THE FOUR KINDS OF DOJI CANDLESTICKS

THE FOUR KINDS OF DOJIS

In Lesson #4 of my swing trading course (the lesson entitled "Swing Trading By Candlelight"), I showed how certain key candlesticks were able to identify every major trend reversal in the S&P 500 for a period of several months. It is vital for swing trading success, I argued, to recognize candlesticks and assess their implications. Starting with today's "Inside The Black Box" article, we're going to return to candles on a systematic basis.

Candles are vital to swing trading because they identify possible reversals in trend. There are several major reversal candles to discuss, and you can rest assured that I will cover all of them in detail in upcoming issues. This week I want to focus on the doji. I will assume in writing this series that candlestick terminology is fairly fresh in your mind. If it's not, you might want to review our "Swing Trading By Candlelight" trading lesson on our web site.

If you were to ask me which of all the candlesticks is the most important to recognize, I would answer unhesitatingly -- the doji. On a daily chart, the doji often marks the beginning of a minor or intermediate trend reversal. Fail to recognize the doji's implications and you run the risk of buying at the top or staying far too late in a trade and leaving substantial profits on the table.

There are four types of dojis -- common, long-legged, dragonfly and gravestone. All dojis are marked by the fact that prices opened and closed at the same level. If prices close very close to the same level (so that no real body is visible), then that candle is read as a doji.

After a long uptrend, the appearance of a doji can be an ominous warning sign that the trend has peaked or is close to peaking. A doji represents an equilibrium between supply and demand, a tug of war that neither the bulls nor bears are winning. In the case of an uptrend, the bulls have by definition won previous battles since prices have moved higher. Now, the outcome of the latest skirmish is in doubt. Meanwhile, after a long downtrend, the opposite is true. The bears have been victorious in previous battles, forcing prices down. Now the bulls have found courage to buy and the tide may be ready to turn.

What I call a "common" doji has a relatively small trading range. It reflects indecision. Here's an example of a common doji:

A "long-legged" doji is a far more dramatic candle. It says that prices moved far higher on the day, but then profit taking kicked in. Typically, a very large upper shadow is left. A close below the midpoint of the candle shows a lot of weakness. Here's an example of a long-legged doji:

When the long-legged doji occurs outside a Bollinger band, my experience says you should be extremely vigilant for the possibility of a reversal. A subsequent sell signal given by an indicator such as stochastics is typically a very reliable warning that a correction will occur.

A "gravestone doji," as the name implies, is probably the most ominous candle of all. On that day, prices rallied, but could not stand the "altitude" they achieved. By the end of the day they came back and closed at the same level. Here's an example of a gravestone doji:

Finally, a "dragonfly" doji depicts a day on which prices opened at a high, sold off, and then returned to the opening price. In my experience, dragonflies are fairly unusual. When they do occur, however, they often resolve bullishly (provided the stock is not already overbought as shown by Bollinger bands and indicators such as stochastics). Here's an example of a dragonfly doji:

When assessing a doji, always take careful notice of where the doji occurs. If the security you're examining is still in the early stages of an uptrend or downtrend, then it is unlikely that the doji will mark a top. If you notice a short-term bullish moving average crossover, such as the four-day moving average heading above the nine-day, then it is likely that the doji marks a pause, and not a peak. Similarly, if the doji occurs in the middle of a Bollinger band, then it is likely to signify a pause rather than a reversal of the trend.

As significant as the doji is, one should not take action on the doji alone. Always wait for the next candlestick to take trading action. That does not necessarily mean, however, that you need to wait the entire next day. A large gap down after a doji that climaxed a sustained uptrend should normally provide a safe shorting opportunity. The best entry time for a short trade would be early in the day after the doji.

The historical chart of Cree Inc. (CREE) below illustrates three kind of dojis: common, dragonfly and long-legged. The candle labeled number "1" is a dragonfly doji. It occurred early in an uptrend and just as a four-day moving average was bullishly crossing above the nine-day. Prices moved higher from there.

Three days later (at number "2") a common doji occurred. Again, prices were in the middle of the Bollinger band. The four-day moving average had just bullishly crossed above the 18-day. This doji marked a pause in the uptrend.

At number "3," however, a more significant doji occurred. The upper shadow was outside the Bollinger band. It occurred after a long clear candle, suggesting the bulls had run out of steam. This candle marked the stalling of the uptrend for several days.

At number "4," a long-legged doji occurred. This doji was completely outside the Bollinger band. It occurred on a volume spike after a sustained uptrend -- a very bearish signal as I described in our October 6th, 2003 issue of the StreetAuthority Swing Trader. There was a gap down the next day, suggesting at the very least profits should be taken. A nimble trader could also have shorted the stock.

Dojis should not be assessed mechanically. However, after a strong trend in either direction they often mark major turning points. Always recognize the doji when it occurs, and be prepared the next trading day to take appropriate action.

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