Admitting the Potential Candlestick Charting Risks

After more than 15 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 over candlestick.

In the interest of fairness, however, and to help you realize the truly versatile and useful nature of candlesticks, I offer a couple of minor potential chinks in the candlestick chart's armor:

1 They don't work in the very short term. Candlestick charts are an excellent display of price action, but for some extremely short-term trading strategies, the patterns that reveal themselves on a daily candlestick chart may not develop on the much shorter time frame — five minutes or less, for example.

I like to think of candlestick charts as a visual representation 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 properly interpreted and traded.

Candlesticks aren't as useful to intraday "scalping" or day trading strategies where hold periods are generally shorter. This speaks more to the utility of the chart and the intended behavior of the trader.

1 They don't reflect trade volume outside of regular market hours. The advent of increased electronic trading means that there can sometimes be significant volume traded outside of regular market hours. This trading can cause patterns that don't reflect the full picture to appear on a candlestick chart.

For example, if a stock officially opens at 9:30 a.m. at a price of $50, but traded as low as $49 during the pre-market hours (on an electronic trading network), the open may not be a true reflection of where the stock initially traded on the day. That means that 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.

Selling short, in short

One of the most well-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 first and then 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. He then sells the borrowed stock to a buyer.

3. When the stock price drops, he buys the stock back and 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 a 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.

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