Technical Trading Explained: Candlestick Patterns, Dojis, Spinning Tops, and Divergences
Investopedia doesn’t really cover this, so let’s start with a brief introduction to candlestick patterns.
It is said that for centuries the Japanese used this system of recording prices, especially in their rice markets. Supposedly they noticed various configurations of candlesticks as correlating with subsequent price movements. As you might expect with the Japanese, they gave these patterns very fanciful names, some of which the Americans have translated from Japanese, and some of which they simply adopted the Japanese word directly.
Much like any other technical indicator, candlestick patterns have limited predictive power. They are not nearly as powerful as trend, support, and resistance. But they do have their uses as part of an overall trading plan.
A doji is a candle where the open and close are right on top of each other, especially where the wicks above and below are roughly equal in size. It looks like a plus sign. Investopedia describes it as a neutral signal, but Investools describing it more as a harbinger of change, especially when it occurs at support or resistance. It means that the bulls and bear fought to a standstill, which suggests that power is shifting away from whichever side has been winning recently. Today’s Dow (INDU) made a near-perfect doji.
A spinning top is similar to a doji, in that the open and close are close to each other with wicks above and below. But the spinning top has more distance between the open and close, so that it has a very short body rather than a line. It looks like a top. The body’s color is unimportant.
The message from a spinning top is similar to the doji, but less urgent. The strength difference between buyers and sellers is decreasing, so its direction could be changing soon. Today’s S&P 500 (SPX) made a spinning top.
A divergence isn’t a candlestick pattern at all. It’s a much larger pattern that forms between price movement and the movement of a technical indicator such as the MACD. Normally the price and the technical indicator move in roughly the same direction. But in a divergence they start moving in opposite directions. Investopedia has a nice explanation and sample chart.
A divergence indicates that the market’s real momentum is moving in the direction of the technical indicator, even though the price is still moving in the opposite direction. So if the price is moving down but the technical indicator is moving up, we call it a bullish divergence and expect the market to start moving upwards. Today we had a bullish divergence between the RUT and its MACD (8,17,9).