Are Your Charts Giving You the Whole Picture?

11/19/2010 12:01 am EST

Focus: STRATEGIES

By simply looking at a chart, it can seem potentially easy to make money. Yet many traders and investors do not watch price action in real-time. Rather, they only see a five-minute, hourly, or daily chart; in hindsight, they may even watch the charts in real-time, but as the period (bar) comes to an end, much information is lost. Common charts, such as OHLC (open, high, low, close) and candlestick, lose information as the period being watched comes to an end. Traders who don't realize this can have a hard time implementing strategies they believe work on the summary data provided by charts, but may fail to work in live trading.

Lost Information

Charts provide summary data for a period, not a detailed breakdown of what happened during that period. When a bar is shown, what happened during the time the bar took place is lost. Only the open, high, low, and close are left to tell of that time period. In hindsight, it may look like during that time period the price went straight from its open to close, when in fact, there may have been many gyrating movements in between the open and close on that time frame.

The lost information may contain false breakouts, rapid back and forth movements or any combination of movements, which are contained with the high, open, close, and low of the bar.

In Figure 1, there is an hourly chart of BP (NYSE:BP). On the hourly chart, it may appear as if the market broke below 39.40 and proceeded to make a low at 39.21 before recovering in the next hour. Since we are looking at a bar, we assume the prices happen in a logical chronological order ― in this case, open, high, low then close. The reality could be very different.

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A trader running visual back tests may inadequately account for the fact that instead of moving through 39.40 and proceeding to 39.21 directly, the one-minute chart reveals that the price action was much more choppy, actually dropping below 39.40 (after moving back above or to 39.40) five times before making a low at 39.21. This is shown in Figure 2, where even price movement to 39.29 was much choppier than what appears when viewing an hourly chart, for example.

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Click to Enlarge

These small movements may not seem significant, but depending on the trading system and stops employed, one true breakout is very different from movement, which fluctuates in a choppy fashion, generally retracing much of its prior movement before continuing. (For more, check out Tips for Creating Profitable Stock Charts.)

NEXT: The Negative Effects

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The Negative Effects

Much research and analysis is done on charts. Often, backtesting is done using completed bars. But since there is a price movement within bars, several problems often develop, which affects actual live trading results:

    * A trader may be stopped out of a position continually and wonder why the strategy worked well on the backtest.

    * In real-time, the prices (entry and exit) expected may be hard to get. Prices quite often move a small amount and retrace. This makes getting the price wanted, at the time wanted, harder than it may appear on a longer-term chart.

    * When a position is a taken, there may be much fluctuation the trader does not expect because often completed bars make it appear a stock only moved in one direction. Often, when novice traders take on live traders, psychological factors such as fear or greed kick in because potentially rapid whipsawing price movements take them by surprise ― this in itself can cause deviation from a set plan.

    * If a bar shows up, movement (closed higher than it opened) it does not mean the low occurred before the high. Visually, we want to see things in chronological order and assume that the information we view is in this order. It is quite possible, in the markets, that what is visually logical did not occur that way in real-time.

    * When implementing trailing stops, using completed bars as a reference can be deceiving. An hourly bar may make price action look like it did not retrace, yet moving to a shorter timeframe may show many retracements potentially triggering a trailing stop which may not appear logical on the longer timeframe.

Getting More Information

From the example above, we can see that looking at more than one timeframe can provide us a more complete picture of what has occurred over a period of time. Analyzing movements on all timeframes can also help us better prepare our trading system for live trading in real-time market conditions.

If a trader trades in real-time, watching price movements all day, he or she may not have to look at multiple timeframes to reconstruct the real-time price movement. Yet looking at multiple timeframes can still provide valuable insights into support/resistance, trends or ranges not visible on one time but visible on another. Traders who cannot watch price movements in real-time should be aware of price characteristics that may not be evident in summary chart data.

Thus, it becomes important for traders to understand movements on all timeframes so they can better implement their system on the timeframe on which they enjoy trading. This is especially true if position stops are tight ― be aware of short-term and longer-term tendencies to better gauge where stops and profit targets should be placed.

Above all, avoid the idea that prices move in one direction even when a bar makes it appear so. Almost always, there is a back and forth movement to prices. While occasionally large moves do occur in one direction, most of the time, this is not the case.

Summary

When looking at charts in hindsight, information has been lost because (generally) all that is shown is the open, high, low, and close. Information other than those four precise price levels is lost, and how the price moved within the bar's timeframe can be significant. If traders are unaware of the tendencies of a given tradable, the system they expect to work (which was tested on completed bars) may not perform as expected in real-time. Therefore, it is important to watch multiple timeframes to understand that prices gyrate, and that shorter timeframe retracements and movements can affect longer-term trading systems that were created by analyzing completed bars.

This article was written by Cory Mitchell of VantagePointTrading.com and first appeared on Investopedia.com

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