Technical Analysis of Renko Charts
Introduction to Renko Charts
Technical analysis can broadly be defined as the study of historical price action of a financial instrument, commodity, currency, etc. that helps in arriving at a reasonable conclusion about its prevailing demand and supply equation.
The following are the basic tenets of technical analysis according to the classic work, Technical Analysis of Stock Trends by Robert D. Edwards and John Magee:*
1. Stock** prices move in trends, and a trend is deemed to continue until it gets reversed.
2. Stock prices are determined by the interaction of demand and supply, and the shifts in demand and supply cause reversals in trends.
3. The price discounts everything. Shifts in demand and supply can be detected in charts.
4. Price history and chart patterns tend to repeat themselves.
Popular Charting Methods
There are many ways to capture, or chart, the historical price movement of a financial instrument. The popular charting methods include line chart, bar chart and candlestick chart. Figure 1.1 explains their construction.
Line charts are drawn by connecting closing prices of the chosen time interval. In bar charts, a bar is bullish when its closing price is higher than the earlier period’s bar; it is bearish when the closing price is lower than the earlier period’s bar. In candlestick charts, a candle is bullish when the close of a period is higher than its open, else it is bearish.
Figure 1.1: Line, bar and candlestick charts
Figure 1.2 shows a typical candlestick chart. As you would observe, there are two dimensions to the chart, namely price and time. In such charts, time is plotted on the X-axis and price on the Y-axis.
Figure 1.2:A candlestick chart with time plotted along the X-axis and price along the Y-axis
A line chart is plotted by connecting successive closing prices. Breakouts and patterns based on closing prices are relatively clear and noise free.
This is perhaps the reason why eminent technical analysts such as Charles Dow, John Murphy and many others prefer line charts over bar charts. Charles Dow considered the daily close as the most significant price and relied exclusively on closing prices. The usual line chart that plots only closing prices is one of the oldest and most important methods of plotting prices. Also, as Murphy
argues, “Many chartists believe that because the closing price is the most critical price of the trading day, a line chart is a more valid measure of price activity.” *
Renko Charts
Renko is a charting method that belongs to the “noiseless” category, i.e. a chart which is free of relatively minor price moves. Apart from Renko, other noiseless charting methods include Point and Figure, Line-break and Kagi.
Renko charts have their origins in Japan where they were used during the 19th century. They were introduced to the rest of the world by Steven Nison who discussed this methodology in his book, Beyond Candlesticks.
In Japanese, Renko means brick; that is why Renko charts are also known as brick charts. A Renko chart is categorised as noiseless because it eliminates insignificant price action. Also, the Renko chart is a one dimensional chart because its plotting only takes price into account. On the other hand, popular
charts, such as bar or candlestick, have two dimensions — price and time. In two dimensional charts, price is plotted on the Y-axis and time on the X-axis. A new price point gets plotted on the chart when the specified time passes by, irrespective of the extent of the price move. A Renko chart, on the other
hand, filters out insignificant price movements and captures only significant price action. The elimination of noise is achieved by selecting a suitable brick value. We shall discuss more about the brick value a little later.
Simplicity and objectivity are the major advantages of Renko charts. Renko is a complete charting system that is objective in nature and applicable on all types of financial instruments and over all time frames. Recent advancement in technology has made it easier to plot and study patterns in a Renko chart.
Besides, the technology today offers the facility to plot log scale Renko charts, but more about that later.
As you go with the flow and process of this book, you will understand all aspects of Renko charts and you will be able to trade any instrument on any time frame.
Construction of Renko Charts
Let us begin by understanding how Renko charts are constructed. This is a most important and fundamental aspect. Readers are often more interested in immediately getting to the trade setups; they don’t focus enough on the basics and struggle later in grasping the nuances of trading strategies. I urge you to spend enough time in understanding the basics before moving on to chart patterns and trading.
The method of plotting Renko charts is slightly different as compared to the plotting of traditional candle or bar charts. Renko charts are constructed, or plotted, by connecting two prices. The method is explained step-wise below.
Figure 1.3 is the image of a simple line chart that is drawn by connecting successive closing prices. In the chart in Figure 1.3, the closing prices at 100 and 105 are connected by a line.
Figure 1.3: A line chart connects successive closing prices with a line
Instead of connecting the closing prices with a line, a Renko chart connects the two prices by drawing a box as shown in Figure 1.4.
The box drawn by connecting the two prices is called a brick. So, every brick would represent two prices, a high price and a low price. In the example in Figure 1.4, the brick’s low price is 100 and its high price is 105.
The brick shown in Figure 1.4 is bullish because the price is rising. Typically, bullish bricks are drawn hollow while bearish bricks are filled with colour. The charting software may use customized colour coding for the bricks, which is fine so long as the difference between a bullish and a bearish brick is
easily identifiable. In this book, hollow bricks represent bullish price action, and black, or filled, bricks represent bearish price action.
Figure 1.4: A Renko chart is drawn by connecting closing prices of a minimum stipulated price difference as a box, called a brick.
Continuing the example of Figure 1.4, if the price goes up to, say, 110, another brick would be drawn diagonal to the existing brick, starting from the existing brick’s top right corner (see Figure 1.5).
Figure 1.5: Drawing the second brick as the price rises higher
The second brick plotted in Figure 1.5 is also a bullish brick as the new price has closed above the previous brick’s price level. The low price of the new brick is 105 and the high price is 110. Note that 105 is also the high price of the previous brick, and we drew the current brick starting from that price.
Another bullish brick will get drawn in the same manner if the price advances further (see Figure 1.6).
The low price of the latest brick (Brick 3 in Figure 1.6) is 110 and its high price is 115. Further bricks will be formed in the same way if the price keeps moving higher. If the price starts moving down, however, and falls below the low price of the previous brick, we need to draw a bearish brick.
In the example in Figure 1.6, the current high price is 115 and the low price is 110. For a reversal, the price has to move down to 105, or below that, which is the low price of the previous brick.
Figure 1.6: Construction of the third brick
Figure 1.7 shows that a new bearish brick is drawn diagonal to the bottom right corner of the previous brick. In the example of Figure 1.7, if the price falls even further and goes below 100, then another bearish brick will get drawn, starting from the bottom right corner of the current bearish brick. On the other hand, if the price moves back up above 115, a bullish brick will get plotted from the top right corner of current brick.
Figure 1.7: A reversal brick, bearish in this case, would be formed were the price to fall to 105
Based on the above discussion on brick construction, you will readily appreciate that the level where a continuation, or a reversal, brick will get plotted is known in advance. For instance, in the case of the Renko chart in Figure 1.7, you know the price levels where bullish or bearish bricks will get
printed. This is an important aspect from a trading perspective which we will discuss further in the coming chapters.
Brick Value
As mentioned earlier, Renko charts are categorized as noiseless and what makes them so is the appropriate selection of the brick value. In the example in Figure 1.7, the brick value used was 5 points, which is the difference between each brick.
The brick value selected defines the price action which the user considers is significant enough to be captured in the chart. In Figure 1.7, for example, a brick will be plotted only when the price has moved by at least 5 points, or multiples thereof.
So if price moves from 100 to 105, a bullish brick is formed. A brick will not be formed if the price is even one tick below 105. Accordingly, if the price is at 104, the Renko chart will not plot anything. Thus, the defined brick value also determines the frequency of bricks and the noise that we want to eliminate.
Renko charts can be drawn by using different brick values but the principle remains the same. Later, we will discuss how best to decide what the appropriate brick value should be. Before that, notice in the example of Figure 1.7 that because it is a 5 brick value chart, the next bearish brick will be plotted only if the price falls to at least 100, and a bullish brick will be plotted only if the price goes up to at least 115.
It is important to grasp that the next bullish brick will be plotted if the price closes either at, or above, 115. It is not necessary that the price must break out, or close, above 115. Similarly, for a bearish brick to be plotted at 105, the price has to close either at, or below, 105.
Thus, the rules for forming the bullish or bearish bricks are clear and objective. Objectivity and noiselessness are the two most important advantages of Renko charts, besides their visual appeal.
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