In this article, we will be discussing candlestick patterns, in particular, Doji, and how they help identify short-term price moves. We will begin with specifying candlestick structure followed by the types of patterns.
The candle is constructed from a period’s open, high, low, and close price data. The structure of the candle comprises a body and a shadow with the colour of the body representing up or down moves for a given period as shown below in figure 1.1. Lighter colour candle normally represents an up move with a darker colour candle representing a down move.
Before we move on to the types of pattern let us see what are the patterns useful for?
They help identify market sentiments, help identify reversal area and help confirm other technical indicators.
Simplest and one of the most popular candlestick pattern is Doji which has an identical opening and closing price as shown in Figure 1.2. This pattern shows indecision and is helpful at market tops and bottoms to show a reversal.
Also, there are a number of variations to the Doji pattern such as Long-Legged, Dragon Fly, Grave stone, and Four Price as shown in the image we will go one by one through these patterns but largely they all show reversal areas.
Long Legged is a Doji that has longer shadows and hence, provides a stronger reversal signal because it shows that even though market moved widely during a given period it closed at the same price as the open.
A Dragon Fly Doji is found at the market bottoms and has a long lower shadow. It’s also a reversal pattern but occurs at the market bottom and is a bullish signal. It occurs when sellers take the market to new lows but then buyers get involved and the price rises and close at the same level as the open.
A Grave Stone Doji is a complete opposite of the Dragon Fly Doji. It also shows reversal but is bearish and occurs at market tops. It’s when new highs are made but then the price drops and close at the same level as the open.
A Four Price Doji has a same price for the open, high, low and close. It occurs mainly when there is a single price for the entire period which means the candle itself is not significant to provide short-term directional clues.
In terms of practical use, it is difficult to find the candle pattern where the open match the close exactly. Hence, some leeway is expected. Normally it’s ok to have a Doji where open and close are a few pips apart. We tend to use candlestick patterns on the daily candle as they tend to be more reliable. Also, it is more likely that candlestick pattern will work if it happens after a small rally or a decline. Long-legged Doji tends to be most common with Dragon-Fly and Grave Stone Doji less common.
Finally, a caveat, the Doji candlestick patterns tend to be unreliable when just used on its own and without help from other indicators. Hence, it will be useful to use these patterns along with the other indicators. That said, these patterns give useful information about market sentiments and trader behaviour.
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