The Japanese word doji means mistake. Can a mistake point to a strong charting signal? The doji candlestick occurs often and is a very valuable signal. Even though it contains only a single session, it is a meaningful red flag.
The key to understand the doji is twofold. First, the typical candlestick consists of a rectangular “real body” representing the distance between opening and closing price. But when trading opens and closes at the same price, you find a horizontal line instead of a rectangle. That is a doji.
The second important attribute is the length and position of any shadows. The shadow represents the full trading range for the session, either above or below the open and close. The longer the shadow is, the greater its importance. A long shadow indicates that buyers (for upper shadows) or sellers (for lower shadows) tried to move the price level farther along, but failed. This means the side on the long shadow lost momentum; and that usually means price is going to move in the opposite direction next.
You may easily locate three common doji types: the dragonfly, gravestone, and long-legged.
The dragonfly doji has a long lower shadow. This is a bullish sign, often foreshadowing a coming bullish trend in price. In this formation, sellers tried to move price downward during the day, but did not succeed. There may be a small upper shadow or none at all.
The gravestone is the opposite of the dragonfly; it has a long upper shadow. As a bearish sign, is may precede a reversal into a downtrend in coming sessions, and the longer the upper shadow, the stronger the likelihood of reversal. The pattern reveals an attempt by buyers to move price higher during the day, but the attempt failed and price closed at the same level as its open.
The long-legged doji has unusually long upper and lower shadows. It may be either bullish or bearish. When the long-legged type shows up after a strong trend, it may signal reversal. So at the end of a downtrend, it is bullish; and at the end of an uptrend, it is bearish. In a long-legged doji session, both bulls and bears took turns trying to move price, and both failed. So it occurs on an exceptionally volatile day. When combined with very high-volume, it is a classic two-part reversal signal that day and swing traders like to see. The combined narrow-range (the horizontal line) with high volatility (shadows on both sides) sets up the likely change in price direction. This is confirmed if you also notice a volume spike on the same session.
Time and again, you are going to notice formations like the doji as the red flag telling you the current trend is ending and about to turn in the opposite direction. The doji might be a “mistake” in the sense that it lacks a real body. But the real mistake is to ignore what the doji reveals.
Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com.