A common complaint from traders is that they are allowing their losers to
run while cutting their winners short. Obviously this process will
produce bigger losers than winners and cause you to lose overall in
your account. To be successful in any type of trading, we want small
losers and larger winners, but how can we overcome the fear that makes
us take profits early in a winning position? Market "noise," or minor
fluctuations, trigger the fearful response in traders that causes them
to exit otherwise profitable positions. One way is to use a system of
charting that filters out most "market noise."
Enter Renko charts. Renko, originating from the Japanese word Renga
meaning brick, offers a simpler view of the trend and allows traders a
clearer view of the price action as well as support and resistance.
The nice thing about Renko is that it can be used for charting any
market, equities, futures, forex, or commodities. It ignores time and
only focuses on the price action and trends.
As you can see from the picture above, Renko charts are constructed by
use of red and green "bricks" or "boxes". The first step to
constructing a Renko chart is to select the size for each box. For
instance, if you are trading Apple stock, you could make the brick
settings $2.00 for each brick. If the price moves up by $2.00, you
would see a new green brick formed to the right and higher than the
previous one. As price continues to move up, another green brick will
be formed only if price advances by a full $2.00. If price reverses by
the size of two bricks, in this case $4.00, then a red brick will
signal a reversal and time to exit the trend.
An easy system to follow is to trade in the direction of the trend, and
exit when it reverses. Support and resistance levels are easily seen
on Renko charts. The thing you have to remember though is that the
reversal signal will be when price moves twice the size of the bricks
in the opposite direction. If you do not want to wait for a $4.00
reversal in Apple, you could make the bricks smaller. Experiment with
your security to see the best settings for your risk management rules.
A trend is defined by a minimum of three green bricks in a row for an
uptrend and three red bricks in a row for the downtrend. You can enter
the trade on the third brick. A reversal is noted by one brick of
opposite color and signals your exit from the trade.
A renko chart is constructed by placing a brick in the next column
once the price surpasses the top or bottom of the previous brick by a
pre-defined amount. White bricks are used when the direction of the
trend is up, while black bricks are used when the trend is down. This
type of chart is very effective for traders to identify key
support/resistance levels. Transaction signals are generated when the
direction of the trend changes and the bricks alternate colors.
Basic trend reversals are signaled
with the emergence of a red or green box/brick. A new green brick
indicates the beginning of a new uptrend. A new red brick indicates
the beginning of a new downtrend. Since the Renko chart is a trend
following technique, there are times when Renko charts produce
whipsaws, giving signals near the end of short-lived trends. However,
the expectation with a trend following technique is that it allows you
to ride the major portion of significant trends.
Renko charts can also be very helpful when determining support and
resistance levels since they isolates the underlying price trend by
filtering out minor price changes. Renko charts are also very
effective at identifying key support or resistance levels.