A Morning Star Wakes Up The Dow

09/05/07 12:02:42 PM

by David Penn

A classic Japanese candlestick pattern reveals a bottom in the hourly Dow industrials.

Security: $INDU
Position: N/A

I credit Steve Nison's four-DVD set, Profiting In Forex: Using Candlesticks To Catch The Next Move, for helping me completely reevaluate my understanding and use of Japanese candlestick lines and patterns. Is there anything in the DVD set that isn't covered in one of Nison's excellent books, Japanese Candlestick Patterns and Beyond Candlesticks? Maybe, maybe not. But for someone with a working knowledge of Japanese candlesticks, I found the DVD set to be just the sort of "continuing education" on the subject needed in order to more confidently analyze and trade markets based on these patterns.

That said, let's look at what the candlestick patterns have had to say about the final days of August in the Dow industrials. To my eye, the rally that began late on August 28 and appeared to end late on September 4 was well-telegraphed by a pair of Japanese candlestick patterns. In the first instance, a morning star pattern was confirmed, allowing traders to get long when the Dow was trading around 13150 (September Dow mini-futures at 13174). In the second, a confirmed shooting star pattern let traders get short — or merely exit — at the 13346.19 level (13365 for the September mini-Dow). For mini-Dow traders, that five-day advance was worth at least $955 per contract.

In Figure 1, I will look just at the first instance, the morning star.

FIGURE 1: DOW JONES INDUSTRIAL AVERAGE, HOURLY. A morning star pattern begins in the final hours of trading on Tuesday and completes in the first hour of trading on Wednesday. One hour later, the morning star pattern is confirmed and the Dow set to move higher.

Graphic provided by: eSignal.

The morning star pattern developed as the market closed on Tuesday, August 28, and opened on Wednesday, August 29. Looking at the hourly chart, we can see the Dow moving down late on August 28. There is a down hour, followed by a half hour with no upper or lower shadow at all to close out Tuesday. Wednesday began with a strong up hour. This, combined with the previous two candlesticks and the fact that the market had been in a downtrend for the past few days and was oversold in both the stochastic and the moving average convergence/divergence (MACD) histogram, created the possibility of a bullish morning star pattern. This pattern meant, at a minimum, that downside momentum was waning quickly. More ambitiously, this meant there was the possibility of the market actually reversing and heading higher.

Confirmation of the morning star pattern came when there was an hourly close above the high of the pattern. While some are content if an hourly close exceeds the real bodies of the pattern, I am much more comfortable when the close exceeds any shadows as well. That is precisely what happened in the second hour of trading on August 29 as the market closed above the pattern by a good six or seven points. This was all the confirmation needed for short-side traders who hadn't completely reduced their exposure to do so, and for long-side traders to take a position for the anticipated ride higher.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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A Morning Star Wakes Up The Dow

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