Forex Walkthrough

AAA

Charts - Kagi Charts

Noise removal is one of the most important aspects of active trading. By employing noise removal techniques, traders can avoid false signals and get a clearer picture of an overall trend. One method of filtering out this noise, which is also the focus of this section, is known as the kagi chart.

Kagi Chart Construction
Kagi charts are comprised of a series of vertical lines that depend on price action rather than on time like the mainstream charts such as line, bar or candlestick charts. As seen in the chart below, the first thing that traders will notice is that the lines on a kagi chart vary in thickness depending on what the price of the asset is doing. Sometimes the lines are thin, while at other times the lines will be thick and bolded. The varying thicknesses of the lines and their direction represents the most important aspect of a kagi chart because this is what traders use to generate transaction signals. (For related reading, see Analyzing Chart Patterns.)



Figure 1
Source: MetaStock



Kagis and Candlesticks
The different thickness of the lines on a kagi chart may seem confusing at first glance so let's walk through an example of Apple Computer Inc. (Nasdaq:AAPL) between May 8 and December 1, 2006. We've also attached a regular candlestick chart to several of the kagi charts to illustrate what the price of the underlying asset has done to cause a certain change to the kagi chart. This example will make it easier to fully understand how a kagi chart is created.

As seen in Figure 2, the price of AAPL shares started to fall shortly after the start date of our chart. As the price fell, a vertical line was created on the kagi chart, and the bottom of this vertical line was equal to the lowest closing price. If the next period's close were to be lower than the current bottom on the line, then the line would continue to extend downward to equal the new low. The line will not change directions until the price moves above the bottom of the kagi line by more than a preset reversal amount, which is typically set at 4%, although this parameter can change depending on the security or trader's preference.



Figure 2
Source: MetaStock



The Reversal
On June 1, 2006, AAPL shares closed above the kagi low by 4.02% - more than the 4% preset reversal amount needed to change the direction of the chart (4%). As seen from the chart below, the reversal is shown by a small horizontal line to the right followed by a vertical line in the direction of the reversal. Now, the rising Kagi line will remain in the upward direction until it falls below the high by more than 4%.



Figure 3
Source: MetaStock



The reversal was good news for many traders because this was the first bullish kagi signal that was generated since the chart was created in early May. However, unfortunately for the bulls, the move was short-lived as the bears responded and pushed the price below the high of the Kagi line by more than the reversal amount of 4%. The downward reversal is shown on the chart as another horizontal line to the right followed by a line moving in the downward direction.

As you can see from Figure 4 below, the bulls and bears spent the following few weeks fighting over the direction of Apple shares, causing the kagi chart to reverse directions several times. Three of the moves higher that occurred between June and July were greater than 4% above the chart's low, which caused the kagi chart to reverse directions. These moves represented an increasingly bullish sentiment, but they were not strong enough to fully reverse the downtrend. (To learn more, read Retracement Or Reversal: Know The Difference and Support And Resistance Reversals.)



Figure 4
Source: MetaStock



The Thick Line
The number of false reversals began to show traders that bullish interest in the stock was increasing, but that the true overall trend remained in the bears' control. This story changed on July 20, 2006, because of a gap that was substantially greater than the 4% needed to reverse the chart's direction. In fact, the gain was large enough to send the price above the previous high drawn on the kagi chart, shown by the most recent horizontal line drawn near $59. A move that surpasses a previous Kagi high like the one shown in the figure below causes the line of the kagi chart to become bold.



Figure 5
Source: MetaStock



A shift from a thin line to a bolded line, or vice versa, is used by traders to to signal buy or sell transactions. Buy signals are generated when the kagi line rises above the previous high, turning from thin to thick. Sell signals are generated when the kagi line falls below the previous low and the line changes from thick to thin. As you can see in Figure 6, the Kagi chart reversed directions after the sharp run up, but it takes more than a simple reversal to change the thickness of the line or create a transaction signal. In this example, the bears were unable to send the price below the previous low on the kagi chart.

When the bullish momentum continued again in mid-August, the price shifted back in the upward direction, creating a new swing low that will be used to create future sell signals. Ultimately, the bulls were unable to push the price of Apple shares back below the low, causing the kagi chart to remain in a bullish state for the remainder of the tested period. The lack of a sell signal enabled traders to benefit from the strong uptrend without being taken out by random price volatility.



Figure 6
Source: MetaStock



Longer-Term Example
Now that we have an understanding of how a Kagi chart generates transaction signals, let's take a look at a longer-term example using the chart of Apple Computers (Nasdaq:AAPL) (April 30, 2005- December 31, 2006). Notice how a move above a previous high causes the line to become bold, while a move below a low causes the line to become thin again. The changing thickness is the primary key to determining transaction signals as this fluctuation illustrates whether the bulls or bears are in control of the momentum. Remember that a change from thin to thick is used by traders as a buy sign, while a change from thick to thin shows that downward momentum is prevailing and that it may be a good time to consider selling.



Figure 7
Source: MetaStock



Conclusion
Day-to-day price volatility and noise can make it extremely difficult for traders in the financial markets to determine the true trend of an asset. Fortunately, methods such as kagi charting have helped put an end to focusing on unimportant price moves that do not affect future momentum. While first learning it, a kagi chart can seem like a series of randomly placed lines, but in reality, the movement of each line depends on the price and can be used to generate very profitable trading signals. This charting technique is relatively unknown to mainstream active traders, but given its ability to identify the true trend of an asset, it wouldn't be surprising to see a surge in the number of traders that rely on this chart when making their decisions in the marketplace.
Economic Indicators
Related Articles
  1. Forex Education

    5 Foreign Currencies Americans Buy the Most

    Look at which currencies Americans buy the most for travel abroad and remittances, and how the current strength of the dollar is impacting those transactions.
  2. Sectors

    2016's Most Promising Asset Classes

    Find out which asset classes are considered to be the most promising for generating portfolio returns and reducing volatility in 2016.
  3. Mutual Funds & ETFs

    3 Morgan Stanley Funds Rated 5 Stars by Morningstar

    Discover the three best mutual funds administered and managed by Morgan Stanley that received five-star overall ratings from Morningstar.
  4. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
  5. Stock Analysis

    Analyzing Sirius XM's Return on Equity (ROE) (SIRI)

    Learn more about the Sirius XM's overall 2015 performance, return on equity performance and future predictions for the company's ROE in 2016 and beyond.
  6. Stock Analysis

    Will Virtusa Corporation's Stock Keep Chugging in 2016? (VRTU)

    Read a thorough review and analysis of Virtusa Corporation's stock looking to project how well the stock is likely to perform for investors in 2016.
  7. Mutual Funds & ETFs

    3 AllianceBernstein Funds that Are Rated 5 Stars by Morningstar

    Discover the top three mutual funds administered and managed by AllianceBernstein that have received five-star overall ratings from Morningstar.
  8. Stock Analysis

    Analyzing Porter's Five Forces on JPMorgan Chase (JPM)

    Examine the major money-center bank holding firm, JPMorgan Chase & Company, from the perspective of Porter's five forces model for industry analysis.
  9. Retirement

    Is it Safe for Retirees to Invest in Technology?

    Tech stocks are volatile creatures, but there are ways even risk-adverse retirees can reap rewards from them. Here are some strategies.
  10. Mutual Funds & ETFs

    Is Morningstar’s Star System An Effective Ranking Tool? (MORN)

    Learn why Morningstar's star rating system is not always a great predictor of future performance, and why investors should not pick funds on star ratings alone.
RELATED TERMS
  1. Collateralized Mortgage Obligation ...

    A type of mortgage-backed security in which principal repayments ...
  2. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Golden Cross

    A crossover involving a security's short-term moving average ...
  5. Cup and Handle

    A pattern on bar charts resembling a cup with a handle. The cup ...
  6. Percentage Change

    Percentage change is a simple mathematical concept that represents ...
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  4. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  5. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center