Candlesticks and intuition: seeking confirmation in a volatile market

Once a forex trader understands that candlesticks give an indication of market psychology and enthusiasm (or lack thereof) at a given point in time, deciphering their meaning becomes intuitive.

Consider the current one-hour chart of USD/JPY, below:

It takes little imagination to see that the candlesticks inside the violet ovals signify unsustainable enthusiasm, with long white bodies and upper wicks vividly illustrating upward momentum. On the other hand, the candlesticks within the red ovals just as clearly illustrate indecision, with the alternating positive and negative colours showing the price being dragged up then down as the market bulls and bears attempt to determine this currency pair’s next direction.

Most candlestick chart reading has the same level of intuitive simplicity; however, it’s all too easy to read something into the market that just isn’t there.

Consider this section of the current USD/JPY chart:

This is obviously a volatile pair, with strong selling pressure giving way to equally strong buying pressure only to reverse again without even a doji to signal the change. Enthusiasm has also waxed and waned with long candles and short ones, but the price is below the 200-period moving average (the grey curving line) signifying bearish strength and the current short-term trend is down. There’s already been one pause in this run for profit-taking; however, the price is approaching a strong support level, where the previous run halted prior to reversing, and the final candlestick is a white doji.

By definition, a white doji at the end of a downtrend signifies that bearish pressure is weakening. It’s easy to leap from that knowledge, which no one would dispute, to the conclusion that the currency pair is again reversing; however, easing pressure does not equal a reversal, and rather than trust what this volatile market seems to be saying, the experienced forex trader knows to look for additional evidence before exiting a current position or entering a new one.

The first and obvious step is to measure the degree of that retracement. Here’s the same chart with a Fibonacci grid overlaid from its earlier high to its first low:

The reference numbers don’t reproduce well on a screen shot; however, the highest gold line is 100%, the lowest one (just above the red support level) is 0%, with 61.8%, 50%, 38.2%, and 23.6% running from top to bottom in between. Of particular interest is the fact that the 61.8% line is very near (within five pips of) the upper blue resistance line, with the MA(200) just above that, forming a very strong, three-fold level of resistance. Note how, after repeated assaults upon this level, the price action finally turned south. It bounced off support at the 23.6% level, retraced to 38.2%, then fell through and is now nearing the 100% line.

At this point, RSI (shown above) measures 35. Although it’s touched the oversold 30 level it has not yet broken through on this current downtrend, confirming that, without any fundamental announcement to alter the balance of USD/JPY, the price still has room to fall.

And fall it did—another 200 pips, illustrating the need to await confirmation prior to market entry, particularly in a volatile market.