While determining the direction of the trend and points of change is essential for entering the market, one of the bigger challenges facing the trader is to find out when the sentiment has changed.
When it comes to determining the earliest reversal of trend direction, one should look at using Renko charts.
Renko is another form of constant‐range charting and offers a way of filtering out the market noise.
It offers a capability to represent a predetermined move in the price.
Where each bar provides the data for low, high, open, and close, Renko provides an additional block only if the closing price has changed to a predefined level.
Here’s another way to think about it.
If the trader wants to determine if there is a continuation in the sentiment, observing successive Renko bricks would concur that the market is displaying the ability to push the price further.
In this type of chart, the volume and time are not used.
The chart is concerned only with price changes and represents it by using bricks.
Renko chart consists of small boxes or bricks (renga in Japanese) with no upper or lower shadows.
The dimensions of the box can be changed based on a chosen set price value.
The smaller the size, the more boxes are needed, so that price changes will be shown on the charts with better details.
The Renko bars have a special name and referred to as bricks.
White bricks signify long trend and black bricks mean short.
They are comparable to Point and Figure charts except that each new brick is plotted in a new separate column.
So what’s the difference?
A new brick is created once the minimum price movement required for a new brick to be plotted is met.
Because the plotting of a new brick doesn’t depend on time, the time axis is drawn in a non‐linear fashion.
As soon as price completes one brick, another begins.
If a price went up by a predefined amount, we add a new white brick.
If the price went down by a predefined amount, a new black block is plotted in the opposite direction.
A unique attribute of Renko is that it is not contingent on time, and because it deals only with price without regard for volume, it indicates areas of support and resistance extremely well.
Let us explain.
The chart is plotted by drawing a box in the adjacent column immediately after the price exceeds the lowest or highest price of the preceding box by a certain amount.
White or hollow boxes are plotted when the trend direction is long, whereas black or filled boxes are plotted when the direction of the trend is short.
Since Renko insulates the underlying price direction by filtering the insignificant price moves, Renko charts can be helpful for zooming into areas of support and resistance.
Basic direction reversals are indicated with the formation of a new brick of white or black color.
A new brick of white color signals the start of a new long trend.
A new black brick shows the birth of a new short trend.
The signals to enter long or short are generated while the sentiment changes when the boxes alternate colors.
For example, one would sell when a black box arrives at the end of a series of ascending white boxes.
But here’s the problem.
One would need to be careful with this approach.
Since Renko’s utility is to judge the sentiment and general view of the price trend, one can get false entries if the box color change takes place too early, thus producing a whipsaw effect.
In essence, the Japanese Renko is a unique variation of a line chart designed to filter out minor, short-term market noise.
What makes this so special?
It is similar to the western Point and Figure technique in that price move (as opposed to the passage of time) determines the progress along the horizontally drawn x-axis.
We make a chart entry only when price moves by a fixed and predetermined amount, or box size, expressed in some obvious unit of local currency, such as one dollar.
A difference is that instead of using intraday high and low extremes like a western Point & Figure Chart, the Japanese Renko Chart uses the close to determine when to lay a new renga (brick).
The current closing price is compared with the highest and lowest price of the preceding bar.
In an uptrend, when this close goes up above the top of the preceding bar by at least the box size (or a greater amount), then one or more bricks of white color are laid above and in the next column on the right side.
If the uptrend reverses, indicated by the current closing price decreasing below the lowest price of the previous bar by at least the box size, then one or more bricks of black color are laid below and in the next column on the right side.
Sounds impressive, right?
Since Renko chart is built using closing prices, the initial step is to determine a unit of price range.
This point of price range is the minimum amount the price has to change before a Renko brick is plotted.
Also, the price range point is used to determine the height of the brick.
Look at it this way.
A ten-point Renko chart, for example, will have bricks that are ten points tall.
A significant element of the Renko chart is that ascending lines are expressed by white bricks of equal size and descending lines are denoted by black bricks of equal size.
Therefore, regardless of how large is the move, it is reflected on the Renko chart as bricks of equal size.
Because the candles do not, generally, offer a price target, the signal to reverse triggered by Renko can be used to close out a market position
Therefore, mutual funds and fixed income yields can be analyzed using a Renko chart.
The nature of Renko charts is that each brick exposes, at various time periods, key data about market sentiment.
In essence, Renko bricks become tools of detection and discovery that allow the trader to determine threats to the profits she has gained.
Why is this essential as a tool for managing trading exits and securing more profits?
The point is that by defining Renko bricks to a small or micro level price levels, the pattern will allow the earliest possible discovery of a sentiment change.
The trader has to see such changes so that he can secure and protect the profits (s)he has gained.
So let’s take a closer look.
In forex trading, for example, a few seconds can be sufficient to wipe out all of the profits gained, and the price can quickly reverse into negative territory.
Using Renko charts, the trader has the ability to quantify the strength of sentiment.
If long sentiment is prevailing, the trader will be able to detect a long pattern even at the smallest level.
Depending on the financial instrument, one can see that the smallest level of trading can be one minute or less.
When using Renko charts, long sentiment is easily recognizable as a sequence of long white bricks.
If short sentiment is prevailing, a descending series of short bricks, easily recognized by a black color, will emerge.
Determining a change in the strength of sentiment is the key to exiting before profits disappear.
The problem is to determine what level of reversal provides the trigger to get out of a position.
Should the trader exit upon the immediate emergence of Renko bricks of an opposite color? To answer this question is important in many ways.
First, the answer will reveal the psychological propensity of the trader.
A very careful trader will close the position on the first arrival of a brick of reverse color.
A one- or two-brick reversal is a natural part of how the price translates during the trend.
Three bricks reversal would be the point at which the trader wanting to protect unrealized profits would exit.
These rules make sense when the context is a short term action and the trader is looking for high-frequency moves that will let her capture small price movements.
These exit guidelines offer almost a zero tolerance for having a profit turn into a loss.
Once a position becomes profitable, the idea is never to allow the profit to turn into a loss.
It doesn’t matter if the pre-set target is much further away.
The original target reflects a conjecture that market move anticipated by the trader will happen.
In contrast, Renko charts offer a blueprint for profit protection.
This strategy follows a simple rule: do not let a profit turn into a loss.
Here are some general rules for the use of Renko bars in trading.
First of all, we look at the setting size.
Since Renko charts’ main purpose is to discover when a reversal threatens existing position, the setting size has to be the smallest amount at which the discovery of a sentiment change is meaningful.
One percent can be a good starting level.
It offers a small enough time interval to determine change in sentiment and a big enough time frame to avoid whipsaw.
While setting size is a matter of preference, the point is to get to a size that is as small as is feasible.
Another factor that influences the setting size is targeted risk level.
For example, if a trader has an average risk of 60 points, a brick size of 10 points will mean that when a position turns to a loss, three bricks would be equivalent to 50% of the 60-point risk.
Using it this way, the size in Renko can be employed as a technique for a risk alert.
The next important variable is the interval of the chart.
The main idea is to sample the price changes at a higher frequency.
A third parameter is the number of bricks needed to trigger an exit.
The number of bricks for legging out of a position after the trader has achieved profits needs to be set in advance.
For example, if a currency trade has generated 15 pips in profits, five Renko chart bricks of an opposite color would trigger an exit.
The result may be a smaller than anticipated profit, but it would almost always result in avoidance of a loss.
The bottom line is this.
While there is no set rule for how profitable a position should be to trigger a Renko charts exit, a good time to consider is when the trade has entered a third of the target profits.
Under this rule set, a trader can leg out of one-third or one-half of the position, protect the profits, and still be able to capture a larger profit if the sentiment reverses and continues in the original direction.
Legging out with Renko charts signal also offers a psychological level of certainty.
Some traders may listen to their gut to close a profitable position, even though Renko charts do not indicate any sentiment changes and may not be showing any reason to exit.
When an instinct takes over, one can compromise and close half of the position, and let the Renko chart signals handle to the remaining half.
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