In my experience, the candlestick pattern that traders recognize most easily and frequently are doji’s. These candlesticks have an open and close that are nearly on top of each other. They look like perpendicular lines that intersect each other at some point on the Y axis. Dojis are usually considered trend neutral when viewed all by themselves but they do indicate trader indecision and a lack of momentum. That means that the market context within which the doji appears is very important.
[VIDEO] Candlesticks: Using Dojis
For example, if a doji representing trader indecision appears after a rally that has paused at resistance, it is probably a bearish signal that the trend may be at a stopping point.
Similarly, a doji that appears after the market has become very oversold near support is a bullish signal that the trend may pause or even reverse. In these contexts dojis can be very useful for traders trying to manage risk or look for opportunities.
There are two general exceptions to the assertion that dojis by themselves are neutral. Dojis with a very tall upper shadow and a non-existent or very small lower shadow are called gravestone dojis and are usually bearish (like a shooting star).
Dojis with a very small upper shadow and a long lower shadow are called dragonfly dojis and are usually bullish (like a hammer.) These two types of dojis are usually much more rare than just a standard doji with an upper and lower shadow.
In the chart below you can see the kind of setup I look for when evaluating a doji. The EUR/USD was at a medium-term resistance level and traders were clearly undecided. That is a reasonably bearish signal and could be used in two ways.
If you were already long it is a good opportunity to add some coverage to your trade or even take some profits off the table. Conversely, if the prior trend had been bearish it is a great opportunity to re-enter a long position.
I tested this candlestick’s predictability using a standard methodology. I set a 25 pip trailing stop loss on long positions that would be “entered” at the open of the candle following the doji. Similarly I set a 25 pip trailing stop on short positions at the open of the candle after the doji. If the position was profitable, I considered that a successful signal. If the position were stopped out with a loss, I considered that a negative signal.
I defined whether I would enter long or short based on whether the doji was appearing at support (long) or resistance (short) levels. This is a mechanical test so it will inevitably be somewhat optimized. Also, no matter how much you try to define support and resistance to a computer, it will not do as good of a job as an experienced technical analyst.
However, I feel like this was a good baseline test to show why evaluating trader sentiment using candlestick dojis can be very productive.
Pairs tested in order of effectiveness:
- Daily Candles 01/01/2000 – 08/11/2008.
Percentage of Winners (profitable trades)
Ratio of Average Gain / Average Loss
- 1.62 : 1
Like many reversal signals, dojis can be risky to trade but the subsequent trends or corrections can provide a lot of profits. Strict money management is an absolute requirement to trade these successfully.
Image courtesy ahisgett.