The Dow’s Dangerous Dragonfly Doji

07/20/2010 12:01 am EST

Focus: STOCKS

A dragonfly doji candle pattern usually marks a turning point in the market. The long lower shadow appears when prices fall sharply below the open, but then recover later during the session to close near the open. This doji is unique in that the prices open and close near the high of the session. When dragonfly doji appears in a downtrend, it more often than not leads to reversal and a new uptrend. However, when it materializes in an uptrend, it hints that momentum is waning and that prices are likely ripe for reversal.

In the first graph below, we see that a dragonfly doji appeared on the Dow daily chart just after a robust rally of approximately 800 points from the July lows.


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The doji emerged as the Dow was tagging it’s 200-day moving average (MA). Another doji appeared at the session right before the dragonfly doji, closing out the session on the 200-day MA. The doji marks indecision among investors and is often accompanied by a change in trend. The dragonfly doji reaffirmed that bearish sentiment.

As with most candlestick patterns, the dragonfly doji requires confirmation in order to be validated. At the end of an advance, validation comes when prices close below the intraday low made during that session. In contrast, when the pattern surfaces at the end of a decline, prices need a close above the intraday of the candle. A confirming close not only validates the pattern, but often gives rise to a new trend.

In this case, the Dow needed a confirming close below 10,240 in order to validate the dragonfly doji. The first graph reveals that the Dow’s dragonfly doji did receive a confirming close on July 16, with a hefty 261-point drop resulting in a 2.50% decline for that session. Interestingly, the candle that confirmed the reversal is a bearish belt hold candlestick. The bearish belt hold candle is an elongated candle that is defined by the lack of an upper shadow as it opens at its high and closes near the lows of the session. The shadow at the lower portion of the candle is usually very small, marking heavy selling pressure throughout the day.

The technical indicators seem to be agreement as both the moving average convergence/divergence (MACD) histogram (12, 26, 9) and stochastic (14) confirming lower highs. Meanwhile, the MACD (12, 26, 9) is starting to turn back down at its center line (graph 2 below).


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Graph two shows that the Dow continues to find resistance off either the 50- or 200-day MAs.  During May and mid-June, the Dow staged sharp reversals off the 50-day MA, and in early June and now most recently in mid-July, it reversed course off the 200-day MA. Our reversal pattern pushed prices back below the 20-, 50-, and 200-day MAs. The market is in a bearish phase when the 50-day MA is below the 200-day (death cross) and prices are below both.  It is this scenario
that defines a bear market with reference to moving averages. The dragonfly doji reversal off the 200-day MA is very bearish, which suggests that we will see plenty more selling pressure in the months ahead and the Dow below 10,000.

By Ron Walker of TheChartPatternTrader.com

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