK-CLOUD COVER

DARK-CLOUD COVER

Our next reversal pattern is the dark-cloud cover (see Exhibit 4.24). It is a two candlestick pattern that is a top reversal after a uptrend or, at times, at the top of a congestion band. The first day of this two candlestick pattern is a strong white real body. The second day's price opens above the prior session's high (that is, above the top of the upper shadow). However, by the end of the second day's session, the market closes near the low of the day and well within the prior day's white body. The greater the degree of penetration into the white real body the more likely a top will occur. Some Japanese technicians require more than a 50% penetration of the black session's close into the white real body. If the black candlestick does not close below the halfway point of the white candlestick it may be best to wait for more bearish confirmation following the dark cloud cover.

The rationale behind this bearish pattern is readily explained. The market is in an uptrend. A strong white candlestick is followed by a gap higher on the next session's opening. Thus far, the bulls are in complete control. But then no continuation of the rally occurs! In fact, the market closes at or near the lows of the day moving well within the prior day's real body. In such a scenario, the longs will have second thoughts about their position. Those who were waiting for selling short now have a benchmark to place a stop—at the new high of the second day of the dark-cloud cover pattern.

The following is a list of some factors that intensify the importance of dark-cloud covers:

1. The greater the degree of penetration of the black real body's close into the prior white real body, the greater the chance for a top. If the black real body covers the prior day's entire white body, a bearish engulfing pattern would occur. The dark-cloud cover's black real body only gets partially into the white body. Think of the dark-cloud cover as a partial solar eclipse blocking out part of the sun (that is, covers only part of the prior white body). The bearish engulfing pattern can be viewed as a total solar eclipse blocking out the entire sun (that is, covers the entire white body). A bearish engulfing pattern, consequently, is a more meaningful top reversal. If a long, white real body closes above the highs of the dark-cloud cover, or the bearish engulfing pattern, it could presage another rally.
2. During a prolonged uptrend, if there is a strong white day which opens on its low (that is, a shaven bottom) and closes on its high (that is, a shaven head) and the next day reveals a long black real body day, opening on its high and closing on its low, then a shaven head and shaven bottom black day have occurred.
3. If the second body (that is, the black body) of the dark-cloud cover opens above a major resistance level and then fails, it would prove the bulls were unable to take control of the market.
4. If, on the opening of the second day there is very heavy volume, a buying blow off could have occurred. For example, heavy volume at a new opening high could mean that many new buyers have decided to jump aboard ship. Then the market sells offs. It probably won't be too long before this multitude of new longs (and old longs who have ridden the uptrend) realize that the ship they jumped onto is the Titanic. For futures traders, very high opening interest can be another warning.

Exhibit 4.25 demonstrates the difference between the dark-cloud cover and the bearish engulfing pattern. The two candlesticks in June 1989 constitute a dark-cloud cover. A long, white real body is followed by a long, black real body. The black real body opened on a new high for the move and then closed near its lows and well into the prior day's white real body. The municipal bond market backed off after this top reversal appeared. The final coup de grace came a few weeks later when the bearish engulfing pattern materialized. We see how the dark-cloud cover's black real body covered only part of the prior white real body. The black real body of the bearish engulfing pattern enveloped the entire previous white real body.

In Exhibit 4.26 three dark-cloud covers can be seen. Other bearish signals confirmed each of these patterns. Let us look at them on an individual basis.

1. Dark-cloud cover 1. This is a variation on the ideal dark-cloud cover pattern. In this dark-cloud cover, the second day's black real body opened at the prior day's high instead of above it. It was still only a warning sign but it was viewed as a negative factor. This dark-cloud cover also signified a failed attempt by the bulls to take out resistance at the mid-February highs.
2. Dark-cloud cover 2. Besides this dark-cloud cover, there was another reason for caution at this $21 level. A technical axiom is that a prior support level, once broken, can convert to new resistance. That is what happened at $21. Note how the old $21 support, once breached on March 9, converted to resistance. The failed rally attempt during the dark-cloud cover pattern during the first two days of April proved this resistance.
3. Dark-cloud cover 3. This shows that there was also a failure at a resistance zone made during the late April highs.

These are instances where the bearish dark-cloud cover coincided with resistance levels. This concept, where more than one technical indicator corroborates another, is important. It is the main focus of the second half of this book where the combination of candlestick techniques with other technical tools is discussed.

Exhibit 4.27 shows that during the early part of March, dark-cloud cover 1 halted a two-week rally. A week-long correction ensued. Two more dark-cloud covers formed in April. Dark-cloud cover 2 hinted that the prior sharp two-day rally was probably over. Dark-cloud cover 3, in mid-April, was especially bearish. Why did this dark-cloud cover turn out to be so negative? The reason has to do with the psychology of this pattern.

As noted previously, the rationale behind the negative aspect of the dark-cloud cover is the result of a new high on the open, with the market closing deeply into the prior white real body. What would happen, though, if, on the second day of the dark-cloud cover, the open penetrates the highs not from days, or even weeks ago, but from months ago and then fails at these new highs? This would produce very negative connotations. This is the scenario that unfolded in April. The highest levels in at least three months were touched on the black candlestick session of dark-cloud cover 3. This high failed to hold and prices closed well within the prior white real body.

In Exhibit 4.28, we see that the price incline commencing February 10 came to an abrupt halt with the mid-February dark-cloud cover.