Heikin Ashi Candles, Reversals, and Strategies

When looking for a potential end to a trend, solely relying on financial media might not be your best strategy. By the time a bear market is declared, the market has already fallen more than 20%. Rather than solely relying on the media to keep you informed, it can make sense to use tools that may provide an objective perspective for a trend change while it's occurring. While there's no foolproof method to identify a trend change, one technique that can provide information to help you make decisions is the heikin ashi (sometimes spelled heiken ashi) charting technique. 

Heikin ashi is a charting style where the heikin ashi candle is created by combining the midpoint of the previous bar with the open, high, low, and close of the prevailing bar. A red bar means the average closing price of the prior six bars is in the lower 50% of its range, indicating a bearish bias. The opposite is true of the green bars.

On the thinkorswim^® platform, you can pull up a heikin ashi chart. From the Charts tab, type in a symbol to bring up a chart, then select Style > Chart type (Candle) > Heikin Ashi. Heikin ashi charts are represented by red and green bars. Additionally, heikin ashi charts appear smoother than candlestick charts because there are no price gaps.

Now that you know how a heikin ashi chart looks, it's time to learn how to apply it to your trading.

Heikin ashi charts can be used to identify potential trends or trend reversals. One reason traders use this chart type is that it takes into context a group of bars rather than a single bar. A group of bars can help confirm a trend change, rotation from a bullish bias to a bearish bias, and vice versa. A single bar can be an anomaly. And changes from long-range candles to short-range ones with wicks or tails on both sides can indicate uncertainty or indecision. This can happen during a turning point and during pullbacks.

In the image above, the group of long green bars moving up indicates an uptrend, whereas the group of long red bars moving down indicates a downtrend. To take the analysis one step further, you can create a heikin ashi moving average strategy using moving average crossovers. One way to do this is to apply two exponential moving averages (EMAs) to identify trends or trend reversals. In the image, there's an eight-period (yellow line) and 21-period (purple line) EMA overlaid on the chart.

Let's look at the chart in the above image as an example.

At point #1, there's a choppy trend up and a couple red bars developing. While these long red bars were developing, the eight-period EMA started to move sharply lower. This should've raised a red flag that a heikin ashi reversal may be taking place. If a trader has a long position open, it might be a good time for them to think about where to place a stop.

Once the eight- and 21-period EMAs cross to the downside, the trend may be over. If the trader hasn't been stopped out at this point, they might consider exiting the trade. When the eight- and 21-period EMAs move downward, it can potentially signal an overall change in trend, indicating that now is not an appropriate time to add to a position or double down.

At point #2, it looks like a new uptrend might be starting. After a group of short-range bars formed, the eight-period EMA crossed above the 21-period EMA, and a group of green bars started forming. But not too long after the crossover, there was a series of red bars. Is this an indication that the trend is short-lived? Note: During this time, the eight-period EMA didn't roll over, so the trader may not need to raise their stop.

Only at point #3 does the eight-period EMA cross below the 21-period EMA. Prior to the crossover, the bars were relatively short, indicating some uncertainty. A support level would be helpful in confirming the trend change. Once price falls below the support level and the EMA crossover takes place, a trader might want to consider initiating strategies more aligned with re-positioning for a different type of trade.

While technical analysis cannot predict or guarantee the future performance of any security or strategy, heikin ashi bars can potentially help traders identify trends that are forming. But it's important to remember that markets are unpredictable, and indicators cannot guarantee that a trend will continue or reverse.