Using Candlesticks with Options

Using Candlesticks with Options

In the mid-1700s, a man named Munehisa Honma had a prominent rice farm­ing estate and, consequently, had considerable influence over the rice market. Through years of trading the rice markers, Honma discovered that, while sup­ply and demand played a role in determining price, the markets were also strongly influenced by the emotions of traders. In other words, traders emo­tions could cause significant changes in supply and demand. Honma found that traders could benefit from understanding emotions. Through his analysis, Honma brought to us one of the most important insights to trading: There can be a vast difference between the price of rice and the value. Hundreds of years later, the legendary investor Warren Buffett came to the same realization when he said, “Price is what you pay. Value is what you get.”

While the words “price” and “value” are often used interchangeably in everyday communication, there is a big difference between them when it comes to investing or trading - as Honma and Buffett have figured out. The price of a financial asset can be found by looking at the current market quote but the value is a subjective measure. Value is something that exists in the trader’s mind and is an assessment of whether the price reflects a good deal.

Here is an example that demonstrates the difference between price and value. Assume you are a currency trader and think the yen will rise against the dollar and you wish to buy one million yen to capitalize on your outlook. An­other trader offers you one million yen in exchange for 7,000 British pounds. Should you take the trade? Note that 7,000 pounds is the price for one million yen - it is what you have to give up in order to buy the yen. However, it should be evident from this example that it may not be a good deal since the value between the two currencies could be vastly different. In order to check, we can convert the two currencies into dollars and then make comparisons. At the time of this writing, 7,000 pounds were equal to $13,440 and one million yen were equal to $9,615. Now it is easy to compare the two currencies and we can see that it is not a good deal to give up something worth $13,440 in exchange for something worth $9,615. In other words, 7,000 pounds is too high of a price to pay for one million yen since there is not an equal amount of value between the two currencies.

But there is something more troubling about the trade than the fact that price is higher than the value. Notice that if you pay 7,000 pounds for one million yen you could still end up losing money - even if your outlook is correct and the yen rises against the dollar. You could lose on this trade because the rise in the yen may not be enough to offset the high price paid to acquire the yen.

When it comes to trading stocks, there is only one thing that a trader needs to know to determine if a particular stock is a good value; that is, the future direction of the stock’s price. That is exactly what candlestick charting helps a trader identify. Unfortunately, most option traders take this same ap­proach when it comes to trading options. They see an option as nothing more than a leverage substitute for stock. If they think the stock will rise, they buy calls; if they think it will fall, they buy puts.

But option trading cannot be reduced to this same simplistic approach. The reason is, while an option’s price is sensitive to the direction of the stock’s price, it is also sensitive to the volatility of the underlying stock. Volatility is simply a mathematical measure of the price swings exhibited by the closing prices. In mathematical terms, volatility is the standard deviation of stock price returns. If there are large price changes from day to day, we say that is a volatile stock. If the price changes are relatively small then the stock is not volatile. It is not important to understand the mathematics involved in measur­ing the volatility of a stock but the ability to interpret those numbers is of utmost importance for an options trader.

As odd as it may sound, knowledge that a stock is moving higher is of little use to an options trader. In order for that information to become useful, we must also know how quickly the stock will move.