A Technical Picture of Human Emotion

January 2, 2017

Traders are often told to ignore the art of technical analysis.

“Technical analysis is fundamentally flawed,” says Forbes.

“The poor reputation of technical analysis is well deserved, noted another analyst.

Even Warren Buffett once noted, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.”

Peter Lynch says, “Charts are great for predicting the past.”

However, as many technicians will tell you, it works quite well because of its popularity. 

And, as we’re well aware, once we can master chart pattern recognition, the quicker the profit.

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However, like most tools of the trade, there’s much more than just lines, trends, and wiggles on a chart.  We must also understand the very psychology of a trade to understand where fear and / or greed is likely to die and move in the other direction.

Much like the Bollinger Bands, Williams’ %R, MACD, RSI and Money Flow indicators we’ve spoken about, candlesticks are relied upon quite often, too.  In fact, they offer an effective way to interpret stock prices.  They provide us with an actual picture of human emotion, which drives fear and greed through buying and selling.

As we all know, there are two main groups in the market – buyers and sellers.

The picturebelow shows how a candlestick can be constructed.

 

The high and low points are referred to as the wicks, representing the high price of the day, as well as the low price.  The candle itself is referred to as the range. 

When stocks closed at the bottom of the range, we can imply that the sellers are in control, that it may be a good idea to avoid as a buyer.  If the stock closes at top of the range, we can imply that the buyers are in control of the situation. 

Where the stock closes in the candle range gives us an idea of who is winning and we can potentially gauge the situation.  However, not all candlesticks were created equal.

Quite literally, there are dozens of candles, but only a handful that are most relied upon, including:

  • The Doji Cross
  • The Gravestone Doji
  • The Long-legged Doji
  • The Gravestone Doji
  • Bullish Engulfing Patterns
  • Bearish Engulfing Patterns
  • Dark Cloud Cover
  • Piercing Patterns
  • Hammer
  • Hanging Man
  • Morning and Evening Star

For today, though, let’s focus on the Doji Crosses, which can look like this.

The Doji can mark a turning point in a chart, especially when found at top or bottom of a trend.  It can signify indecision among the bulls and bears.  It can also tell you that a stock may be about to pivot. Again, though, to strengthen your argument, you would confirm with other indicators.

 

He could literally see the psychological behavior of buyers because emotion had such a significant impact on rice prices and his patterns.

With his technical insight, he could position himself against the market when all buyers were bearish and vice versa.  He was so successful stories say he made the equivalent of $10 billion in today’s dollars.

Sure, to the average trader, candlestick patterns are just a bunch of crosses and oblong shapes with odd names, like the abandoned baby or the doji cross. 

But once understood, even the craziest sounding candlesticks can help make you a fortune, as their creator, Japanese rice trade, Munehisa Homma would learn.

Years later, the rice trading trick would be applied to stock markets, allowing technical analysts to gauge possible direction of stocks, as highlighted by candlesticks and market psychology.  In short, candlesticks were highlighting two of the stock market’s chief drivers—fear and greed.

For instance, doji crosses are a sign of indecision of bulls and bears.  When found at the top or bottom of trend, it can indicate that a reversal in the other direction is nearing.

Quite literally, they help traders excel at finding market turning points.  And when used with technical analysis tools we’ve shared can strengthen your research.

Let’s look at the doji crosses today.

The Doji can mark a turning point in a chart, especially when found at top or bottom of a trend.  It can signify indecision among the bulls and bears.  It can also tell you that a stock may be about to pivot. Again, though, to strengthen your argument, you would confirm with other indicators.

Long legged doji formations are most significant when they occur after a strong up or downtrend.  It implies that a shift off the lows or highs is nearing. 

The Dragonfly doji can be difficult to spot.  But when found it has been deemed a reliable indicator of trend change.  We can also rely on the gravestone doji, which can suggest that a bullish rally or trend is about to shift and die, giving it the gravestone name. 

Have a very happy, healthy and profitable New Year.  Here’s to a great 2017!

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