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May 12, 2006

Using Dojis for Short Term Trading

by Scott Hoffman, Senior Broker & CTA

Doji bars are one of the single most useful single bar patterns that any trader can identify. They can be used for entries, exits or to determine position bias. "Doji" is a term used by Japanese candlestick chartists that refer to a bar where the open and close of a bar are in close approximation to each other. They don't have to be exactly the same, but close. For our purposes we use a definition where the open and close are within 25% of the days trading range of each other. It doesn't matter if the "Doji" occurs near the top, middle or bottom of the days trading range, just that they are close. For example, if the days range: (High - Low) is 10 cents, then the open and close would need to be within 2 ½ cents of each other to qualify as a Doji.

The underlying theory of the Japanese Candlestick approach is:

1. The "what" a market is doing (price action) is more important than the "why" (news, market reports, and so on).
2. All information known to the public is reflected in the current price.
3. Buyers and sellers move markets based on expectations and emotions (fear and greed).
4. Markets fluctuate and oscillate.
5. That actual current price may not reflect the real underlying value.

But more importantly, what most Doji bars represent is indecision in the market place, a place in the market where neither buyers or sellers have a advantage over each other nor are willing to commit to the market and are at an impasse.

This is significant for 2 reasons for all traders -
Position, Swing and Day Traders:

1. For longer-term traders dojis are often found at turning points, where trends reverse and they are almost always found in patterns of consolidation where it's indeterminate whether a trend will continue or reverse.
2. For day traders dojis can act as the catalyst for signal set-up bars that may indicate potential trend days that day traders need to take note of.

Although the term doji refers to Japanese candlestick charts you don't actually need to look at a Candlestick chart to recognize dojis-in fact they can be easily recognized on conventional bar charts. There is one significant difference between candlesticks and the conventional bar chart. Candlesticks tend to highlight the Open-to-Close relationships where traditional bar charts tend to highlight a Close-to-Close relationship. With a little practice Doji bars are easily identifiable when looking at a traditional bar chart, if you prefer. In the illustrations you'll be looking at, a red "body" will highlight a "Down" bar (where the close is below the open), and Green will highlight an "Up" bar (where the close is higher than the open). Standard black will be used for the traditional bar charts.

Here's an example of Doji bars plotted both ways-Japanese candlestick style versus the traditional bar chart method.

Now let's take a look at a few examples with both Japanese candlesticks and the traditional bar chart together and discuss how to practically incorporate the "Doji" bars into our trading approach. The featured market here will be Soybeans. We picked one of the Grain markets because we're entering the 2006 growing season which is normally a great time to trade grains. We also added them because of all the markets available to trade there is much information, and misinformation, available to the public.

There are several points of interest in Chart #1.

First, the obvious point is that Doji bars occurred at both ends of the downtrend, beginning at point "A" and ending at point "B". The second and most important point is that even though Doji bars occur at both ends of this short trend, they did not forecast the trend or the reversal. What they did do was provide the "Heads-Up" that the previous price action in the market was changing and the market might merit a trader's attention. One of the largest problems a speculator faces is learning "Where" to focus his/her attention or funds. Learning to identify and trade Doji bars can help do this.

Note that while the Doji at point "A" gave the heads up, the trend was not initiated until the bar labeled "Initiating Sell" was established. After the short downtrend, notice that at point "B" we see 2 Doji bars back-to-back. At this time there is know way to know whether the trend is pausing before resuming the move lower or whether the trend will reverse.

In most successful trades there is a point when markets are cooperating and the trader feels secure with his or her position, then at some point the picture becomes "muddled" and uncertain. Learning to identify and properly react to Doji bars can help a trader deal with this period of uncertainty.

Now let's see what happens next in Chart # 2.

Here we pick up where we left off in the first example. As you can see at point "A" there was a moderate rally after the previous downtrend. Although the market moved higher, this is hardly what could be called a reversal. Again we'd like to emphasize that a Doji bar is not predictive of future price direction, only that the previous environment has changed. Market bias, entry/exit signals and positions should still be determined by additional analysis.

At point "B" we can see another "Doji" bar on the 2-day break from the recent high. Here it might be appropriate to expect a move to the upside but it would only be a suspicion. The potential trend reversal wasn't complete until new highs were made, in particular a close above the previous swing high marked by the dotted horizontal line.

Moving forward, we can see that the area marked by point "C" begins a consolidation phase that last for 5 days. It's important to note that in this case the Doji bar(s) did not result in a trend reversal but rather defined a trading range and a period of consolidation before the trend resumed the move to the upside. Markets are in a constant state of flux going from trending to consolidation to trending again, either by reversing or continuing the previous trend. Learning to identify, understand and react to Doji bars can help a trader identify where a market is in the cycle and trade accordingly.

About the Author

Scott Hoffman is a Senior Broker and CTA with Daniels Trading. After graduating from the University of Chicago in 1986 with a degree in Economics, Scott worked on the floor of the Chicago Mercantile Exchange. Following his time at the CME, Scott went to work off the floor, serving as the personal broker to a former chairman of the Chicago Board of Trade. Here Scott learned the trading and brokering business, a process that he continues to expand and refine.

Scott is the publisher of Swing Trader’s Insight, a comprehensive swing trading advisory service covering all of the major futures markets. In addition to a nightly newsletter, Swing Trader’s Insight provides in-depth client education complete with specific trade recommendations and market analysis, including an S&P Morning Insight commentary, Midday Updates and Trade Management Updates. Although Scott specializes in swing trading, he has years of brokerage experience that is available to all of his clients, regardless of their individual trading styles.

PLEASE NOTE THAT THERE IS AN INHERENT RISK OF LOSS ASSOCIATED WITH OPTION CONTRACTS. OPTIONS TRADING IS NOT SUITABLE FOR ALL INVESTORS. OPTIONS CAN AND DO EXPIRE WORTHLESS. IF YOU PURCHASE A COMMODITY OPTION, YOU MAY SUSTAIN A TOTAL LOSS OF THE PREMIMUM AND OF ALL TRANSACTION COSTS.