Justin is an active trader with more than 20-years of industry experience. He has worked at big banks and hedge funds including Citigroup, D. E. Shaw and Millennium Capital Management.
With trend-following being such an important part of trading and one of the best ways to make consistent returns, it’s no surprise that there are various ways of trying to establish when momentum is driving a market. One of those is the Heiken Ashi trading strategy.
This approach analyses candlestick patterns to filter out some of the “noise” in the market. In Japanese, the meaning of “Heiken” is average, and “Ashi” refers to bar, and unsurprisingly the Heiken Ashi approach involves establishing the average bar. Once that has been done, it’s possible to decide whether momentum is building, continuing, or reversing. All the information needed is included on simple price charts. It’s just a case of reflecting on what the data contained in the charts reveals.
In this article, we'll use real-life trade examples to look at:
Standard candlestick charts display the opening, high, low, and closing price in purely numerical terms.
In the below price chart of the Russell 2000 stock index, the hourly candle A's opening, high, low, and closing prices are 2235.8, 2238.4, 2220.3, and 2224.7.
Setting that same price chart to report prices using Heiken Ashi methodology results in a new set of opening, high, low, and closing prices = 2229.4, 2238.4, 2220.3 and 2229.8. Also, note the colour change from red to green, meaning that on a Heiken Ashi chart, the same time interval is reported as an upward price move.
The different dimensions of the candle are due to Heiken Ashi candles using the same raw price data but applying a particular formula.
Monitoring a single market over the same period makes it possible to flick between standard and Heiken Ashi mode settings. The Nasdaq 100 index set to 1hr candles looks like this:
The two charts have obvious similarities, they are, after all, based on the same raw data, but the Heiken Ashi candles have applied a formula that creates subtle differences. As a result, the shape of the Heiken Ashi candles offers different insights into market momentum.
The below example from the forex markets illustrates the effectiveness of Heiken Ashi candles in spotting a trend reversal. These changes in momentum, of course, also mark the start of a new trend and can be easily identified in the GBPUSD' Cable' market on an hourly time frame.
Reversal candle one has a lower close than the previous candle and changes colour from green to red. This indication of momentum moving from upwards to downwards proves reliable, and the size of this candle and the next one suggests the move has strong support. The following candles in the sequence are of varying size, but all are the same colour, red, indicating now is the time to sell short.
Extra momentum is needed and found to break through the 1hr 20, 50 and 100 Simple Moving Averages, but smaller candles then follow, and the trend can be seen to be slowing down. That is a sign that short positions put on near Reversal Candle 1 might need to be exited.
The doji candle, with a small body and relatively long wicks to the upside and downside, is a classic Heiken Ashi sign that a trend is reversing. Being quickly followed by a green candle confirms that the time has come to close out short positions and look to go long.
The upward move after Reversal Candle 2 is at first marked by smaller candles which suggests that the amount of buying interest is not as strong as the selling interest that followed Reversal Candle 1.
This indicates that the trend may not be as long-lasting, and sure enough, there is soon a period of sideways trading denoted by a mixture of red and green candles. The green doji candle at Reversal Candle 3 is the clue that it might be time to exit long positions and look to go short again. The downward trend which follows is marked by a long sequence of red candles and a chance to profit from positions that are short GBPUSD.
In the above example, effective risk management would have been able to have been applied without hampering returns. Below are some standard parameters that would have worked in the GBPUSD case study that are worth practising using a Demo account.
Heiken Ashi candles are great at providing a clearer understanding of market momentum and cutting down on the number of false signals. Still, all indicators benefit from being used in conjunction with others. Whether your trading style is based on day trading, swing trading or trend following, incorporating signals from the below is always a good idea.
Heiken Ashi candles make charts more readable and trends easier to analyse. Developing trend spotting skills is a key ingredient to successful trading, and Heiken Ashi helps traders go with the flow rather than against. It can't be guaranteed that future price moves will carry on in the same direction, but the Heiken Ashi approach tilts the scales in the right direction.
The methodology is simply a different way of displaying price data on charts, and the result is a chance to get an in-depth view of the market. You can use it when making trades that require precise entries and exits, and the tools to apply the methods are freely available at good broking platforms.
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