Brief Background on Kagi Charts
It is believed that the first kagi charts, and candlestick charts, were used around the time the Japanese stock market started trading in the 1870s. Candlestick chart expert Steve Nison introduced Kagi charts to the Western world when he published his book Beyond Candlesticks: New Japanese Charting Techniques Revealed, in 1994. Kagi charts, at first glance, look like swing charts. Like swing charts, they have no time axis and are made up of a series of vertical lines, however in the case of kagi charts, the vertical lines are based solely on the action of closing prices, not a bar's high and low prices. Another difference is that the thickness of a kagi chart line changes when closing prices penetrate the previous column top or bottom.
Kagi Chart Construction
Kagi assumes that the trader wishes to day trade or swing a security for profit while accepting a little loss as to ensure the bulk of the profit. All that means is that the trader/swinger enters just a bit after the trend establishes and leaves a bit earlier than the finalization of the trend; in essence, swinging with the momentum. Let us assume, that you as a trader/swinger, you are willing to lose out on 10% of the overall profit in the trade; 5% upon entering and 5% upon exiting. Thus you will retain 90% of the “pop” and that will be your profit. But what does that mean for the KAGI chart? Let's find out buy building one given the above scenario. In the above paragraph, we accepted a 5% loss on entry AND exit – call this 5% the “reversal amount”. This will be the loss you incur during a buy or sell signal on a Kagi chart while riding out the trade. To build the chart on this assumption will teach you how to read the chart and understand its signals.
First step in building the chart is to choose an initial closing price from the past; this price is called the “base price” at Day 1. Now follow these rules to start building the chart from the base price:
- Rule 1: If the closing price of Day 2 is greater than the closing price of Day 1 (the base price), draw a thick vertical line upwards from the closing price of Day 1 to the closing price of Day 2.
- Rule 2: If the closing price of Day 2 is less than the closing price of Day 1, draw a thin vertical line downwards from the closing price of Day 1 to the closing price of Day 2.
- Rule 3: If the closing price of Day 2 is equal to the closing price of Day 1, do nothing. Instead, wait until the end of Day 3, and compare this price with the base price.
- Rule 4: If the closing price continues to rise (or fall), we keep moving the kagi chart up (or down) to the close of each day, regardless of how much or how little it moves.
- Rule 5: If the closing price moves in the opposite direction by less than a predetermined number of cents, the reversal amount, we ignore the small move and do nothing to our chart.
- Rule 6: If the Kagi line has been moving upwards, and the closing price has fallen by more than the reversal amount, we draw a short horizontal line, called the 'inflection line', then a new line downwards, to the lower close of that day.
- Rule 7: If the Kagi line has been moving downwards, and the closing price has risen by more than the reversal amount, we draw an inflection line, then a new line upwards, to the higher close of that day.
- Rule 8: If a thin line is extended beyond the previous swing high we thicken the line beyond that point. I prefer to draw this thickened line with a green pen, to give it greater impact.
Usually the reversal amount is denotes as a percent of the PPS. If there is a 5% reversal on a 1 USD stock, the 5% reflects a 0.05 change in the PPS as to reverse the direction of the kagi line. If the reversal amount is large, it will help you to stay in a profitable trade longer, however you will lose a little more profit when you exit the trade. If the amount is small, you will lock in more profit when you exit the trade, however you are more likely to exit the trade prematurely.
Kagi charts look different from swing charts in that they have thick and thin vertical lines. To draw the line thickness correctly, we do the following:
| || |
Kagi Chart Interpretation
Kagi charts are an excellent way of viewing the underlying supply and demand of a market. A thick green line indicates that demand is exceeding supply (accumulation) during an upward trend. A thin red line indicates supply is exceeding demand (distribution) during a downward trend. When such lines alternate, the security is “boxed” into a price range and indicates channel trading.
Kagi charts are of great value to a trader of trending markets. Traders can use kagi charts for their entry and exit signals, and to place their stop-loss orders to lock in profits. They would consider buying a stock when the line changes from thin to thick. They would consider selling the stock when the line changes from thick to thin. I say 'consider' because a trader with a proven trading methodology would also consider factors such as the market phase, the relative strength of the stock and the strength of the stock's trend, in order to maximize profits while minimizing risk. More experienced traders can use a smaller reversal percentage when entering a trade, then when the trade is in profit, change this to a larger percentage. Should the stock commence an almost vertical climb, called a blow-off top, a smaller reversal percentage can be used to help lock in profits. As a general rule, when a Kagi chart has made eight to ten higher highs, the market is considered to be due for a correction.