day. The closing price is considerably higher than the opening price. The first day is a victory for the bulls.2 The second day reveals very little price action because the close is very near the open. The second day is a wash because higher prices entice more bears to be sellers.
3 After this shift from bullish to neutral price action, the following day is a down day. The third day is a winning day for the bears!
SELLING SHORT, IN SHORT
One of the best-known trading adages is “Buy low, sell high” — the simplest way to turn a profit in a market. But other ways exist, including short selling or shorting a security. This somewhat-counterintuitive process involves selling a security and buying it back later. Traders who practice this strategy are known as shorts.
The mechanics of selling short can be fairly complex, but I’ll try to sum them up:
1 A short borrows a stock from a bank that holds it for the owners, expecting the price of the stock to go down.
2 The short sells the borrowed stock to a buyer.
3 When the stock price drops, the short buys the stock back, returns it to the bank at the original (higher) price, and pockets the difference.
Shorts get a bum rap and are often accused of being responsible when a stock trades lower. Companies have even sued shorts on claims that they spread negative rumors to drive down the company’s stock price. But short sellers are really just part of the overall market mechanism, and they can actually help keep companies honest, because they’re constantly on the lookout for companies with deteriorating fundaments or evidence of suspicious accounting.
Once again, a trader who studies candlestick charts and patterns can easily spot this change. Such a momentum shift is useful to someone who owns a security and is considering selling it or to a trader who has the ability to sell short. (See the sidebar above for more information.)
Admitting Potential Candlestick Charting Risks
After more than 25 years of using candlestick charts to inform my trading decisions, I can honestly say that I have a difficult time coming up with any substantial arguments for using other common types of charts.
They don’t work in the very short term. Candlestick charts are an excellent way to display price action, but for some extremely short-term trading strategies, such as holding for a matter of minutes, the patterns that reveal themselves on a daily candlestick chart may not develop on a much shorter time frame — fewer than 5 minutes, for example.I like to think of candlestick charts as being visual representations of the battle between the bulls and bears, which is played out in the price action of a stock. That battle takes some time to play out, so patterns on a very short-term chart may not produce signals that can be interpreted properly and traded on.Candlesticks aren’t as useful in intraday “scalping” (buying or selling in a matter of seconds) or day-trading strategies in which hold periods are generally shorter. Candlesticks are a bit more useful for periods where behavior is developing over time versus the reactionary trading of day traders.
They don’t reflect trade volume outside regular market hours. The advent of increased electronic trading means that significant volume is sometimes traded outside regular market hours. This trading can cause patterns that keep the full picture from appearing on a candlestick chart.If a stock officially opened at 9:30 a.m. at a price of $50 but traded as low as $49 during the premarket hours (on an electronic trading network), the open may not be a true reflection of where the stock initially traded on the day. As a result, the open recorded on the candlestick is somewhat inaccurate. Also, if the stock never trades down to $49 during the day, the low on the chart may not be an accurate depiction of the day’s price action.
Comparing Candlestick Charts with Alternative Charting Methods
Knowing a bit about alternatives to candlestick charts serves as a point of reference and makes clear the benefits of using candlestick charts for analyzing price data.
Line charts are simple and straightforward.
Bar charts are important to understand because they’re still relatively prevalent and often the default setting in a charting package.
Point and figure charts are great for revealing support and resistance levels.
I’m confident that you’ll be a believer in candlesticks when everything is said and done, but understanding the alternatives is certainly worth your time.
Line charts
A line chart is a line on a chart that displays security prices over time. A line chart represents the price — usually, the closing price — of a security from one period to the next.
Figure 2-5 is a line chart showing three months of daily closing prices for a stock.
FIGURE 2-5: A line chart.
Bar charts
A traditional bar chart contains bars that represent price action from period to period. Each bar is a vertical line that shows the difference between the high and the low of the period. The top of the bar is the high, and the bottom is the low. The distance between the top and bottom is similar to the wick of a candle on a candlestick chart. (The wick is discussed more in Chapter 1.) The finishing touch on a bar chart is a little notch on the right of the bar that’s made to mark where the security closed. Figure 2-6 shows a single bar taken from a bar chart.
Figure 2-7 is a chart of the same data that appeared in the line chart in Figure 2-5.
Bar charts have been the industry standard for some time but are quickly being replaced by candlestick charts. When The Wall Street Journal starts using a new charting convention (as it has with candlestick charts), the convention is considered to be the industry standard.
