The long legged doji giving a good buy signal

Figure 6-5 is a long legged doji that occurred in late 2002 on the futures contract of the Canadian dollar. It occurred after three very bearish days in a row and was followed by a very nice uptrend. This example shows how a long legged doji works when it signals the end of a down move. Unfortunately, I didn't trade this particular scenario, but I definitely will if I see the same pattern in the future!

Figure 6-5:

Canadian dollar futures contract with a nice buy signal from a long legged doji.

Figure 6-5:

Canadian dollar futures contract with a nice buy signal from a long legged doji.

Notice that the doji buy signal in Figure 6-5 works almost immediately — what's expected of a trend changing signal. If the signal doesn't seem to be working very quickly, beware.

Trading against a trend is a very dangerous prospect. You need to be sure you're prepared to take a loss and move on quickly to the next trade if things go sour.

A faffing tang legged doji

Now on to the bullish long legged doji that didn't work too well. In all honesty, it was difficult to find a good real-world example. The long legged doji is fairly rare, and when it shows up during a trend, it usually does signal an impending trend change. It does happen, though, and Figure 6-6 is an example of a long legged doji that didn't signal a change in trend.

Figure 6-6 features price action for a stock with a long legged doji showing up after a few downtrending days. The price trends up for the next day or two and things look fine, but then the long legged doji's low is broken, and the signal is no longer valid. If you were trading this stock and didn't get out at that critical point, where a stop order should've been placed or an exit trade should've been executed, you would've endured some pretty painful losses.

Figure 6-6:

A long legged doji buy signal that fails quickly.

Figure 6-6 features price action for a stock with a long legged doji showing up after a few downtrending days. The price trends up for the next day or two and things look fine, but then the long legged doji's low is broken, and the signal is no longer valid. If you were trading this stock and didn't get out at that critical point, where a stop order should've been placed or an exit trade should've been executed, you would've endured some pretty painful losses.

Be sure you're prepared to get out of a trade immediately after the signal you're trading goes bad. Use that as a rule, and follow that rule regardless of how much it may hurt. To help me remember the importance of these rules, I taped the following quote from Zen in the Markets by Edward A. Toppel to the monitor on my trading desk: "You can break the rules and get away with it. Eventually the rules break you for not respecting them."

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Using long legged dojis as sell signals

Just as a long legged doji that appears during a downtrend can be considered a buy signal or the end of the downtrend, a long legged doji that appears in an uptrend may be considered an uptrend reversal or sell signal that can be extremely helpful if you're looking to short a security.

Sometimes in the market no trend is obvious or exists. If you see a long legged doji during one of these times, do nothing. The long legged doji is only useful as a signal when it appears during a trend.

Seeing a good short signal on the long legged doji

Have a look at Figure 6-7 for an example of a long legged doji that provides a useful signal for shorting. This daily stock chart is for Gap, Inc. (GPS). The long legged doji appears in the middle of an uptrend. Notice that there wasn't much of a chance to get out of a long position, and although the opportunity to put on a short was definitely there, you would've had to have been on your toes to pull it off. The stock opened up slightly the next day, and then the bears took over and dominated most of the day. Even the bears that were late to the party toward the end of the day were rewarded with a substantial gap down the next day.

The long legged doji sells signal failing

As always, an example that didn't work too well is in order. Figure 6-8 is a chart of the futures contract that trades on the Canadian dollar. In the center of the chart is a nice long legged doji that appears in an uptrend that may seem to be rolling over. Rolling over means that the price action on a chart has been strong but is starting to top out. I've highlighted the uptrend and then where the price begins to roll over or top out. Toward the right side of this rolling price action, a long legged doji appears. Things look good for a little while, and then the high of the doji is overtaken, and the price is off to the races once again.

Figure 6-7:

A long legged doji sell signal on GPS that works out quite well.

Figure 6-7:

A long legged doji sell signal on GPS that works out quite well.

Figure 6-8:

A long legged doji sell signal on Canadian dollar futures that fails.

Figure 6-8:

A long legged doji sell signal on Canadian dollar futures that fails.

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