Technical Tuesday: The Most Potent Reversal Pattern – Ever

You probably either already know, or have heard about, “the doji,” which is the most-powerful reversal pattern you’ll spot on a “candlestick chart.” 

Perhaps you saw Martin Tillier’s article from a few weeks back. 

But even if you’re familiar with candlesticks and the “doji,” you’ll still learn something new from this article. 

Why should you care?   If you spot a doji on a chart after a significant advance, or a significant decline, it’s extremely likely the trend is about to change

Of course, it’s never a guarantee. But some chart patterns are more-reliable than others, and the doji is the most-reliable of all chart patterns.

Get to Know the Doji

A doji is created when a stock, Exchange-Traded Fund, index, currency or anything else that’s tradable, has a closing price that’s exactly (or almost-exactly) the same as the opening price — and, during the day, the security trades up and down.  

I should probably start by explaining the mechanics behind how a candlestick is created … where the high is, where the low is, where the opening price is, and where the closing price is.  

But let’s make this more fun and jump right into some real-life examples, and then we’ll get into the mechanics. 

Here’s What it Looks Like

You can see in the General Electric (Symbol: GE) chart below that the three arrows all point to what appears to be a day that created the shape of a cross. 

Each time we saw it, the trend was reversed. 

The red candles represent down days, and the white candles represent up days. 

The thick part of the candles represents the difference between the opening price and the closing price, and the parts that look like the wick represent the intraday high and low. 

There.  That was easy!

As I said, a doji is created when the opening price is the same as the closing price. 

This kind of action always makes the bullish or bearish reversal pattern more-potent.

Beyond the Deadlock

A doji reflects a deadlock between bulls and bears. This makes sense because, since the prior move was usually an uptrend or downtrend, there were obviously either more bulls than bears or vice versa.

If the new situation is a deadlock between bulls and bears (represented by the doji), then the side that was previously in control has obviously lost some steam.

And when that happens, we usually get a “reversal.”  

What’s important here is to understand that, when a chartist says “reversal pattern,” a reversal just means a change in trend — which could be a change from a downtrend to a horizontal trend, or to a new uptrend.

The point is, the current trend is likely to end, or stall and consolidate. 

What we see above are dojis that reversed to an uptrend.  But again, it could have reversed the downtrends to horizontal trends. 

Find Clarity in Shadows

You can see the three examples above are candles that have small “wicks,” also known as “shadows.” 

In the case of a bullish reversal like you see above, the longer the lower shadow is (the lower wick that signifies the intraday low), the more-potent the reversal pattern is.

Below is a chart of Apollo Group (Symbol: APOL).  You can see a doji that has a VERY long lower shadow (lower wick).  This told traders that it was EXTREMELY likely that the downtrend was going to reverse. 

In this case, it reversed to a horizontal movement that eventually turned into an up movement. 

But dojis can also reverse uptrends. 

Let’s look at Agilent Technologies (Symbol: A).  The first and last doji seen below were found at the top of the uptrend. 

When you see a doji after an uptrend, it’s likely going to end — at least for a while. 

Notice the shadows (wicks) are on the top in the first and third examples.  This signifies that the stock opened at one price, then during the day it rallied way up. But then sometime in the middle of the day, it reversed back down and closed at the same price where it opened. 

Dojis at the top can either have long upper or lower shadows, and that also goes for dojis found after a downtrend.

You should know that I didn’t have to look through 100 charts to try to make this work, to try to prove a point.  I literally just pulled up three charts off the top of my head and found the dojis. 

You should try that yourself. You’ll be amazed at how well it works, and how few false signals you’ll see!

Now let’s get into the mechanics of how the candlesticks are created. Check out the example below…

The thick part of the candlestick is called the “real body,” and the skinny parts that look like the wick are the “upper shadow” and “lower shadow.”

The “real body” represents the difference between the opening price and closing price. 

The top of the “upper shadow” to the bottom of the “lower shadow” represents the time period’s trading range.

This example shows candlesticks with black or white “real bodies.” 

The real body is black when the stock’s closing price is lower than opening price (the stock closes down). The real body is white when the stock’s closing price is higher than opening price (the stock closes up).

Although the real bodies are black or white when down or up (respectively), they can also be represented in colors.

In the Merrill Lynch (Symbol: MER) chart example above, the first two candlesticks show down days — as we can see, since the real bodies are black.

Notice that the opening price of candlestick No. 2 was slightly lower than the closing price of candlestick No. 1. Also notice that the opening price of No. 3 was higher than the closing price of No. 2.

Candlestick No. 3 closed at the high of the day. We know this because there is no “wick” at the top of it. 

Even though candlestick No. 4 opened at a price that was lower than No. 3’s closing price, we can see that Merrill Lynch traded higher and closed slightly higher than No. 3.

We can also see that on day four, the candlestick has a long wick on the top part of the candlestick … indicating that the stock had been much higher. The stock closed near the middle of the day’s trading range.

Finally, focus your attention on No. 6.

There is no real body in candlestick No. 6. That is because the stock opened and closed at almost the same price.

The stock’s trading range (high and low) was $76.25 – $73.80. Although the stock’s price swung $2.45, it only closed 2 cents lower than the opening price. 

There are many variations of the doji, and there are many rules of the doji. 

So, keep an eye out for developing trends in stocks and in the market itself.  And keep your eye out for those dojis, because the market is trying to tell you something!

Until next Tuesday, stay profitable!

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