Technical analysis is the study of actual movements in the price of a financial product. However in my opinion, technical analysis is less about trading and more about the study of mass psychology. We study the way people react in certain situations in the market, which is quite prevalent when identifying and trading using chart patterns.
This is particularly pertinent in one of my favourite candlestick patters – the doji.
In the image below, you can see a variety of different candlesticks. Here, the extremities of the symbol represent the high and low price, and either end of the body of the candlestick represents the open and the close of each period’s price.
Extending from these candlestick patterns are theoretically an infinite number of possible different patterns. There is extensive material available on different types of patterns and their interpretation.
One of my favourite candlestick patterns is the doji. A doji is defined by the opening and closing price for the period being very close, if not the same. A perfect doji is shown in the image below. It is perfect as the opening and closing price for the period is the same and the central line across the candlestick is located precisely in the middle of the high and low prices for the period.
The middle bar across the doji (representing opening and closing prices) doesn’t necessarily have to be in the centre. In fact, you will often find dojis where it is slightly off centre and the difference between the opening and closing prices for the period is not precisely the same. When the horizontal component of the doji candlestick is more towards either end, it can still have a similar effect. Variations on the doji are often referred to dragonfly or gravestone dojis.
What the candlestick is representing in the price action, is far more important than demanding perfect candlestick shapes.
In a doji candlestick, the fact that the opening and closing price are so similar means that it often represents indecision. However more importantly if the doji is found within a trend, it often represents something more significant and useful – a weakness in the prevailing trend. Either buyers are losing conviction in an uptrend or vice versa for sellers in a downtrend.
You will often find dojis very close to turning points, or price reversals. It is this characteristic that many traders find useful.
You will see in the daily chart below of the U.S. dollar / Japanese yen (USDJPY) a number of dojis at price reversal locations.
In this example below, you will notice how strongly the market has moved higher only to be sold off just as strongly, with a doji candlestick at the top. It is this candlestick that indicated weakness in the prevailing up trend and led to the reversal.
You will see another example in a recent chart of the Australian dollar / U.S. dollar (AUDUSD).
A doji loses its effectiveness if the market is not already trending, as by definition a non-trending market is already showing signs of indecision.
For traders who do trade shorter term trends, being able to readily identify reversal points can be tremendously advantageous. Some traders will choose to trade as soon as they see the doji candlestick complete (i.e. the next candlestick appears and the doji is now set), whilst others may wait for confirmation to ensure the reversal does happen.
There is no right or wrong way – what is important is you find an approach that you are comfortable with and then stick to it. Clearly those who trade earlier may enjoy greater gains however they are also trading at a higher risk point, as they have not waited for any confirmation. Therefore, understanding where you sit on the risk acceptance scale is critical.
There is a well-known saying in trading which says, “trade what you see, not what you believe”. The chart will tell you everything you need to know and doji candlesticks can provide us great insight into the interaction between buyers and sellers.
Unfortunately in this environment, what we think and believe counts for nothing. Remain objective and let the chart tell you precisely what is happening.
About Stuart McPhee
Stuart McPhee has traded for over 20 years and is the author of the best selling book Trading in a Nutshell, 4th Edition. He is one of Australia's most compelling speakers on trading and has personally coached high net worth traders all over the world. Since 2001, he has spoken live in front of tens of thousands of fellow traders from Mumbai to New York, Tokyo to London, Melbourne to Beijing, and many places in between. He has helped countless traders improve their performance with his expertise in technical analysis, trading psychology, risk management, the trading process and developing a trading plan.
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