When utilising Japanese candlesticks to trade forex, being able to judge the sentiment of the market is of key importance in being able to predict when a reversal is likely to happen (important for both entering and closing trades).  In this next in the series of article about the use of candlestick analysis we will review an important type of candle, the doji.  When encountered in a strongly trending market, the doji can offer quite a powerful indication of shift in market sentiment.  When seen alone or in a two- or three-candle pattern it may signify that the current trend is losing steam and that a shift in market trend may be approaching.

The doji is formed when the opening and closing prices are the same and represents a market that is equally balanced between supply and demand.  This represents an indecisive market and could be an early indication that the current trend is losing momentum and a reversal could occur.  Although an ideal doji occurs when the opening and closing prices are the same, a candle may be considered a doji when the opening and closing prices are only slightly different.

Doji’s are however more significant in predictive value when they appear in an up-trending market than in a downwards moving market.  When found at the end of a long up-trending market they may signify an exhausted market, when appearing during a downwards trend they may not represent the same thing.  This is because a doji represents market indecision and indecision in an oversold market may merely be a resting point before the market continues to decline.

Doji candles have several nicknames depending on the placement of the open/close price on the session.  These specially named doji are still reversal indicators but may be more strongly associated with a change in market sentiment.  A couple of the ’special’ doji candlestick patterns are dragonfly doji (looks like a capital ‘T’) and the gravestone doji (an inverted ‘T’).

The dragonfly doji looks a capital ‘T’ with the open and close near or at the top of the candle.  This candle has good bullish implications as it indicates that the market fell sharply during the session (shown by the long lower shadow), but then rose back again under buying pressure to close at or near the sessions peak.  It resembles the hammer candlestick pattern, but lacks a real body.  The dragonfly doji is of particular importance for candlestick trading when it is found in an oversold market.  As mentioned previously, a doji that is found in a decline is normally of little importance, but the dragonfly is an exception.

The bearish equivalent to the dragonfly doji is the gravestone doji and it resembles an inverted ‘T’.  The open and close is found at the bottom of the long shadow and represents a market that was initially bullish but then prices fell and closed at or near the low of the session.  The gravestone doji when found at the end of a uptrend could indicate a trend reversal.

Trading forex can be risky business so we always want to stack the odds in our favour.  Therefore, when examining candlestick charts involving the doji pattern, it is important to wait for a confirmatory candle.  The doji represents a potential trend reversal (especially when found at the end of an up-trend), but it is not as strong an indicator of reversal than the previously discussed candlestick patterns.  In order to consider the doji a valid trend reversal indicator, the subsequent candle should close at a lower price than doji (remember we only trade off the doji when it is seen in an uptrend).

Below are some examples of when to use and not to use the doji.  In the first example (moving from left to right), a doji appears during the down trend (not an ideal doji as open and close price differ slightly).  If you waited for the next candle to confirm the trend reversal, you may have been tempted to go long, but remember, don’t trade the doji in a downtrend!  If you had entered the trade you would have been stopped out.  In the second example, another doji appears, this time in an uptrend.  If you entered this trade straight away, again you would have lost money.  You need to always wait for a confirmatory candle, and in this case, the subsequent candle closed at a higher price than the doji, invalidating the potential trend change.  In the final example on the far right, we see a gravestone doji.  This is quite a strong indicator of trend reversal, and as the second candle closed lower than the doji, it represents a valid trade.  In this case I probably would have waited for the price action to retrace before entering the trade as the required stop would have been quite large (above the top of the doji).