Candlestick Patterns: Why it Pays to Catch the Doji

When Munehia Homma first created candlestick charts in they 1700s, they were meant strictly to track and profit from the rice trade.

He’d record the opening day’s price of rice, the low and the close. And over time, he’d begin to see price patterns in his recordings, mapping out repetitive signals in the price bars. He’d soon give them names, like spinning tops, and hanging man. 

The discovery of such patterns helped him successfully predict future direction of rice prices, giving him a significant advantage over other traders.

But 300 or so years later, those very charts took on a life of their own in the stock market.

To this day, we still use those silly – yet profitable – named candlesticks.

In fact, one of my favorite ones to keep an eye on is the doji cross.

The profit stars — more commonly known as dojis — are commanding reversal signals. These are formed when the candlestick opens and closes at the same level, implying indecision in the stock price.  They can often be a sign of indecision of bulls and bears.

When found at the top or bottom of trend, it can indicate that a reversal in the other direction may be nearing. However, as with any technical indicator, confirmation is key. Typically, when we see a doji at top or bottom of trend, it can be a sign of indecision among the bulls and bears.

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Depending on the location and length of the shadows, dojis can be categorized into four subcategories:

1. Doji: This candlestick looks like a cross, inverted cross, or plus sign. At the top of a trend, it can indicate that a reversal is near.

2. Long-legged doji: Long-legged doji formations occur when the stock opens at certain levels, trades in a wide trading range intra-day, and closes at the same level that it opened. These become better predictors when preceded by small candlesticks. Long-legged doji formations can imply a change in trend.

3. Dragonfly doji: The bearish dragonfly doji can usually be found at the market top or during an uptrend. This candlestick tells us the bulls may be losing their way and casts doubt on the market's ability to continue north. Confirmation is essential. You can confirm with a gap down or a lower close on the following day.

4. Gravestone doji: Gravestones are the opposite of dragonflies and indicate top reversals when confirmed with a bearish engulfing scenario (which we also use). These dojis look like gravestones and can signal the death of a stock.

While not all traders and investors rely on them, or believe they actually work, they are worth paying attention to for their insight into the psychology of the trade.

We can clearly see one at the top of trend on the Dow Jones Industrials for example.  Interesting to note, the day after it popped up the Dow fell 250 points.  Then again, we don’t just want to rely on a sole indicator to buy or short a stock or an index.

We also want to confirm with other indicators.

For example, not only do we have a doji at top of trend, but we can also see the stock is failing at its upper Bollinger Band (2,20) again with oversold reads on relative strength (RSI), MACD and on Williams’ %R (W%R).  In fact, each time these technical indicators align in overbought territory – at least dating back to early 2018 – the index has reversed in the other direction.

We can also see one at the QQQs for example, too prior to a pullback in early May 2018.

These indicators may not produce the right results 100% of the time, but it’s a great early alert system for spotting potential tops and bottoms.