Sunday, November 09, 2008

A Common Mistake Traders Make Using Candlesticks

I'd like to discuss a common mistake I see many traders make when it comes to using candlestick charts. I'm not about to go into a lengthy discussion as to what candlestick charts are because you can find that information all over the Internet but I will say that the open to close relationship is very important. The reason why the open to close relationship is so important is because that determines the color of the candlestick.

If the close is greater than the open the candlestick is bullish and will be colored white or in some cases green depending on the color scheme of the charts. If the close is below the open the candlestick is considered bearish and is colored black or in some cases red. The combination of these open to close relationships from one bar to another creates the various candlestick charting patterns.

The mistake that I see many traders make is that they sometimes use indices that always have an unchanged open. In other words, there are never any gaps in the chart even though the components within the index have opened substantially higher or lower. To better explain what I am talking about I'd like you to look at the above chart.

Above we have a daily candlestick chart of the Dow Jones Industrial Average and in the lower panel we have the ETF for the Dow which is better known as the Diamonds or DIA. You'll notice in the top chart of the dow that there are no gaps and that every open is an unchanged open. This can be very misleading to a trader who is using candlestick charting patterns because the true open is not being reflected in the chart! This means that the color of the candlesticks will NOT be accurate.

Lets walk through a few examples so you can better understand my point. In example (A) you'll notice the color of the bar is white (top panel) but if you look at the chart of the Diamonds (lower panel) the color of the bar is black! These two markets are identical yet we have different colored bars. The reason for the different colored bars is because of the open. In the top panel the dow has an unchanged open and then rallied so the bar is colored white, but in the chart of DIA we see that stocks actually gapped up higher on the open and then sold off giving us a black bar. In my opinion DIA is a much more accurate chart to apply candlestick patterns to than the dow jones industrials (INDU) and I think you can now understand why.

We see the same thing take place at points (B) and (C). Notice how the bars in the top chart are colored differently than the bars in the lower chart and this is all because of the gap up and gap down opens which can be seen in DIA but not the dow jones industrials.

So the bottom line is if you are going to use candlestick charting patterns, you want to use them on charts that reflect the true open which means we need to see gaps in the chart. In my opinion applying candlesticks to many of the indices can be very misleading which is why I prefer to use the ETFs so I can get a much more accurate reading.

I hope this helps and if any of you have any questions or comments, feel free to ask and I will do my best to answer.


Jesse said...

Good point. I've wondered about something similar. I see people use SLV and GLD charts to analyze the metals. The charts look very different than $gold or $silver, because the metals are trading nearly 24 hours a day, yet the ETF's trade just during New York trading. The ETF's end up with tons of gaps and other chart features that are different. In this case it always seems like a mistake to use the ETF charts for analysis. Thoughts?

Kevin said...

In the case of GLD vs $gold I'd rather look at the $gold chart because there are gaps on the chart which is what we want to see. $GOLD does not open unchanged everyday like $INDU so its OK to use candlesticks on $GOLD.


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