Credit: Original article published by The Capital.

Understanding the Japanese average — bar

There is a common expression in the market that ‘Trend is your friend,’ the appropriate interpretation would rather be, ‘Trend is your friend only when you can rightly identify it.’ Traders have developed numerous techniques to identify this very trend, including the Heikin Ashi. The main advantage of Heiken Ashi is that it allows you to spot trends more easily.

Decoding Heikin Ashi

Heikin Ashi is both a technical indicator and a chart type. The word gets its meaning from the Japanese language, Heikin means “average” and Ashi means “pace,” taken together Heikin Ashi means “average pace of the price.” It is not only used to identify market trend signals but also to forecast price movements.

While other candle charts are based on the real-time price movement of the stock, Heikin Ashi represents the average price movement of the stocks. This helps in avoiding the noise in the charts. The absence of market noise results in a clear illustration of market trends and direction, which helps determine potential price movements. This trading technique assists traders in identifying when they should hold on to a trade, pause a trade, or identify if a reversal is about to occur. Traders can adjust their positions accordingly, i.e., either avoid making losses or lock in a profit on the chosen position.

Calculating the Heiken Ashi candles

While all the candles are composed on the OHLC ( open high low close ) series, the Heikin Ashi uses a modified formula and has a COHL ( close open high low) approach. Although both, the candlesticks and Heikin Ashi denote the price movements with the colour of the candles, the main difference between the two lies in the candle construction, while candlesticks are plotted on real-time price movement, the Heikin Ashi are constructed on the averaged prices, providing more smoother chart patterns.

Close= 1/4 ​ (Open+High+Low+Close)
(The average price of the current bar)

Open=1/2​ (Open of Prev. Bar+Close of Prev. Bar)
(The midpoint of the previous bar)

High=Max[High, Open, Close]

Low=Min[Low, Open, Close]​

Benefits of the Heikin-Ashi Technique

  1. Accessibility: Heikin-Ashi is one of the most accessible indicators that does not require any installation and can be found on any trading platform.
  2. High chart readability: It is easy to interpret as any trader can read the candlestick patterns. Heikin-Ashi candlesticks are better deciphered than traditional candlestick charts hence it's easier to identify market trends and movements.
  3. Reliability: Heikin-Ashi is a very reliable indicator, providing accurate results. It uses historical data, which is also quite dependable.
  4. Filtering of market noise: The indicator filters out market noise and reduces small corrections making the signals more transparent. The smoothing effect makes it easier for trend identification. Markets are full of noise nowadays; hence, with the help of noise reduction, the Heikin-Ashi technique helps traders plan their entry and exit points more efficiently.
  5. Ability to combine with other indicators: The Heikin-Ashi indicator can be combined with other technical indicators to give even stronger signals on market movement.
  6. Timeframe tolerant: The technique can be used on any time frame from hourly, daily, monthly, etc. However, bigger time frames are more reliable.

Limitations of the Heikin-Ashi Technique

  1. Time gap: The use of historical prices where the base signals of the Heikin-Ashi indicator are based on means that there is a time lag involved.
  2. Lack of price gaps: Most traders use price gaps to analyze price momentum, trigger entries, or position stop-loss orders. Although Heikin-Ashi lacks price gaps, traders can counter such a limitation during a trading session by switching temporarily to traditional candlesticks.
  3. No full price information: Heikin-Ashi data is averaged; hence, it does not show actual open and close prices. This may not work well for day traders or scalpers with more active securities.

This is a brief introduction on the working of Heikin Ashi, the calculation and the pros and cons of the chart pattern, to understand it furthermore and build trading strategies based on this chart pattern, look out for the second part of this article where backtest results of the strategy will be embedded using Streak platform.

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Heikin Ashi was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.

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