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 this 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 (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. 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.

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Thanks for reading my article,
Clinton Lee. Founder, Home Options Trading: a uniquely retail-focused option-centric trading firm.

See what is meant by “Candlesticks/OHLC Charts Lose their Patterns on a Distribution Curve” at
http://www.homeoptionstrading.com/point_figure/candlesticks.html

Please see Consistent Results at http://www.homeoptionstrading.com/consistent_results/, displaying

the Model Portfolio's Performance YTD, updated each month-end. The portfolio models a typical retail
option trader's account up to USD $50,000. Here's the stats in summary:
 Return: Profit/Start of Year Cash Balance = $91,593/$58,380 = UP 157%.
 Win/Loss Probability = 60/68 = 88.24%.
 Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 88.24% x $2.99 = 2.64.
 Positive Expectancy = (Win Probability x Average Win) - (Loss Probability x Average Loss) =
$1,347 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 an $800 options basic course as a Bonus!

Clinton's career spans 16 years of treasury, finance and banking across Hewlett Packard, JP Morgan Chase,
Citibank, Royal Bank of Scotland (previously ABN Amro); and, is currently a Senior Liquidity Advisor at Bank
of America in its Global Treasury Services division. Despite the years in the finance/banking industry, it did
not help him directly grasp online options trading from home.