For day trading, finding an adequate representation of the financial products you are going to trade is essential. You can trade shares, options, futures, turbos and more. These are displayed in many different ways, with the candlestick method being the most popular. However, why is that so?
In the past, the use of tickers was widespread, especially in the 1920s. That was necessary, because computers did not exist yet. Prices were written on boards, and the market was not directly real-time. People made their own charts by hand and technical analysis was applied to them. Completed transactions were shown as Time and Sales . This is a way of showing volume, but also recording the price of the traded share.
Line graphs were made from the raw prices. These are graphs on which one line indicates the value of a share or other financial product. This line is an average of the bid and ask prices and is commonly used in newspapers to show stock prices. However, most traders do not use this chart because it does not show the high and low of a chart. Stop-losses can be triggered by these highs and lows.
Professional traders started using bar charts. This divides a graph into different bars depending on time. A bar is a figure with open, close, high and low. Suppose a bar is drawn on a 5-min bar chart. When one then switches from 0:04:59 to 0:05:00, a new bar is drawn. The price that is the price of a share at that moment is the open, when you switch to 0:10:00 the price is recorded, which is the close of a 5-min bar. The extremes of all price movements in between are the high and the low. Please note that the open, close, high and low are still averages of bid and ask prices.
After World War II, a new phenomenon emerged from Japan, the candlestick . This graphing method had been practiced there for hundreds of years. The candlestick bar is the same as a regular bar, but with a body. This body can have different colors depending on which direction the bar is facing. For example, if the bar is bearish it will be red, if it is bullish it will be white or green. The candlestick therefore provides a little bit of extra information on top of a normal bar chart. This made candlestick charting quite popular. As much information as possible was presented compactly. One can also choose other time divisions of the candlestick bars, called the timeframes , so that information on charts can be displayed even more conveniently. The commonly used timeframes start from the tick level, which is the level at which one trade is executed. From here on, customized timeframes are used, such as 1 min, 2, 3, 4, 5, 10, 15, 30, 60, 120, 240, daily, weekly up to monthly. But few use larger timeframes such as quarterly (one candle per quarter).
Candlestick analysis emerged from the popularization of candlesticks. This idea was especially encouraged by the founder Steve Nison. The computerization of day trading also helped, you can literally put graphs on the screen within a few seconds. In candlestick analysis it is assumed that certain types of candlesticks lead to statistical trading advantages, or an edge . For example, when one observes a doji, the market is uncertain and could go up or down. With a key reversal, the chance that the market will turn is more than 50%. Based on this philosophy, candlestick analysis became a form of technical analysis: one can trade the future from the history of the candles. However, the question is how useful candlestick analysis is for day trading. One can say that when one sees a key reversal, one can expect the market to turn. However, the opposite can also be said: when the market is turning, there is a greater chance of seeing a key reversal. When a market trend changes, one sees more key reversals, but this does not necessarily mean that there is a causal relationship that key reversals lead to trend changes in a market. One should carefully consider whether there is a statistical and/or logical connection that supports candlestick analysis (see article Day trading: the trend is your friend).
The existence of multiple timeframes led to the popularization of fractal analysis. From the level of the smallest timeframe, all the way up to the largest, price always moves in one direction. However, the interpretation of the direction of the market depends on a time frame. A “small” move down may be large on the 1 min timeframe, but minor on a monthly timeframe. It can be argued that when a trend is present on a large number of timeframes, this trend is more important and/or more profitable than a trend that is only present on a small number of timeframes. The term fractal analysis therefore means that the market essentially starts small, from the smallest fractal , and becomes increasingly larger, up to the largest fractal. The more fractals that are in agreement, the more likely the trend is a “real” trend that can be monetized. As a result of this philosophy, many day traders use multiple time frames. They not only look at daily charts, but also at charts based on 60 minutes, 30 minutes or 15 minutes. Scalpers sometimes even look at the tick level of a chart.
Elements that make up a graph
Basically, a graph of a standard financial product like a stock always consists of the following three inputs: price, volume and time . Indicators, such as moving averages, rely on price or volume as input, which is why some traders consider indicators to be nonsense. They only look directly at price and volume, and use that to determine whether the market is going up or down. These are the so-called tape readers . There are also traders who take time into consideration when making their decisions. These traders are especially fans of esoteric technical analysis such as Gann and Elliot Wave. Because this is a lot like fortune telling, even more so than normal technical analysis, this technical analysis is not very popular.
Variations on candlestick
Candlestick bars are based on time to divide into. Because not everyone believes that every moment of the day is equally important, other forms of candlestick charts have been devised. Examples are tick charts (not to be confused with timeframe tick or market internals tick), range charts, Heiken-Ashi, and renko.
- Tick charts draw candlesticks after a certain number of trades, instead of a certain number of seconds. In this way, trades made by professional traders (with more shares) can be better distinguished from private investors (based on volume). If you think that professional investors are the so-called “smart money” and want to follow these investors, tick charts can help.
- Range charts draw candlesticks after a minimum amount of price movement. The idea is that when price consolidates there are few gains to be made. By not showing small movements in a graph, it is easier to ignore the consolidation periods. The result should be that trends are more visible on range charts.
- Heiken-Ashi and Renko are two forms of charts that, like candlesticks, come from Japan. The first is used to make candlestick charts with gaps look smoother. Gaps are parts of a chart where no candle is visible, while this is aesthetically more convenient. The second does not use time and volume in its graph. In principle, both variations should ensure that trends are more visible on a graph of a financial product.