Price action on ‘naked’ charts using Heikin Ashi candles, how simplicity can trump complexity

Dec 19 • Between the lines • 1841 Views • 1 Comment

shutterstock_126901910There is no debate that indicator based trading actually ‘works’, despite the levels of critique from experienced and successful traders, indicator based trading has stood the test of time. Indicator based trading works particularly well on the daily chart, which is the time frame the creators of the various indicators designed the indicators to work on.

If traders read articles containing opinion from leading analysts in major institutions they’ll quickly realise that, at the very top of our food chain, indicators are used very effectively. Time after time articles will reference analysts at for example JP Morgan or Morgan Stanley and their use of certain indicators.

Articles in Bloomberg or Reuters, will often quote the use of oversold or overbought indicators such as the RSI and stochastics, or quote Bollinger bands and the ADX. Many traders at the very top of their profession in institutions actually use single or multiple indicators to base their decisions on. Similarly articles will often point to opinion regarding looming round numbers and simple moving averages such as the 200 SMA. However, despite the effectiveness of indicators there is a criticism that is hard to argue versus – that indicators lag.

Despite opinion to the contrary there are no indicators that lead, all the indicators we’ve become familiar with actually lag. There are no indicators that can predict price movements. Many indicators can suggest turning points, or the exhaustion of a momentum move, but none can predict where price is headed. Indicator based trading methods and overall strategies are superb mechanisms for following price.

That lack of predictive quality is what causes many traders to abandon indicator based strategies in favour of price action. Price action is, in the belief of many experienced and successful traders, the only trading method that can immediately represent investor sentiment and as such has the potential to lead as opposed to lag on a chart, particularly a daily time frame.

Price action can often confuse new traders

Despite the simplicity of price action it’s a trading paradox that new traders appear to need to experiment with indicator based trading methods before discovering and experimenting with what we term “price action”. One of the reasons being that many new traders become confused with the concept of higher highs or lower lows and lower highs, higher lows.

At this stage it’s probably wise to provide a definition of price action which the majority of traders and analysts would agree with…

What is price action?

Price action is a form of technical analysis. What differentiates it from most forms of technical analysis is that its main focus is the relation of a security’s current price to its past prices as opposed to values derived from that price history. This past history includes swing highs and swing lows, trend lines, and support and resistance levels. At its most simplistic price action attempts to describe the human thought processes invoked by experienced, non-disciplinary traders as they observe and trade their markets. Price action is simply how prices change – the action of price. It is readily observed in markets where liquidity and price volatility are highest.

Traders observe the relative size, shape, position, growth (when watching the current real-time price) and volume (optionally) of the bars on an OHLC bar or candlestick chart, starting as simple as a single bar, most often combined with chart formations found in broader technical analysis such as moving averages, trend lines or trading ranges. The use of price action analysis for financial speculation doesn’t exclude the simultaneous use of other techniques of analysis, and on the other hand, a minimalist price action trader can rely completely on the behavioural interpretation of price action to build a trading strategy.

Price action using only Heikin Ashi candles

Despite the overall simplicity there is a method of price action trading that simplifies the process even further – by using Heikin Ashi candles singularly without any trend lines, pivot point levels or using key moving averages such as the 300 SMA.

Heikin-Ashi Candlesticks are an offshoot from Japanese candlesticks. Heikin-Ashi Candlesticks use the open-close data from the prior period and the open-high-low-close data from the current period to create a combo candlestick. The resulting candlestick filters out some noise in an effort to better capture the trend. In Japanese, Heikin means “average” and “ashi” means “pace”. Taken together, Heikin-Ashi represents the average-pace of prices. Heikin-Ashi Candlesticks are not used like normal candlesticks. Dozens of bullish or bearish reversal patterns consisting of 1-3 candlesticks are not to be found. Instead, these candlesticks can be used to identify trending periods, potential reversal points and classic technical analysis patterns.

The simplicity of Heikin Ashi candles

Trading with Heikin Ashi candles simplifies the overall concept as there’s far less to look at, analyse and make decisions from. The ‘reading’ of the candles, in terms of price behaviour, becomes simplified, particularly in comparison with using ordinary candlestick patterns which do require a lot more skill and practice to decrypt.

For example, with Heikin Ashi there are principally only two candle patterns on the daily chart that may indicate a turn (a reversal in sentiment); the spinning top and the doji. Similarly if traders use a hollow or filled candlestick setting on their charts the filled candlestick or bar represents bearish conditions, whereas the empty hollow candlestick indicates bullish sentiment.

Thereafter the only other requirement to gauge sentiment is the actual shape of the candle. A long closed body with a significant shadow equals a strong trend, particularly if that pattern is repeated over several days’ candles. Comparing and contrasting this with attempting to decipher sentiment using ordinary candlesticks lends ammunition to the theory that trading using HA candles is far simpler, yet loses none of the supposed predictive nature price action trader’s favour.

For new and fledgling traders Heikin Ashi offers up a tremendous opportunity to discover the benefits of trading from a clean and uncluttered chart. It provides a perfect ‘half-way house’ solution between indicator based trading and using traditional candlesticks. Many traders actually try experimenting with Heikin Ashi and stay with it given its simplicity and effectiveness as the clarity and efficiency displayed on daily charts offers up some of the best interpretation methods available.      
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