This system is based on the “Kagi” chart style, which originated in Japan and reportedly dates back to the mid- to late-19th century. Like point-and-figure (P&F) charts, Kagi charts plot price moves of a certain magnitude regardless of the passage of time. Whereas P&F charts show price up and down movement with columns of ascending x’s or descending o’s, Kagi charts connect closing prices that have moved a specified amount with a solid line, as shown in Figure 1. The chart style is designed to filter out noise and help traders focus on more significant price moves.
The primary variable in a Kagi chart is the “reversal amount,” which is the minimum amount the closing price must move to start drawing a new vertical line in the opposite direction of the current trend. The reversal amount is traditionally a fixed point or percentage amount, but a volatility measure such as average true range (ATR) may be substituted to create a chart that adjusts to market conditions.
Figure 1 shows a Kagi chart using a 1.00-point reversal amount, and zooms in on a section that corresponds to the period covered in the inset bar chart. The stock reversed more than 1.00 point from a low close of 10.01 on Aug. 26, 2010 to 11.07 on Sept. 8, 2010, indicated by the green up arrow. In real time, a horizontal line, which candlestick analyst Steve Nison calls the “inflection line,” would be extended to the right from the previous lowest close and a vertical line drawn to 11.07. On its way to 14.00 on Nov. 5, 2010, the stock rallied without reversing more than 1.00 point on a closing basis, so the vertical line continued upward without interruption.
Notice the line width changed from thin to thick after price exceeded the previous high. This is an important feature of a Kagi chart: When making higher highs, the line is thick (bullish); whereas the line remains thin following lower lows (bearish).
Continuing with the illustration, the stock quickly reversed to a low close of 12.94 on Nov. 17, 2010; a horizontal line connects to the next column at which point the line descends to 12.94. The line remains thick because price is still above the previous Kagi low of 10.01. This reversal turned out to be a “head fake,” as the stock once again quickly resumed its bullish course, reaching 17.59 on Feb. 14, 2011.
In his book Beyond Candlesticks (1994, John Wiley & Sons), Nison outlined several Kagi patterns and trading techniques, but the most basic strategy (which he suggested had the most risk and best potential reward) is to go long when the line is thick and sell (or go short) when the line is thin. Although it would be easy to cherry pick a chart showing a Kagi line catching long trends, it is very likely this approach would whipsaw traders and result in long losing streaks.
In fact, initial testing indicated the basic strategy was not particularly appealing, but it was also not necessarily without merit. For example, trading a single Euro FX (EC) contract, long or short according to Kagi reversals ranging between 0.5 percent to 2.5 percent, would have produced returns similar to those in Figure 2 during the 10 years ending March 1, 2011.
The strategy tested here trades Kagi signals from the long side only, and incorporates a moving average filter. Two versions of the system will be discussed, one using a three-ATR reversal (three times the five-day ATR) amount and another using a (partially optimized) fixed 8-percent reversal amount.