In candlestick charting, one of most powerful patterns is the doji. It has the ability to signal tops, bottoms and continuation moves on a pullback. The doji is a simple to recognize and simpler to understand single-bar pattern. The bar will have one or two spikes with almost no body to it. The body of a candlestick (the fat part) is the distance between the open and close. In the case of a doji, the close and open are at the same price. This creates a very distinguished candlestick bar that sticks out on any chart.
Reversal points will sometimes occur on extreme dojis. These two dojis are called Gravestones and Dragonflies. “Short signal,” (below) shows a Gravestone Doji on a five-minute bar from Dec. 27 in the March 2018 E-mini S&P 500.
To expand the universe of possible trades, allow the body of the doji to be a little fatter. In other words, the close doesn’t have to equal the open, but the bar needs to open or close near or on the extreme. An expanded Gravestone Doji is called an Inverted Hammer or Shooting Star.
An Inverted Hammer means that the close is above the open. The Shooting Star is the opposite with the close below the open. The expanded Dragonfly is called a Hammer or Hanging Man. With the Hammer, the close is above the open. The Hanging Man has the close below the open.
A basic reversal pattern can be made up of any of these variations. From this point forward we will refer to an Inverted Hammer, Shooting Star and Gravestone as simply a Gravestone. We will refer to a Dragonfly, Hammer and Hanging Man as a Hammer. These are generic terms used to designate possible turning points.
With a Hammer type of doji, the price makes a final push to the down side, but fails. Its run the stops and finds support. The reversal can be severe.
Entry point: The doji entry and exit are pretty natural. The entry point is the close of the bar. The stop is one tick beyond the extreme of the doji. In this case, the stop is one tick below the doji’s low (see “Euro reversal,” above). The opposite is true for a reversal from the up-side; the stop is one tick above the doji’s high.
For a reversal doji, the extreme is usually a new high for a (sell) short reversal and a new low for a (buy) long reversal. There are situations where there are multiple attempts at a new low or high. A doji reversal is a strong signal even if it is only the second or third lowest low or highest high all bunched together. It is a failure to maintain a move, which portends a reversal.
“Third time’s the charm,” (below) shows three hammers occurring on a five-minute March Treasury bond chart on Dec. 21. A $500 move ensues. If you base your trade on a doji, but the doji’s high/low is not the most recent extreme high/low, use the most recent extreme price and put your stop one tick beyond that.
War Room: Once the trading methodology is set then next is setting up the war room. This involves setting up the charts for the different products: Futures, options, stocks, exchange traded funds or currency pairs that you want to trade. Use multiple timeframes for each entity. You are looking for opportunities. Look for liquid markets. Look at the most active stocks, ETFs, currency pairs, commodities or financial futures. You might even look at some very liquid options to buy if a Gravestone occurs.
Elastic Stops: The default stop target is one tick below the reversal bar. If you are day-trading you might want to look at buying short-term options instead of using a stop. With a short term option you won’t lose much theta (time value). But it will allow your trade room to breathe. The market can hit your initial stop level several times, but since you have an option to protect yourself from an opposite breakout it gives your trade time and a chance to produce a profit, particularly when there is a series of hammers.
Profit Targets: You can use the height of the doji bar as the distance for your profit target. The height is simply the high minus the low of the doji bar. If taking a long position after a Gravestone, the profit target would be your entry plus the height of the doji bar. If going short after a Hammer, the profit target is the entry minus the height.
Doji Minimums: Determine the minimum height of the doji bar, max body percentage, and how close to the extreme the Hammer/Gravestone needs to be. Fins (where there is a little price difference between the body and the extreme) are allowed. The Gravestone below has a fin on the bottom. The body is still within 85% of the extreme.
The body percentage is only 15% of the bar’s height. For each market, you want the bar to be a certain minimum number of ticks. All these parameters create a trade justification. Otherwise, ignore the doji if it’s too short, not extreme enough or has too much body mass.
Watch for dojis after market pauses such as Sunday nights and after the afternoon break. In the currencies there is a one-hour halt to trading in the late afternoon. Sometimes orders bunch up, which cause a temporary rush to one side. Eventually, the move putters out and a reversal sometimes occurs.
The nice thing about doji trading is that the pattern is very easy to recognize and it gives an opportunity to catch some extremely nice reversal points. Many markets and entities can be traded along with various time frames.
About the Author
Robb Ross runs White Indian Trading Co., and developed its Stairs trading program (see “Ross: White Indian and rubber chickens,” August 2010). He is an experienced programmer and system developer, having worked at both Microsoft and NASA.