No matter what technical tools we have at our disposal, certain events can happen – global or domestic – that we just have no way of predicting.
While these “prediction indicators” (like the relative strength index and the moving average convergence divergence) can warn us of trends that are forming and reversing, they can’t tell us how the markets are reacting right now.
Instead, what we need is a reliable technique that will tell us how the markets are reacting to any event … in real time.
Luckily… I have a technique that does exactly that… and it’s been helping technical analysts make money for more than 300 years…
The Basics of Japanese Candlestick Charting
I want to show you a reliable indicator I use that’s been around since the 17th century. It’s still one of the most relevant and viable forms of technical analysis used today.
And it’s called “candlestick charting.”
Last week, I told you a little about this charting technique developed by Japanese rice farmers. The man credited as being “the father of the candlestick chart” is a man named Munehisa Homma.
Homma was a Japanese rice merchant from Sakata who followed the pricing patterns of rice to determine future prices. He traded in the Dojima Rice market in Osaka. And what Homma understood was that the markets, though tied to the supply and demand of rice, were strongly influenced by the emotions of traders and that the value and price of rice heavily depended on traders’ emotions.
Candlestick charting (and the various types of candlestick charting) has evolved from the time Homma first developed it to what it is now. But there are a few overriding principles that exist in both modern Western and Japanese candlestick analysis today:
- Markets fluctuate, and market moves are based on the expectations and emotions of investors (the buyers and sellers).
- Price is a reflection of all known information.
- Price action itself is more important than the reasons behind it… meaning, how a price moves is much more important than why a price moves (such as earnings, new products, and company scandals).
Now let’s talk about the key components of the candlestick chart…
The Japanese candlestick analyzes four different components of price action, whether it be over a one-minute, one-hour, or one-day period of time. A “candlestick” represents the time frame that you’re charting, and it can be any time frame your charting software will allow. (Even one month’s or year’s price can be encapsulated by one candle). But to keep things simple, we’ll use one day as the period of time that one candlestick represents.
As I mentioned last week, each Japanese candlestick represents four crucial pieces of price information for the day: the open, close, high, and low.
Depending on your charting software, the color coding of the body is usually black or white, but many others use green and red.
White or green usually indicates that the stock closed higher than its opening price, while black or red usually indicates that the stock closed lower than its opening price.
So what does this actually mean?
The basic reason for seeing if a stock closed higher or lower is to determine whether the bulls or bears ultimately won the price battle.
Certain candlestick patterns can help us understand what the market is thinking. One of the most interesting — and rare — candlestick patterns is the “doji,” which indicates market indecision.
A doji candlestick occurs when a security’s open and close are virtually the same.
Consider what has to have happened for a standard doji — which has a very short body and upper and lower wicks — to form: A security opens at a certain price, bulls push prices higher… but the market rejects it. Then bears push prices lower… only for the market to reject that too. In the end, prices rise back up to right around where they opened. (This scenario also occurs when prices move lower first and higher second, as long as the market closes back where it started.)
As you can see, doji patterns reveal serious market indecision. The bulls don’t ultimately have enough traction to win out… but neither do the bears.
A doji often tells us a reversal is coming, although the best conclusion to draw when you see a doji form is that there is indecision in the market.
There are other multiple variations of dojis, including the Gravestone Doji, the Long-Legged Doji, and the Dragonfly Doji. You can see all three in the image below.
While not every doji pattern points to a specific directional price move, it’s thought that the Gravestone indicates a downward move is coming, the Dragonfly indicates an up move is coming, while the Long Legged Doji indicates a sideways move is to come.
As you can see from the chart above, price moved down following the Long Legged (Doji #1), it moved up after the Gravestone (Doji #2), which were both incorrect moves. That said, the stock price did rise after the two Dragonfly patterns (Doji #3 & #4).
With the doji pattern by itself, it’s better to NOT draw any “directional” conclusions when they appear. As I said earlier, they are better used as an indicator of market indecision.
Next time, we’ll go into more candlestick patterns that you can use to determine directional price moves.
Tom Gentile
America’s #1 Pattern Trader
