The doji, which is shown below, is a unique and readily identifiable candlestick. It is definitely easy to spot on a chart.
The body of the candle is very short, almost non-existent while the wicks are elongated relative to the body. The short body shows that the opening price and the closing price were very close to one another…virtually equal. The elongated wicks show that even though the opening price and closing price were quite close, during the time that the candle was open, price fluctuated quite a bit.
Taking all this into consideration, the doji signifies indecision since the buyers and the sellers pushed price around quite a bit. But, in the end, they finished up about where they started. This indecision also points to the potential for price to change direction.
So when a trader sees a doji, they would look to determine the direction that the pair was moving prior to the formation of the doji. If the pair was moving up prior to the doji appearing on the chart, we would be looking for a reversal to the downside after the doji closes. The opposite would be true if the pair had been moving down prior to the doji.
One of the advantages of using the doji for trading signals is the guidance that it offers in placing a tight stop. Take a look at the 4 hour chart of the GBPCHF below…
Created with Marketscope/Trading Station
In the above scenario, price had been moving down toward the 200 SMA (green line), since price initially broke above the 200 SMA. When the doji forms right along the 200 and “wicks” below it, this long wick provides an ideal guide for our stop…just below its wick.
Since price had been moving lower prior to the doji, the potential change in direction would be to the upside. Once the doji closes, a trader could take a long position with the stop placed just below the wick as noted on the chart.
The benefit of a trade such as this is that there is very little risk and the potential for gain far surpasses the risk.
Bottom Line: we have entered a trade with a solid Risk Reward Ratio.
As with all things in trading, there are no guarantees and trading with a doji is no exception. All trades based on dojis will not work out but with a prudent Risk Reward Ratio, we can put the longer term trading probabilities in our favor.
Also, anytime a doji signals taking a trade in the direction of the overall Daily trendthat will be a higher probability entry.
---Written by Richard Krivo
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