Author: Clinton Lee.
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, see the video on Candlesticks/OHLC Charts Lose their Patterns on a
Distribution Curve.
Is it necessary to
reconcile a charting method with the distribution curve? Yes, 68% is equal to
one Standard Deviation (σ). –/+1σ
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. See 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.