Stock Option Trading – Candlesticks & OHLC Bars Lose their Patterns on a Distribution Curve
Time-based charts (namely Candlesticks, OHLC Bars and Heikin-Ashi) fail to truly depict price. This article will help you realize that time-based pattern recognition is an unreliable method for stock option trading.
Some retail training firms like to popularize the myth that, “Everyone looks at these patterns in the charts”. They are partly right. Though, their use of the term “Everyone” applies to retail off-the-floor traders who collectively only make up ~ 15% at most, in some cases even less, of the total traded volume on exchanges, depending on which exchange it is.
Which raises the question: What are the eyes of those on the floor moving 80+% of traded volume looking at? Some of you have visited the exchanges organized through your broker. If you’ve picked up the paper scattered on the floor, all you’ll find is quick math notation: addition, subtraction, division and multiplication. Nothing more. No drawings of a Tri-Star Doji, Dumpling Tops or Frypan Bottoms. It makes sense, because all that is in front of floor traders are screens with price data and price alone. With truck loads of calls and puts to hedge, floor traders could care less how many times during the day, price touched the tail of a dragon fly doji. They’ve already pre-planned to get more of; or, offload their inventory of calls/puts at a specific strike, for a given price.
As a retail option trader, trading less than 10 contracts per trade, you are not exempt from tuning your eyes to focus only on price. How do you simulate the observation of price alone from off-the-floor, if you remove the use of Candlesticks, OHLC Bars and Heikin-Ashi charts? Use Point & Figure charts instead.
Why is it valid to only use Point & Figure charting for trading options? It is the only method that plots just one type of data – price alone without time – price is the only data element needed on a distribution curve. The same distribution curve used in the Bjerksund-Stensland, Black-Scholes or Binomial pricing models in your options trading platform.
What about other charting methods like Candlesticks and OHLC Bars? Let’s take the Doji, a well known candlestick, as an example. The Doji is characterized by it’s Open and Close at the same price, the High is a different price from the Low. Remember with a Distribution Curve, it records Price on the Horizontal axis and Frequency on the Vertical axis. To map the doji onto the relevant axis of the distribution curve, it needs to be flipped on to its side, for the doji’s price points to line up against the vertical axis. So, a price that Closes at the same price it Opened, is recorded as 2 price points with twice the frequency of the High and Low. With a distribution curve, you cannot leave the lines joining the dots of the doji on the graph. All that is mapped is 4 dots representing the doji’s price points. Take away the lines joining the dots. Question: Where’s the doji? Not relevant anymore. Same logic applies to any candlestick (spinning top, hammer, etc.). Candlesticks lose their characteristics, once they are mapped onto a distribution curve. The implication is the same for the OHLC method used to count fractals in Elliot Waves and wave counts once price is mapped in its dispersion mode, the waves lose their characteristics.
To visualize this problem with time-based charts, watch the video on Why Time-Based Charts (Bar/ Candlesticks/Heikin Ashi, etc.) lose their characteristics once mapped onto a Distribution Curve.
Is it necessary to reconcile a charting method with the distribution curve? Yes, 68% is equal to one Standard Deviation (?). –/+1? sets the parameters for the probabilities, which you construct an option spread around to test if the strikes will be touched or not touched, from the date a spread is filled till its expiry date.
Bear in mind, changing the time frames in time-based charts be it Candlesticks, Heikin-Ashi, OHLC from minute/hour/day/week to reconcile conflicting patterns in one time-frame against another, does nothing to help you work out the Theta as decay in a debit spread; or, the positive Theta as premium sold in a Credit spread. The only unit of time required to feed into a Theoretical pricing model is the expiration date, in turn affecting the probabilities per day for the number of days that passes. As the units of time in time-based charts have no value in Theoretically pricing an option, it makes no sense to use them.
So, what are time-based charts (Candlesticks, OHLC Bars and Heikin-Ashi) useful for? They are useful, for trading the underlying itself. When you trade the underlying itself, aside from dealing with +/- Delta (directional risk), all the other Greeks (Gamma, Theta and Vega) are equal to zero. Time-based charts are relevant for trading deep ITM options as a surrogate to the product for purely directional trading of the underlying itself.
Do bear in mind with options, the deeper the ITM you go, the wider the Bid-Ask spread becomes compared to the narrower Bid-Ask spread differences in the ATM or OTM strikes. Have you got enough capital in the account to keep trading at the ITM strikes only? This is why many retail traders with account sizes below USD $25K look for increasing lower priced products, for e.g. $20 and below, as they search for ITM strikes that are affordable for them to trade using Candlestick/OHLC/Heikin-Ashi charts. By virtue of being lower priced, these products often suffer illiquid open interest at their strikes, making you chase price for an uncompetitive fill, only to result in poor price-profit performance. The other extreme is to over spend on ITM strikes of a higher priced product, for example $100 and above, as you found a trade candidate using some “special” pattern scanning software, only to breach the money management rule of 2%-5% per trade, in filling the order.
Is there an example of a portfolio with consistent wins and limited losses that applies Point & Figure methods without the use of Candlesticks/OHLC/Heikin Ashi? Yes. Follow the link below, entitled “Consistent Results” for a model retail option trader’s portfolio that only uses Point & Figure techniques. Other than stock option trading, the portfolio includes option trades from non-equity asset classes.
Light is needed to see; but, trading enlightenment will not come from a candlestick. And counting fractals within waves only serves to oscillate your pupils.
About the Author
Please see Consistent Results http://www.homeoptionstrading.com/consistent_results/.
Here's the summary for month-end July 2009 ...
❑ Return: Profit/Start of Year Cash Balance = UP +115%! That's +16.43% Return per Month!
❑ Win/Loss Probability = 90.20%. 9 Wins per 1 Loss. Average Win/Average Loss = $3.66 Won per $1 Loss.
❑ Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 90.20% x $3.66 = 3.30.
❑ Positive Expectancy = $1,316 per trade.
Preview an original 55 hour video-based course for online options trading from home, at http://www.homeoptionstrading.com/original_curriculum.html
Purchase the curriculum and receive a $800 options basic course as a Bonus!
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