The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick charting, "Japanese Candlestick Charting Techniques." However, by itself, the only thing it indicates is temporary market indecision. To use the doji candlestick pattern effectively, traders need to look at other technical indicators for confirmation of a possible market reversal.
A doji is formed when the opening and closing prices of the time period charted are identical. If a person is trading off the hourly chart, and EUR/USD opens and closes at that hour at the price of 1.3595, then a doji candle is formed by that hour's trading activity. There are a variety of doji candlesticks, differentiated by where in the time period's trading activity the identical open and close occur. For example, if all of the hour's price activity takes place below the open/close spot and the doji candle looks like a capital "T," it is a dragonfly doji. The classic doji candle features trading above and below the open/close price and looks like a cross or lowercase letter "t."
Any of the various doji formations signal market momentum has at least temporarily stalled or the market is momentarily undecided, but more importantly, a doji candlestick may signal that a change in direction, or a market reversal, is about to occur. To accurately determine the probability that the doji foretells an upcoming reversal, traders look at other factors and technical indicators for confirmation.
The Trends Is Your Friend
One of the first factors to consider is whether the market is trending. As with most technical trading indicators, the doji is more likely to be of significance in a trending market. In a ranging, trendless market, traders often see familiar chart patterns form that ultimately prove insignificant due to the fact the market overall is without direction, just aimlessly trading up and down until something happens to cause it to choose a direction and start a new trend. If there has been a clear overall market trend preceding the formation of the doji candle, it is more likely the formation is significant, or that it is signaling a market top or bottom, at least in the near term.
Momentum indicators can be helpful in reinforcing the probability of a doji correctly forecasting a change in direction. If the moving average convergence divergence (MACD), average directional index (ADX) or stochastic oscillator show divergence, or are turning lower even though market price is continuing higher, or in a downtrend, turning higher as price continues lower, this increases the likelihood of a change in market direction. Traders also consider whether price is at, or approaching, a major support or resistance area identified by previous price action or by Fibonacci or pivot points. The doji candle occurring in a significant price area lends credence to it being a reliable indicator of a turning point.
Chart formations like a head and shoulders pattern or double top can also back up the doji pattern. Doji candlesticks are always worth noting but do not always mean a market reversal is imminent. Therefore, it is important for traders to consider other technical indicators to evaluate potential trading opportunities.