Understanding Heiken Ashi Candles
Before we move on to its benefits and strategic applications, there is a basic question; what are Heiken Ashi candles? How are they constructed? Well, the essential formula for those Japanese candles is as follows:
- Heiken Ashi Open = (Open previous candle + Close previous candle) / 2
- Heiken Ashi Close = (Open + Close + High + Low) / 4
- Heiken Ashi Low = Min (Low, Open, Close)
- Heiken Ashi High = Max (High, Open, Close)
So basically, the opening of the new Heiken Ashi Candlestick is placed on the midpoint of the previous candle. For example, if one day USD/JPY opens at 105 and closes at 106, then for the next session the candle will open at 105.50. Now let us move on to the next essential formula for Heiken Ashi Close.
Here we can see that the closing mark is calculated as an average of the open, close, high and low price of a given currency pair. For example, suppose that USD/JPY opened at 105, had reached a daily high of 105.80, daily low of 104.90 and closed at 105.30. The sum of those 4 values is 421, by dividing this number to 4 we will get 105.25. Therefore the Heiken Ashi candlestick for this pair will close at 105.25. However, there is one final piece of the puzzle with low and high.
To complete the candlestick a trader must set low and high indicators. In case of low, he or she must choose between daily low, Heiken Ashi Open or Close, whichever is the lowest number. In the case of setting High, a trader must select either daily high, Heiken Ashi Open or Close, depending on which one represents the highest value.
The essence of the Heiken Ashi formula is that it aims to filter out all daily market noise and false signals and present a trader with a clear picture of the direction of the currency pairs.
Why use Heiken Ashi
As we have seen from the previous charts, it is usually much easier to identify the potential trends with Heiken Ashi candles, rather than more traditional candlesticks.
From the second chart, we can observe EUR/JPY trends during the last couple of years. By April 2017, the pair was trading near the 116 level and there are also 2 red candles, representing a decline. However, after that, the situation changed significantly, we have 5 quite long green Heiken Ashi candles, with the Euro appreciating and reaching as far as 123 mark.
This uptrend was interrupted 3 times, by small red candles, representing an indecision and consolidation. However, in each case, the Euro resumed its appreciation, until EUR/JPY reached a high watermark by the end of January 2018, when the pair was trading at 134 level.
This is the point when the trend began to change. Instead of 2 or 3 small red candles, after January 2018 we have 8 consecutive red candlesticks, which marked the beginning of a reversal. EUR/JPY entered a long term downward trend which might be still active today. Obviously it was not just the case of straight-line descriptions. In fact, as we can see from the second chart there were at least 4 occasions when Euro rallied and recovered some of its losses, however, after that the trend resumed.
Since during this period, the heavy majority of Heiken Ashi candlesticks were red, it points to the fact that the long term downtrend might be intact. Nowadays, EUR/JPY is back to 116-117 mark, which means that the pair has given up all of its gains since April 2017.
So as we can see, Heiken Ashi charts can be a very helpful tool for identifying trends, which is so necessary for successful trading. However, this is not the only benefit the Japanese candlesticks can have. Here not only the color but also the actual shape of candles can give us some clues about the strength of the trend.
Returning to the second EUR/JPY chart, we can notice that the red candles during the initial Euro uptrend, were very much Doji shaped small candles with large upper and lower lines. This can be interpreted as a sign of indecisions and it may not be considered as a strong sign of reversal. So, sure enough, the uptrend continued for several months.
The trend change took place in January 2018, however by that time the Heiken Ashi chart patterns have changed considerably in several ways. Instead of one or two red candles, we have 8 consecutive candlesticks.
Also, most of those red candles were much longer and without an upper shadow, which represents a strong selling pressure. We can also notice that when red candles became smaller with larger upper shadows, then the trend temporarily stopped, the pair recovered, then consolidated and resumed a downtrend.
So as we can see from the above example in many cases Heiken Ashi can be really helpful not just for the purpose of trend determination, but also for measuring its strength and by extension, detecting potential reversals.
Heiken Ashi Forex trading strategy
We have already discussed the basics and advantages of those Japanese candlesticks, however, the next obvious question is: how to use Heiken Ashi in Forex trading?
The basic method is as follows: a trader can check Heiken Ashi charts of several currency pairs and look for ones where there is a clear uptrend or downtrend. As mentioned before, for example, several green candles with little or no downward shadows can be a sign of an upward trend. Therefore in those cases, traders might consider opening a long position.
On the other hand, a number of red candles with little or no upward shadows can represent a form of downward trend. Consequently, traders might prefer opening a short position.
Finally, several short candles with large shadows on both sides can be a sign of indecision and consolidation. Therefore, this might be a good Heiken Ashi exit indicator, one where traders might consider closing trades and locking in payouts.
Limitations of Heiken Ashi
Despite all of its advantages, Heiken Ashi candlesticks do have their own limitations and imperfections. There can be several cases when the Japanese Candlesticks might be a bit late to show the trend changes or alternatively give out some confusing signals.
To illustrate those arguments,s let us take a look at this daily USD/JPY chart:
As we can see from the chart above, from September 2019 until February 2020 the USD/JPY was in long term uptrend. This all changed at the end of the winter when the pair fell sharply, as a result, we have 12 consecutive long red candles. So far everything seems rather clear.
However, after that point, the candles start to get confusing. As we can see from the chart, the 12th red candlestick is followed by a relatively medium-sized green one and then consequently we have a small red candle with long shadows. So at this point, many traders would be confused. One green candlestick in isolation is hardly a sign of a major reversal. However, if a trader kept the sell position open, then he or she might be faced with some serious losses.
From 102 level the pair has risen to well above 110 mark. Obviously, by the time 3 long green candles have shown up in the chart, most people would have guessed that the trend was changing, however by that time USD/JPY has already reached 105 level, so it might have been late for many traders.
This example demonstrates that although Heiken Ashi candles are useful in many ways, they are not 100% infallible sources for technical analysis. In fact, those recent surprising fluctuations with USD/JPY took place during the time when COVID-19 concerns started to affect the market and also the US Federal Reserve made serious adjustments to its monetary policy. Therefore traders might be more successful if they combine their Heiken Ashi chart observations with the Fundamental analysis.