Trading Multiple Types of Doji Candles
In the previous article dedicated to Japanese Candlestick techniques, we looked at one of the most powerful reversal patterns, the hammer/hanging man. A hammer was defined as being a candle that has a very long shadow and a small body. Moving forward, still on the patterns that have only one candle in their componence, the doji is the most enigmatic pattern to be found under the Japanese Candlestick techniques. The reason for this is that, on the one hand, this is not always a reversal pattern, and on the other hand, there are multiple types of doji candle that can appear at any one moment in time. By definition, a doji candle represents a candle where the opening and closing prices are the same. In other words, there is no body to be seen in the candle, but only shadows and a line given by the same opening and closing prices. The image below depicts what the standard type of a doji candle looks like. Such a candle is a distinct trend-change signal, especially during rallies, whether bullish or bearish ones. However, as you’ll find out below, doji candles are also considered to be continuation patterns when future price action is not confirming the doji candle. The real interpretation of a doji candle should therefore be a candle that is showing hesitation; that shows that both bulls and bears are fighting at that current level, and the market is in a state of uncertainty. The ideal doji candle will have the same opening and closing prices, but because we’re talking about the Forex market here, this is difficult to find. The reason for this is that lately the Forex market technology has improved, and now brokers are offering five-digit accounts when it comes to quoting a currency pair. Because of that, it is rare, if not impossible, to find a candle that opens and closes at exactly the same level. This is particularly true in the case of longer timeframes, such as weekly and monthly ones. A little flexibility is therefore needed, but nevertheless, the opening and closing prices of a doji candle should tend towards equality.
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Types of Doji Candles
Even though there are multiple types of doji candle that can be identified, they can be classified into two categories: doji candles that act as continuation patterns, and doji candles that act as reversal patterns. In both cases, it is vital to keep in mind that this is the overall tendency, not a rule of thumb. Having said that, here are the specific things to look for when trading a doji candle that belongs to one of the two categories mentioned above.
Doji Candles as Reversal Patterns
Like other candle groups that form the basis of Japanese Candlestick techniques, doji candles are valued for their ability to call a market top or a bottom. This is especially true when the doji candle follows a big green candle (if a strong bullish trend formed prior to the doji candle) or a big red one (if the previous trend was a bearish one).
The chart above is the AUD/USD 4-hour timeframe, and shows a doji candle forming after a strong bearish trend. Moreover, the doji candle follows a strong bearish candle, or a red one, and this is all a trader needs for a reversal pattern. Note the way the doji candle looks! The opening and closing prices are not the same, as a little bit of flexibility is important, because this is the Forex market.
Doji Candles as Reversal Patterns
A doji candle does not only act as a reversal pattern, though, as, like mentioned a bit earlier, there is a certain degree of uncertainty when such a candle appears. In other words, the market is hesitating. It is not mandatory in a bullish trend for the market to decline after a doji candle appears, just as it is not mandatory in a bearish trend for the doji to signal a reversal. After all, the real value of a doji candle is the fact that it shows that the trend may be in the process of changing.
The image above shows no less than two consecutive doji candles that in this case act as a continuation pattern, as after the consolidation ended, the price simply exploded to the upside, thus resuming the previous trend. This is what a doji as a continuation pattern looks like. However, if we are to respect everything that has been mentioned in this article, it is important to look at the candle prior to the doji candle. It was pointed out earlier in this article that, for a doji candle to be a reversal one, it needs to follow a strong candle from the previous bullish or bearish trend. In the example above, the candle prior to the doji one was supposed to be a strong green one, and it is not. This means that it is not a reversal that the doji is signalling, but more likely a continuation pattern. As such, staying with the direction of the previous trend is indicated, as the doji calls for this kind of trading decision to be made. Needless to say, after one more candle that shows the market consolidating, the price resumes the previous trend. In this way, the doji candle was useful in spotting a fake reversal and offering the possibility to add to a previous long trade. So powerful are these candles that they sometimes offer great opportunities to end up on the right side of the market.
The two situations presented in this article are the main ones worth considering when trading a doji. These candles are subdivided into further subcategories such as long-legged doji, southern and northern doji, gravestone and dragonfly doji, etc. However, they represent variations on the same theme: A doji candle can be either a continuation or a reversal pattern. With this in mind, traders have little room for error when it comes to making a trading decision after a doji candle appears.
Other educational materials
- Spot Reversal Patterns with a Hammer and a Hanging Man
- Trading 5th Wave Extensions
- Trading with the Cloud – Use Ichimoku Cloud to Spot Reversals
- Forex Market Terminology
- Profit from Forex Trading Using Different Trading Styles
- How to Set Up an Expert Advisor
Recommended further readings
- “Finding trading patterns in stock market data.” Nesbitt, Keith V., and Stephen Barrass. IEEE Computer Graphics and Applications 24, no. 5 (2004): 45-55.
- “Stars, crows, and doji: The use of candlesticks in stock selection.” Horton, Marshall J. The Quarterly Review of Economics and Finance 49, no. 2 (2009): 283-294.