Trading the Doji Candlestick Pattern
Introduction to Candlestick Patterns
Candlestick pattern is a term that you will come across many times during trading. Candlestick patterns are specific candlestick formations which are often used to facilitate trading decisions and assist in properly reading the market. In this article, we will explain what candlestick patterns are, and then we will present an important candlestick pattern, called the Doji candlestick pattern. We will explain how to detect and consider a Doji candlestick pattern in your trading.
To begin with, let’s define what a candlestick is. In brief, a candlestick is a chart formation that displays four pieces of information for a specific time period, in the form of a candle. Candlesticks have been invented in Japan, hence many times they are also referred to as Japanese candlesticks. The displayed information is the open, high, low and close price for the timeframe represented by the candle. Below you can see an example of a typical Japanese candlestick.
As you can see, the high and low points are connected with lines to the candle’s body which is defined by the open and close prices. Usually candlesticks with a close price higher than the open price are coloured in green while candlesticks with a close price lower than the open price are colored in red.
Candlestick patterns are common candlestick formations that often contain useful information for trading decisions. There are many candlestick patterns with a name, like a hammer, the inverse hammer, the morning star, the doji candlestick, the hanging man and many more with even fancier names.
In this article, we will talk about the Doji candlestick and explain how it is used in trading. We will continue with more candlestick patterns in subsequent articles.
What is the Doji Candlestick Pattern?
A Doji candlestick is a candlestick with virtually no body. In other words, a Doji candlestick has identical open and close prices and it often resembles a cross or a + sign. Below we can see an example of a Doji candlestick from Fondex cTrader.
There are four subtypes of the Doji candlestick. These are depicted below
Long Legged Doji
A long-legged Doji candle is a candle in which the high and low price legs are long compared to the body of the candle. This means there was a wide range of price movement during the candle, both above and below the opening price, but the price closed at the exact same level as it opened. A long legged Doji reflects a great amount of indecision about the future direction of the underlying asset, since the price fluctuated both upwards and downwards.
The gravestone Doji is composed of a long upper shadow and open and close prices at, or very close to, the candle’s low price. A gravestone Doji candle usually signals the exhaustion of an upward trend and the beginning of a reversal towards a downward movement.
The dragonfly Doji is composed of a long lower shadow and open and close prices at, or very close to, the candle’s high price. A dragonfly Doji candle usually signals the exhaustion of a downward trend and the beginning of a reversal towards an upward movement.
Any Doji candle that cannot be classified into the above categories can be considered a general Doji candle. Such candles need to be always traded in context with other market information.
Trading the Doji Candlestick Pattern
Doji candlesticks are usually considered reversal flags and more rarely as continuation flags, depending on the current market context. When a Doji candle appears on a chart, it means that the market sentiment has probably changed, and a reversal of the price is imminent. Hence traders should be ready to trade the reversal of the price on the appearance of a Doji candlestick. Nevertheless, Doji candlesticks are poor trading signals on their own, therefore it is advisable they be traded in accordance with other market indicators, like oscillators, which also indicate a possible price reversal.
A good combination of trading signals is the use of a MACD histogram in conjunction with a Doji candlestick. Below we can see some examples of such an approach
In the example above, taken from a BTCUSD chart, we can see a Doji candle coinciding with the MACD Histogram crossing the 0 level. The Doji candle can be interpreted as a failed attempt of sellers to regain control of the price movement and the Histogram crossing to a positive value is a signal that a strong upward movement might start. This is confirmed by the subsequent candles.
Below we can see an example in the opposite direction, taken from the EURUSD chart.
Here we can see a Doji candle very close to the MACD Histogram flipping point, serving as a strong confirmation of the upcoming downtrend.
Limitations of the Doji Candlestick Pattern
Doji candlesticks can generate a lot of false signals that could lead to substantial losses if used out of context. Therefore, when using strategies based on Doji candlesticks, always consider the market fundamentals that currently move the market and combine the signals with other confirmation signals, like oscillators, support/resistance levels and the relevant price action taking place on the chart.
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