Doji are valued for their ability to call market tops. This is especially true after a long white candlestick in an uptrend (see Exhibit 8.4). The reason for the doji’s negative implications in uptrends is because a doji represents indecision. Indecision, uncertainty, or vacillation by buyers will not maintain an uptrend. It takes the conviction of buyers to sustain a rally. If the market has had an extended rally, or is overbought, and then a doji surfaces (read “indecision”), it could mean the scaffolding of buyers’ support will give way.
Yet, as good as doji are at calling tops, based on experience, they tend to lose reversal potential in downtrends. The reason may be that a doji reflects a balance between buying and selling forces. With ambivalent market participants, the market could fall due to its own weight. Thus, an uptrend should reverse but a falling market may continue its descent. Because of this, doji need more confirmation to signal a bottom than they do a top. This is examined on Exhibit 8.5.
As seen in Exhibit 8.5, after doji 1, the bond’s uptrend changed to a lateral band. The market summit was at doji 2. Doji 2 was a long-legged doji. A long-legged doji means a doji with one or two very long shadows. Long-legged doji are often signs of a market top. More about them later in this chapter. We can see how important doji 1 and 2 were after uptrends in calling a trend reversal. (The October 31 doji was in the middle of a trading band and thus unimportant.) Once prices broke to the downside, doji 3, 4, 5, 6, and 7 developed. Yet, these doji were not reversals. The market still continued down after they appeared. Only when doji 8 and 9 formed a double bottom was there a trend reversal (albeit temporary). Thus there may be less need for confirmation of a top reversal via a doji than for a bottom reversal.
Exhibit 8.6 illustrates that the rally which began in mid-1987, gave its first sign of peaking with doji 1. Another warning flag was hoisted with doji 2, a few months later. The hanging man after doji 2 confirmed the top. A minor rally attempt ended in late 1989 at doji 3. This exhibit exemplifies that confirmation after a doji increases success in projecting a trend reversal. The white candlestick, which appeared a month after doji 1, did not confirm the top hinted at by doji 1. Bearish confirmation came only after doji 2. After doji 2, this verification came in the form of a hanging man and then a long black candlestick. Confirmation of doji 3 as a top came with the next month’s long black candlestick session.
The more conservative trading style used, the more important it is to wait for verification of a trend change. How long should one wait for corroboration? It is a trade-off between risk and reward. If one bases one’s trading style on waiting for trend reversal corroboration less risk should be involved but, it also could provide less reward. By the time the reversal is substantiated, profit potential may be reduced.
Exhibit 8.7 shows three doji, each after an uptrend. Doji 1 signaled a minor top. Doji 2 did not correctly call a reversal, but it was followed the next day by an $.08 decline. Doji 3 is interesting. It is more important than the prior two doji since it followed a series of three long white candlesticks and it formed a harami cross. Doji 3 strongly stressed that the
prior uptrend might be over. When it appeared, longs should have taken protective measures (the prior strong uptrend negated short selling). This means that they should either be liquidating some longs, moving up protective stops levels, and/or selling calls.
An intra-day spike higher the next day made it appear that the prediction about the end of the uptrend was going to be wrong. But, on that day, the market sold off sharply toward the close. This action helped confirm the original view that the prior uptrend was about over. The market then went into a congestion phase for the next few weeks. A pattern resembling an evening star then arose. It was not an ideal evening star pattern since the star portion did not gap away from the prior long white real body, yet it presaged a top.
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