|
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.
|
|
