How to swing trade a gravestone doji candle: Is it a stock market rally killer?

In this video I will go over the gravestone doji candle pattern that has formed on the Nasdaq 100 (QQQ) weekly chart and what that means for stocks in general, as well as analyze how it has impacted the market in the past.

For some background, a gravestone doji candle is a type of candlestick pattern used in technical analysis of financial markets.

It has the following characteristics:

  1. The opening and closing prices are the same or very close to each other.
  2. These prices are also at or pretty close to the low of the day.
  3. There is a long upper shadow (wick) extending upwards, indicating that prices rose significantly during the trading period before falling back down.

The gravestone doji resembles an upside-down “T” or an inverted hammer. It’s called a “gravestone” because it’s thought to signify the death of an uptrend.

This pattern is generally considered bearish, especially when it appears at the top of an uptrend, suggesting that, despite a strong push upwards during the trading period, sellers ultimately took control and pushed the price back down to its opening level.

The significance of the gravestone doji in trading:

  1. Bearish reversal signal: When a gravestone doji candle appears at the top of an uptrend, it can signal a potential reversal. Traders often see this as a sign that bullish momentum is weakening.
  2. Rejection of higher prices: The long upper shadow indicates that buyers pushed the price up during the session, but couldn’t maintain those levels. This suggests a lack of buying pressure at higher prices.
  3. Confirmation needed: Like most candlestick patterns, traders typically look for confirmation in the following candles before making trading decisions.
  4. Volume consideration: The pattern is considered more significant when accompanied by high trading volume.

Comparison to other doji patterns:

  1. Dragonfly doji: The opposite of a gravestone doji. It has a long lower shadow and little to no upper shadow. It’s often considered bullish when appearing at the bottom of a downtrend.
  2. Standard doji: Has small shadows on both sides, indicating indecision in the market.
  3. Long-legged doji: Has long shadows on both sides, suggesting high volatility but ultimate indecision.
  4. Four-price doji: Extremely rare, where open, high, low, and close are all the same price. Personally, I would stay away from these as it usually means there’s no trading taking place, and you’ll usually see hardly any volume.

Traders typically use the gravestone doji as part of their broader trading strategies in the following ways:

  1. Trend reversal indicator: When a gravestone doji candle appears at the top of an uptrend, traders may interpret this as a potential sign that the trend is about to reverse. As a result, swing traders may consider closing long positions to protect profits, open a short position in anticipation of a move lower, or set tighter stop-losses on existing long positions.
  2. Resistance level identification: The high point of the gravestone doji’s upper shadow can be seen as a resistance level, especially if the stock or ETF has seen resistance at these levels in the past. As a result they may tighten stop-losses in case of a shar reversal lower on existing positions or even consider placing entry orders for a new short position if the price approaches this level again, and a sharp rejection ensues.
  3. Confirmation with other indicators: Traders often combine the gravestone doji with other technical indicators for stronger signals like overbought conditions on the Relative Strength Index (RSI), Bearish divergence on the Moving Average Convergence Divergence (MACD), or an overbought reading on Stochastics. I personally like to see it when the market has been overbought for a while, and the market breadth is worsening with overbought conditions.
  4. Time frame consideration: Traders may look for gravestone dojis on multiple time frames for stronger signals. A gravestone doji on a daily chart might be considered more significant than one on a 5-minute chart. I personally take it much more serious when it appears on the weekly chart after a multi-week rally, preferably 6-8 weeks or so.
  5. Volume analysis: High volume accompanying a gravestone doji is often seen as adding credibility to the potential reversal signal. This tells me that the emotions are getting amplified, especially if the rally before it was on very low volume.
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Gravestone Doji Probabilities

When discussing the probabilities of trading gravestone dojis, it’s important to note that exact probabilities can vary depending on market conditions, timeframes, and other factors. However, I can provide some general insights as to what my own personal experience with them in my own trading.

  1. Reliability: Studies have shown that the gravestone doji, when appearing at the top of an uptrend, can be a reliable reversal signal about 55-60% of the time. This means that in slightly less than 6 out of 10 cases, a downward move may follow.
  2. False signals: Consequently, about 40-45% of gravestone dojis may not lead to the expected reversal, resulting in false signals. That my friend, is why you have use stop-losses because they can rip higher and against your trade.
  3. Confirmation importance: The probability of a successful trade increases significantly (to around 70%) when the gravestone doji is confirmed by the next candle closing lower. Of course success is relative because it will all come down to how you manage the risk and the trade itself.
  4. Market context: The probability of a successful reversal is generally higher when the gravestone doji appears at a known resistance level, ater a prolonged uptrend, or in overbought conditions. If the market recently appears to have put in a short-term bottom and a gravestone doji candle appears, I would avoid that candle like the plague, because there is a good chance that stock is going to continue ripping higher.
  5. Timeframe influence: Gravestone dojis on longer timeframes (daily, weekly) tend to be more reliable than those on shorter timeframes (hourly, 5-minute).
  6. Volume impact: High volume can increase the reliability of the signal, potentially pushing the success rate higher for the swing trade.

Again these are my own approximations, and not certifiably reliable by any means. Trading based solely on candlestick patterns without considering other factors can be risky and definitely not something I would even consider doing.

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