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Magic Doji or Myth and How to Use Doji for Stock Trading

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Doji candlestick  is also known as magic doji because of its power in technical analysis. Doji candle comes in different forms and types in the chart patterns with different implication. Even though there are several types of doji reversal, all the doji candles’ indicates the market indecision in different forms.

 

Doji Candle:

Doji is a stock trading reversal candlesticks widely used in technical analysis indicate the indecision in stock market. This candlestick is called magic doji because of its single handed power of predict possible trend reversal in the upward movement.

Doji Candlestick

Doji candlestick formation:

  1. Upper shadow and lower shadow: Doji candle has both upper shadow and lower shadow. Idle canadlestick has the same upper level and lower level shadow but this is not important. Upper shadow indicate that bull moved the market up but failed to hold its position and give up. Lower shadow indicates that bear had the control of the market and moved down the market to downside. However, bear also failed to hold the downtrend intact.
  2. Open and close: Idle  candlestick has the same open and close. Candlestick is also considered doji if the price difference between open and close is minimal or very low.
  3. Color of the Doji: color of the doji  candle is not important. Because real candlestick has no actual body. So any color on  candlestick is acceptable.
  4. Support and resistance: Doji candle like all other candlestick works in the support and resistance zone. Specially this candle after prolong uptrend at the resistance label is very strong trend reversal signal. On the downtrend, this is also true. However, not as strong like uptrend. Doji candle itself works as support and resistance for the relevant stock.

Myth about Doji candle:

  1. Doji candle means trend change or reversal: This is true that doji is a reversal signal. However, all the doji candle  is not indicative of the reversal. We see lots of doji at the middle of the trend line. Doji at the market tops and doji at support has different implication.
  2. Multiple dojis are sign of strong reversal: This is not true. Multiple dojis or near doji candle indicate noise not a clear trend. According to steve nison author of Japanese Candlestick Charting Techniques” doji sessions are important only in markets where there are not many doji. If there are many doji on a particular chart, one should not view the emergence of a new doji in that particular market as a meaningful development. That is why candlestick analysis usually should not use intra-day charts of less than 30 minutes. Less than 30 minutes and many of the candlestick lines become doji or near doji except for the very active markets such as bond and S&P futures)”.
  3.  Signal is same at market support and resistance line:  Doji candlestick is famous for calling the market tops. The reasons is that at the top of the market uptrend appearance in doji candle indicate indecision or lack of confidence from the buyer. As market can not move up without buyers confidences. That’s why doji candle at prolong uptrend is very important and warning sign for the market. On the other hand doji candle at the bottom or support line, does not have the same significance. Steve nison mentioned in his book  “Yet, as good as doji are at calling tops, based on experience, they tend to lose reversal potential in downtrends. The reason may be that a doji reflects a balance between buying and selling forces. With ambivalent market participants, the market could fall due to its own weight.Thus, an uptrend should reverse but a falling market may continue its descent. Because of this, doji need more confirmation to signal a bottom than they do a top.”

How to Trade Doji Candlestick :

Doji is known as magic doji because of its power of calling market tops. But all the doji candle in the uptrend is not the magic doji. If doji appeared after big white candlestick in a prolong or extended uptrend, that a good setup for powerful doji reversal. In the above chart of CME,   a tall white candlestick is appeared in the uptrend after that a doji candlestick is appeared. Even though this is not ideal doji reversal, but this is good setup . After doji candle appeared at the top of the uptrend, stock broke down from uptrend and continued to move down.

 

Bearish doji candlestick chart

Pattern Recognition for bearish Doji:

  1. An established uptrend: This pattern should have an established uptrend. After a straight uptrend or extended upward move, Doji reversal pattern works better. In the chart of CME, we see an upward extended move and move is indicated by yellow trend line.
  2. A tall white candlestick: This pattern works better if it combined with white tall candlestick. In the CME chart, stock gaped up and made a big move and close in high of the day. This big tall candlestick indicates possible breakout of the stock.  Stock failed to break previous day high and made an intraday near doji candlestick and next day stock even went down below of previous day  candlestick. This signs clarifies the weakness of the breakout and possible trend reversal. Since stock failed to move up above the white candlestick, that means this breakout occurred by novice buyers and momentum traders and institutional traders did not participate in this break out.
  3. Doji reversal candlestick: This pattern last and most crucial sign is the appearance of the doji candle at the market tops and predict possible trend reversal. CME chart shows  this candle is  accompanied by tall white candlestick. This candle tried to break the high of the tall candlestick and failed to hold above the high of tall white candlestick and made a reversal pattern at the top of the market. This  candlestick warned that breakout is fake and a possible trend change in the market.

 

Bearish doji candlestick charts

Trade setup for Bearish Doji:

Trade Entry:

Stock Trader should wait for the confirmation. After stock broke down the low of the doji candlestick, entry is triggered. Entry point is shown by blue line. Chart shows that stock completely collapsed as stock went down below low tall white candlestick and also broke the uptrend (indicated by yellow line). This point is very important because as stock went down low of the tall candlestick, breakout is failed and uptrend is also breached. These two forces collapsed the stocks. Stock trader should hold the stock until the price hits the target of the trader or stock pull back hits the stop loss point. Psychology behind this trade setup is that as doji candlestick indicates the market indecision, stock price broke down below the low of the doji reversal candlestick  indicate uptrend is broken. After stock broke the low of the white candlestick, lots of trader stopped out and many of them joined with bear. This forced the stock moved down even harder.

 

Exit of the trade:

Stock trader should exit the trade if stock moved up to the high of doji candle and supersede the high price of the candlestick. Stop loss or exit price is shown by yellow line. Reason for trader should leave the trade if price exceed the high of the doji candlestick  uptrend is presumed and possible  reversal  pattern is failed.

 

Doji trading strategy  in the Downward or Bullish doji:

Bullish doji is also another good pattern to indicate the bottom. Even though this pattern is not powerful like doji reversal at the tops of the market.

Bullish doji candlestick chart

Pattern recognition for Bullish doji:

  1. An established downtrend: This pattern should have clean downtrend. Cleaner the downtrend, better the pattern output. In the chart of CME, stock went down from 76.5 to $70 almost 10 percent down in less than one month.
  2. Slope of the trend becomes less steep over time: At the beginning of downtrend, stock fall down sharply. As time moves on, the rate of steepness fall down. In the strong downward move, taking a bullish doji pattern is less reliable. Because stock in the downtrend could fall down of its own merits and bullish doji candlestick does not work sometimes. Best idea is to wait for the stock downtrend becomes less steep. As stock downtrend becomes less steeper or a bottom is already formed in the downward move and   pattern becomes more reliable. In the CME chart, stock moved down sharply at the beginning and formed a bottom. In the chart, down trend has two trend line. Yellow one is steeper trend line and brown one is less steep trend line.
  3. Bullish Doji candlestick: Third criteria is the appearance of a bullish doji. Doji candle  appearance works better in less steep trend line. In the beginning ,trend line is steeper and doji reversal  is relatively less reliable. In the chart of CME, after steep downward move, stock made a beautiful bottom and stock downtrend became less steep. In the less steep trend line, stock move down below the low of the bottom and stock move up to the open and close above the low of the bottom. Blue circle indicates the bottom. This beautiful doji reversal clearly indicate the end of down move. The reason behind this is as doji candle stick went to the bottom area of the stock, buyers started to buy the stock and moved up the price above the low of the bottom. This means there is a lot of buying pressure and stock already made a support line in this area. Support line is indicated by blue bold line.

Bullish doji candlestick charts

 

 Bullish doji trading strategy:

Trade entry:

Trader should entered into the trade next day after confirmation is occurred. In the OMC chart, entry into the trade are shown by the blue line. Trader should get in to the stock trading after price breached the above of the doji  candlestick and hold the stock until price reached target of the trader. OMC chart shows that as stock moved up to the resistance line, a hammer is formed. This hammer came back to the support area and retested the bullish doji area. This gives additional confirmation for the uptrend that stock uptrend is not fake and possible continuation of uptrend.

Trade exit or stop loss:

Stop loss of this pattern is below the low of the tail of the bullish doji. Yellow line in the above chart indicates the exit point or stop loss of the trade. Stop loss is fixed below the yellow line or low of the bullish doji candlestick because if price breached the low of the long tail that means downtrend is resumed again and new traders will join the downtrend and stock will go further down.

 

 

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