Technical analysis became more and more sophisticated in time. That’s not surprising: markets change continuously. In fact, both markets and the way the market is presented to us changed. Nowadays, robots govern trading. A rough estimation tells us more than eighty percent of trading is automated. Hedge funds, quants, expert advisors, or straight stop loss, take profit and pending orders, rule trading.
For this reason, reversal patterns have a tough time surviving. Because trading algorithms learn to spot them, they’re programmed to trade in the opposite direction than the classic one. The stock market has an advantage: it is well-diversified as traders don’t focus on a single product. When compared with a currency pair, or an index, trading individual stocks offers more chances to use technical analysis concepts.
One such a concept is the Doji candle. Perhaps the most enigmatic candle from the Japanese approach to the market, the Doji candle shows both continuation and reversal conditions. For a candle to be a Doji, it must meet a single condition: the opening and closing prices to be the same. Careful here, as this is tricky. Today’s markets, with superfast execution and multiple digits quotations, make it difficult for a pure Doji candle to form.
On top of it, the pattern is old enough to beat any pattern part of the Western technical analysis approach. Japanese rice traders used it back in the 1800 to spot future rice prices!
Interpreting a Doji Candle
Because of today’s execution, a certain flexibility degree helps. In other words, traders should look for almost similar prices. That’s especially true when it comes to bigger time frames. Imagine the daily chart: what are the chances for a daily candle to close precisely at the same level? In today’s trading, almost zero. Yet, candles with similar opening and closing prices do appear. Even on the daily charts!
Below is the Tesla (TSLA) daily time frames, showing a bullish trend. Here’s how Doji as continuation patterns look like.
Notice something interesting? As a Doji candle shows both continuation and reversal conditions, traders don’t know what will follow. Hence, a Doji signals uncertainty. As always when it comes to patterns, the bigger the time frame is, the more critical the pattern. However, even if the pattern forms on the daily chart, traders pick the actual entry from a lower time frame.
How to Trade a Doji Candle
When a Doji candle appears, the focus shifts to its highest and lowest point. When the market pushes beyond, we know if the Doji showed continuation or reversal conditions. But, every trade must have a predefined risk. And, a proper reward. Therefore, the following steps help. First, look for a Doji candle to appear. Second, place a pending buy stop order to buy at the highs and one pending sell stop to sell at the lows. Third, when one of the two gets triggered, the other one gets canceled. Some brokers even have a special type of order, called OCO (One Cancels Other) for this kind of trading.
Next, set the stop loss at the lowest point in the Doji candle (on a long trade), or at the highest end of a short trade. Finally, use a 1:3 risk-reward ratio, with the possibility of trailing the stop or moving the stop loss at break-even as soon as the market allows.
The key here is to avoid the gaps. As such, don’t leave any pending orders after the market closes, as the risk is you’ll be filled at different levels. Doji candles signal strong reversal conditions. It is strange that a single candle has such a power, but it works like magic.
Above is the same TSLA daily time frame, showing a Doji candle at the end of a bullish trend. The same rules as listed earlier apply. At the moment the Doji appeared, traders don’t know if it’ll reverse the trend or it’ll show continuation. All we know is it shows uncertainty: both bulls and bears fight for their lives. The moment the lowest point gives up, a trade setup appears. Short at the lowest point, stop at the highs, target 1:3 risk reward ratio. Isn’t trading fun?
Now let’s zoom and have a look at that Doji candle to see it for more details. From a distance, it looks like a pure Doji, but a closer look shows “similar” opening and closing prices.
In today’s trading, it is enough for it to be a Doji, for all the reasons explained earlier. The long shadows are almost equal, signaling a beautiful pattern.
The discussion surrounding a Doji candle doesn’t stop here. Japanese traders used different terms for different Doji types, like:
- Gravestone Doji
- Dragonfly Doji
- Long-legged Doji
However, it makes no sense presenting them here, as trading them follows a similar path.
For a single candle, the Doji shows remarkable powers. What’s even more interesting is that traders can use it to trade both bullish and bearish trends. Moreover, to trade both in the trend’s direction, as well as in the opposite one.
The most significant advantage over the classic, Western technical analysis patterns, comes from the very tight stop needed. After all, we talk about a single candle, that gives the entry, stop and target, right after the price breaks.
The stock market has the significant advantage of being less liquid than other markets. For example, the Forex market is more liquid. As such, Doji candles are hard to find, as a currency pair’s quote has five digits. For the stock market, that’s not an issue. But, traders must be aware of the possible gaps to follow a daily Doji candle.
All Japanese patterns depict a battle between bulls and bears. No other patterns can show it so vividly and offer a quick entry in a trend. Thus, there’s no need to wait much before opening a trade, and appropriate risk-reward ratios do form. The only thing needed is to be patient and to trade the pattern as it was intended: in both directions, with no bias in mind whatsoever.