I’d like to thank you all for the positive feedback I’ve received for part 1 of this post. If you haven’t read it you can read it here. In this part we’re going to learn how to you can even understand from “nothing”. Learn what are candle additions. See examples in real life stock charts. Understand the Log scale for representation of data and why you should use this the next time you see any graph or figure on the news.
In the last post using the “Beard length” example we understood individual candles how each day candle’s data represented some useful information for us. There can be some very important information communicated by two or more candles in relation to each other.
We’ll be looking at the following : Gaps, Addition and Scale
No not that gap or the jeans brand. The literal nothingness between two things, a space or interval; a break in continuity. When that is seen between two candles it is also called a GAP.
We know there each candle has an open and close price. The difference between the close of previous candle and open of the current displays what we call gaps. Some gaps can be very easy to spot like below:
In the above candle B opens at a level which is higher than the close of candle A. Some gaps are more subtle which we tend to miss like the below one:
At first glance the candles look normal with no visible gap but as marked there is a difference between the last close and current open. They are not easy to identify unless you pay attention, which I recommend you do.
News or break between close and open of next day causes gaps to for in the stock price.
e.g. If Milk price for this week started at Rs. 60 (open) and on Friday(close) ends at Rs.65 increasing 1 per day. If the price of Milk on next weeks Monday starts from Rs 70, which means an increase of 5 without any continuity. That difference of 5 with the absence of milk transactions at those prices we call the Gap.
The interpretation is that there was some factor which caused that no one was ready to complete a transaction at that price. This goes for stocks, products or anything else.
Have you noticed any Gaps recently in any stock charts? Why don’t you try find them using any charts and let me know in the comment section. I’ll confirm them for your learning and practice. e.g. Gap between 21 and 22 April 2020 in the daily charts of Reliance Industries.
Consider the below image of two candle sticks. both are opposite color and have the same height(low to high) and there is no gap, what do we make of this particular chart.
We understand that on day one price opened up but fell and recovered but not entirely to close and form a red candle. On day two It opened and fell again but recouped and surpassed the open to close at a high point and hence a green candle. Instead of considering these as two candles we can mentally add them and understand them as a whole. It’s like using multiple letters and instead of remembering each letter you understand it as a whole word. This can be done with any number of candles. Candles of 5 days of a week can be added to form one candle to represent the entire week.
Now here comes the rule for adding any number of candles
1. Pick the Open of the first, and Close of the last candle
2. High is the highest point of all those candles
3. Low is the lowest point of all those candles
Thus you have the OHLC values for forming a new candle which is the sum of the previous two. By tracing the 4 points from the two candles in the image, and adding them it forms a new candle representing that the value has gone down tremendously and then recovered that amount.
It is possible that the price can fluctuate in that range as it has proved the same.
On line charts this displayed as a rather flat or slightly growing line. By ignoring the true range up to the lows that are possible and lead to a wrong conclusion.
p.s the candle formation is traditionally called “Tweezer bottoms”
If you’ve ever seen any article or breaking news title, It’ll be something like “SENSEX is down 999! points” or “400 new corona virus cases today”.
Now don’t get me wrong these are serious cases. Don’t YOLO your trading account buying calls or go out of your house unprotected. The problem I have with these is generally you are only given the figure without a scale or comparison. Okay that sounds like a big number but what is the usual range it fluctuates? A normal 2% swing in the SENSEX can be close to 800 points. Whenever you get a news title or a “fact” with only one number and nothing to compare to, become very suspicious of that figure!
That is why in the finance world and in many other fields, professionals tend to use Logarithmic or log charts.
We can see from the first chart(linear) that the flattening of the curve is not visible until mid April while as in the below chart(logarithmic) it is visible from march itself. If you based your decision on the first chart you’d believe that you methods are not working but by the second chart you can clearly notice the impact and progress made in march itself.
The above info represents the exact same data in two different ways but on the second the scale on the y axis is not of equal distance like 2k, 4k, 6k. It is in a factor of magnitude at 200 , 600, 2k, 10k. This is because cases going from 1000 to 2000 and 20000 to 21000 in quantity on Linear scale is displayed same as a growth of 1000 i.e same length. We know that 1k to 2k is a much more alarming figure because the increase is 100% , essentially doubling while the latter is a 5% increase. The former is 20x more severe than the latter.
In the above images we see the same with the stock of Eicher Motors Ltd. we can see two different charts. If you were to invest seeing just A you’d believe that the rate of acceleration of the stock price is high and you might buy it. While if you look at B you’ll have a more realistic understanding of that growth which has been stagnant for the last 5 years.
To summarize Logarithmic scale has the Y axis set at percentage or logarithmic values to represent rate of change of value realistically. Especially in the stock market or any news where the data fluctuates a lot i.e has a lot of volatility you should use log scale to give you a realistic view and not panic. Because, If I may take the liberty to say so, “kuch toh LOG kahenge”
The COVID-19 cases graph is of the country of South Korea, who have done a commendable job in containing the virus in their country. Keep an eye out on the logarithmic scale to identify flattening of the curve in your country/region. Help spread calm and diffuse panic that the news channels are trying to sell you. That said, always focus on what you can control which is taking the right social distancing measures, avoiding leaving the home for unessential work and maintaining good hygiene. Stay home, Stay safe.
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