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Dragonflies, Gravestones and Shooting Stars: The Doji as

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a Reversal Signal in Candlestick Charting

Colorful names: important candlesticks. Many candlestick reversal signals are built on variations of the doji. The doji, a candlestick introduced in last weekend's article on the basics of candlestick charting, results when a session opens and closes at the same price. The candle possesses no real body, but it may have upper or lower shadows or both. Doji, a word appropriate for single or multiple candles of this type, may comprise part of multiple-candle reversal signals or may serve alone as possible reversal signals.

Annotated 120-Minute Chart of CME:

Some call Steve Nison the father of candlestick charting. When introducing the doji, he explains that the appearance of a doji signals indecision. If a doji appears after a trending move, the trend may be weakening. Not always, however.

While doji sometimes signal reversals, a study of CME's 120-minute chart illustrates a couple of points that Nison makes. Don't assume a reversal will occur after each doji, he counsels. Doji that come in the middle of consolidation zones merely corroborate the indecision that prompted the consolidation pattern to form. Several such doji occurred in the May 23-31 period on CME's 120-minute chart.

A doji's position matters. A doji can be a neutral candlestick when it occurs during consolidation or a potential reversal signal after a trend. Its significance depends on the market action prior to its formation. The size of the preceding candles also matters. A doji that follows a long candle assumes more significance than a doji that follows a small-bodied candle.

Nison also addresses candles that are nearly, but not quite doji. Their bodies are small, but the open and close were not at exactly the same price. Are they ever treated as if they were doji? That depends on the size of nearby candles, too. If the near doji's body appears small in comparison to nearby candles, the near doji can usually be treated as if it were a doji. A spinning top, a small-bodied candle with both upper and lower shadows, sometimes appears at the end of a trend, serving the same function as a doji.

Annotated Daily Chart of LSI:

Even when doji or near doji occur after a trending move, a reversal cannot be assumed. LSI's action produced several doji or near doji as it declined early in August and again in mid-September, and their appearance did not herald a reversal.

Doji need confirmation. Sometimes confirmation comes in the form of a gap in a direction opposite to the prior trend. That sort of gap confirmed the reversal after LSI's doji was printed at the early September swing high. Other times, confirmation comes in a single long candle that reverses the prior direction or in a move that eventually surpasses the open of the tall candle that preceded the doji. The order might be as follows: long white candle, doji and long red candle, or long red candle, doji and long white candle.

Annotated Weekly Chart of the TRAN:

The doji shown on the TRAN's chart was the second of a three-candle reversal signal known as an evening-star pattern. In this pattern, a doji or small-bodied candle follows a long white candle. Ideally, the doji sits above the long white candle. A long red candle is the third of this three-candle formation, with the red candle ideally forming beneath the doji's close. Traders know the comparable bullish reversal signal as a morning-star formation, and it consists of a long red candle followed by a doji or near doji, with the pattern completed by a long white candle that forms above the doji.

Wait for the confirmation. GOOG bears who saw a doji at the top of a climb in May and automatically entered a bearish position had reason to rue that decision when GOOG did not confirm the reversal the next day.

Annotated Daily Chart of GOOG:

Doji come in many variations. Doji can be spinning tops, although not all spinning tops are doji. Some possess small real bodies. Doji also come in long-legged variations. They can be gravestone doji or dragonfly doji or shooting stars. The different names describe the size and position of shadows. Generally, the longer the shadows, the more pronounced the indecision has been.

Annotated Three-Minute Chart of INTC:

Doji names can vary according to where the doji appear. A gravestone doji at the top of an uptrend may be known as a shooting star, for example. Shooting stars can also have small real bodies. A dragonfly doji is a specialized type of hammer or hanging man candle, a candle with a small real body, no or a small upper shadow and a long lower shadow. Hammers and hanging men have the same shape, with the candle named a hammer if it occurs after a downtrend and a hanging man if it occurs at the top of an uptrend.

Don't get hung up on the names. The general idea is that doji or small-bodied candles that occur after a trending move indicate a weakening of that trend. They indicate indecision and can presage a reversal. Since they can also presage consolidation, the trend reversal needs confirmation. The longer the shadows associated with that small-bodied candle or doji, the more indecision that is expressed.

The previous article offered some basics of candlestick charting, and this one offered the basics of doji as reversal signals. Readers who want to know more might check out the books mentioned in the previous article. Steve Nison's JAPANESE CANDLESTICK CHARTING TECHNIQUES is an often-quoted favorite and Greg Morris' CANDLESTICK CHARTING EXPLAINED is another possibility.
 

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