Forex Trading System- Japanese Reversal Charts

OVERVIEW

The Japanese reversal charts described in this chapter are a relatively new addition to the realm of technical analysis. Their introduction to Western traders is primarily due to the efforts of trader and author Steven Nison.

RENKO CHART

The renko charting method is thought to have acquired its name from renga, the
Japanese word for bricks. Renko charts are similar to three-line break charts except
that in a renko chart, a line (or “brick” as they are called) is drawn in the direction of the prior move only if prices move by a minimum amount (i.e., the box size). The bricks are always equal in size. For example, in a 3-unit (“3-brick”) renko chart, a 12-point rally is displayed as four 3-unit-tall renko bricks.

Basic trend reversals are signaled with the emergence of a new white or black
brick. A new white brick indicates the beginning of a new uptrend. A new black brick
indicates the beginning of a new downtrend. Since the renko chart is a trend-follow-
ing technique, there are times when renko charts produce whipsaws, giving signals
near the end of short-lived trends. However, the expectation with a trend-following
technique is that it allows you to ride the major portion of significant trends.
Since a renko chart isolates the underlying price trend by filtering out the minor price changes, renko charts can also be very helpful when determining support and resistance levels.


Brick Size

Brick size is analogous to the point and figure box size and determines the minimum
price change to display. Renko charts do not have an equivalent to point and figure reversal amount since the default is always one brick. To filter out noise, simply increase the brick size.


Algorithm

To draw renko bricks, today’s close is compared with the high and low of the previous
brick (white or black):

•If the closing price rises above the top of the previous brick by at least the box size,
one or more white bricks are drawn in new columns. The height of the bricks is al-
ways equal to the box size.
•If the closing price falls below the bottom of the previous brick by at least the box
size, one or more black bricks are drawn in new columns. Again, the height of the
bricks is always equal to the box size.
•If prices move more than the box size, but not enough to create two bricks, only one
brick is drawn. For example, in a two-unit (“2-brick”) renko chart, if the prices
move from 100 to 103, only one white brick is drawn from 100 to 102. The rest of the
move, from 102 to 103, is not shown on the renko chart.

Programmatically, the same CalculateReversalColumns() function is called prior to
plotting the chart (this function appears in Chapter 12 on point and figure charts).
Note that the x-axis does not represent time in a linear fashion, since there is one x-axis unit per brick.

KAGI CHART

Kagi charts are believed to have been created around the time that the Japanese stock
market began trading in the 1870s. Kagi charts display a series of connecting vertical lines where the thickness (or color) and direction of the lines are dependent on the price action. The charts ignore the passage of time. If prices continue to move in the same direction, the vertical line is extended. However, if prices reverse by a minimum reversal amount, a new kagi line is then drawn in a new column. When prices penetrate a previous high or low, the thickness (or color) of the kagi line changes. Kagi charts were brought to the United States by Steven Nison in 1994 with the publication of his book Beyond Candlesticks.

OTHER REVERSAL CHARTS

Algorithm

The first closing price in a kagi chart is the starting price. To draw the first kagi line, the current close is compared to the starting price.

•If the current price is greater than or equal to the starting price, then a thick line is drawn from the starting price to the new closing price.
•If today’s price is less than to the starting price, then a thin line is drawn from the starting price to the new closing price.
To draw subsequent lines, compare the closing price to the tip (i.e., bottom or top)
of the previous kagi line:
•If the price continues in the same direction as the previous line, the line is extended in the same direction, no matter how small the move.
•If the price moves in the opposite direction by at least the reversal amount (this
may take several days), then a short horizontal line is drawn to the next column and
a new vertical line is drawn to the closing price.
•If the price moves in the opposite direction of the current column by less than the
reversal amount no lines are drawn.
•If a thin kagi line exceeds the prior high point on the chart, the line becomes thick.

Likewise, if a thick kagi line falls below the prior low point, the line becomes thin.

Kagi charts are designed to plot a single line until the price reverses by a predetermined amount, where another line is then begun. It is an attempt to smooth out the noise of daily trading activity so that the trend can be more clearly represented. The thickness of kagi lines is significant when prior highs and prior lows are exceeded.

Kagi charts use a modified form of the orthogonal line chart as a basis. When new
highs above the previous column occur, the line color becomes green. When new lows
below the previous column occur, the line color becomes red. Originally, the technique was to draw thick lines for new highs and thin lines for new lows, but the color alternation scheme accomplished the same end and has more visual appeal. (

Interpretation

Kagi charts illustrate the forces of supply and demand on a security:

•A series of thick (or green) lines shows that demand is exceeding supply (a rally).
•A series of thin (or red) lines shows that supply is exceeding demand (a decline).
•Alternating thick (or green) and thin (or red) lines show that the market is in a state of equilibrium (i.e., supply equals demand).

The most basic trading technique for kagi charts is to buy when the kagi line
changes from thin to thick (or red to green) and to sell when the kagi line changes from thick to thin (or green to red). A sequence of higher highs and higher lows on a kagi chart shows that the underlying forces are bullish, whereas, lower highs and lower lows indicate underlying weakness.

THREE-LINE BREAK CHART

Three-line break charts display a series of vertical boxes (lines) that are based on
changes in prices. As with kagi, point and figure, and renko charts, three-line break
charts ignore the passage of time. The three-line break charting method is so named because of the number of lines typically used. Three-line break charts were first brought to the United States by Steven Nison in 1994 with the publication of his book Beyond Candlesticks.

An advantage of three-line break charts is that there is no arbitrary fixed reversal
amount. It is the price action that gives the indication of a reversal. The disadvantage of three-line break charts is that the signals are generated after the new trend is well under way. However, many traders are willing to accept the late signals in exchange for calling major trends.

Number of Lines

You can adjust the sensitivity of the reversal criteria by changing the number of lines in the break. For example, short-term traders might use two-line breaks to get more reversals, whereas a longer-term investor might use four-line or even 10-line breaks to reduce the number of reversals. Of these choices, the three-line break is the most popular in Japan. Steven Nison recommends using three-line break charts in
conjunction with candlestick charts. He suggests using the three-line break chart to
determine the prevailing trend and then using candlestick patterns to time your indi-
vidual trades.

Algorithm

Line break charts are always based on closing prices. The general rules for calculating a line break chart are:

•If the price exceeds the previous line’s high price, a new white line is drawn.
•If the price falls below the previous line’s low price, a new black line is drawn.
•If the price neither rises above nor falls below the previous line, nothing is drawn.

Japanese Reversal Charts

In a three-line break chart, if rallies are strong enough to display three consecutive lines of the same color, then prices must reverse by the extreme price of the last three lines in order to create a new line:

•If a rally is powerful enough to form three consecutive white lines, then prices must fall below the lowest point of the last three white lines before a new black line is drawn.
•If a sell-off is powerful enough to form three consecutive black lines, then prices
must rise above the highest point of the last three black lines before a new white
line is drawn.

Interpretation

The following are some very basic trading rules for a three-line break chart:

•Buy when a white line emerges after three adjacent black lines (a white turnaround
line).
•Sell when a black line appears after three adjacent white lines (a black turnaround
line).
•Avoid trading in trendless markets where the lines alternate between black and
white.