Series 3 - National Commodities Futures

Orders And Price Analysis - Technical Analysis

Technical Analysis
Technical analysis studies trends and uses them to forecast price movements of both single commodities and entire commodities alike. In the commodities futures world, players are concerned with the interrelationship between trends of three market elements:
  1. Price,
  2. Volume and
  3. Open interest.
Price
We start with a discussion of price, which is certainly the most important concern.

Here is a simplified chart showing the movement of a futures contract price over 18 months, as well as a trendline:



The chart above demonstrates what a trend line looks like against the day-to-day changes in a security's price. Specifically, it shows a "
downtrend;" if the future had started the period at $18 then risen to $22, it would show an "uptrend."

The above trendline is not especially useful from an analytical standpoint, because it is simply a linear, straight-arrow bullet path. In technical analysis, trend lines have to be far more subtle than that. Technical analysis searches not only for trends, but also for changes in and/or reversals of them. Using a polynomial trend curve, a technician may see a different pattern emerge:



The data line is exactly the same, but at this point a technician might see a saucer shape, which suggests a trend reversal. A "saucer bottom" indicates the security's price has reached its "support level," the lowest price at which it is likely to trade, and it has nowhere to go but up. A saucer top signals exactly the opposite: the futures contract has reached its ‘resistance level," the highest price at which it is likely to trade. The band between the support and resistance levels is called the "trading channel."

Another sign of a trend reversal is the "head-and-shoulders pattern:"



SEE VIDEO: What Is The Head And Shoulders Pattern?

You do not need a trend line for this: the data line tells the story. The price glided up until it formed its first shoulder in May 2001, then it dropped off; then it surged to form a higher peak - its head - in December. It then fell off again and surged one more time - weakly - to form the second shoulder in March 2002. Technicians consider this a "bearish" chart. An "inverted head-and-shoulders" would be "bullish."

Technicians have an old adage: "The trend is your friend - ‘til it comes to an end." That end is signaled by a "breakout," which happens when a security penetrates through a support or resistance level. If a futures contract's price breaks out through a resistance level and is accompanied by higher-than-usual trading volumes, technicians consider this a bullish indicator. It means, according to technical analysis, that the security is now looking for a new resistance level, and it may be able to continue climbing on momentum for quite some time.

In this example, anyone who bought the contract in July 2001, when it was trading below its four-month moving average, would have been amply rewarded later on.

Although this sort of line graph is helpful for determining trends, often investors want more precise data. Line graphs typically show closing prices only, and investors are often curious about the intraday highs and lows, as well as how sentiment toward a commodity might have changed overnight and might be reflected in an opening price that differs from the previous day's close. These details are frequently presented as "bar charts." The figure below illustrates the anatomy of a bar chart:



The top of the vertical line indicates the highest price a security traded at during the day, and the bottom represents the lowest price. The closing price is displayed on the right side of the bar and the opening price is shown on the left side of the bar. Often the opening price is omitted because most futures markets are not active after hours:



When there is a difference between one day's close and the next day's open, it is called a "gap" and usually suggests a sudden shift in market dynamics. Gaps can also occur midday if there is shocking news about the economy or of the soundness of a futures contract's underlying assets, and this news is dramatic enough to change the market substantially between one trade and the next. Oil supply disruptions or earnings announcements can affect futures for commodities and stocks, respectively. Although gaps are a regular occurrence in most financial markets they are rare in foreign exchange futures because such markets are highly liquid and trade 24 hours a day.



(http://www.thegraintrader.com/chart-patterns/price-gaps.html)

Bar charts are particularly useful for spotting trend reversals. A "double top," two daily price highs reaching the same level, is a bearish signal that prices have peaked and have nowhere to go but down. The days can be back to back, or several days apart. "Double bottoms" are the inverse of double tops, and indicate prices may be ready to change from a down-trend to an up-trend.

SEE:
Keep It Simple – Trade With The Trend

There is another type of chart that futures traders use called a
point-and-figure (P&F) chart. This is something of a blunt instrument and has long since fallen out of favor in other securities markets, but it is still widely used by futures investors to determine when to buy into a position or when to reverse it. Not developed with day-traders in mind, P&Fs historically have focused solely on the securities' closing prices and eliminates all the noise inherent in intraday price fluctuations. A variation of P&Fs focuses on highs and lows rather than closing prices, but that too ignores non-essential price movements.

P&F charts track a unit of measurement of a price movement that is plotted on the graph; this unit is typically, but not necessarily, $1. Price is tracked, but not time. Rising prices are shown with X's and falling prices are shown with O's. These points appear on the chart only if the price moved at least one unit of price in either direction.

So if a futures contract's price moved up $3, this would appear as a column of three X's. If the price movement reverses direction, the chart shows a new column of one O per dollar of downward price movement. X's and O's never appear in the same column. The technician's artistry comes into play by establishing how many dollars the price must move in the opposite direction for the chart to begin a new column. This quantity is called the "reversal box" or simply the "box."

Say, for example, the contract you were tracking was trading at $25, and you were using a $1 unit measurement and a three-unit reversal box. If the stock had been trading upward to $25, your P&F would look like this to start:

$25
X

X

X

X

X
$20



If the price then went back down to $23 it would look like this:

$25
X

X

X

X

X
$20



There is no difference. The box is set to $3. A $2 difference won't show up. But now let's say it moves down to $22. It will look like this:

$25
X


X
O

X
O

X
O

X

$20


Notice that we have no idea how much time this took. That's because the P&F tracks only price movement, not how long it takes.

Fully fleshed out, a P&F chart might look something like this:










+
+
+
+
+











X

X

X











X
O
X
O
X
O








X

X
O
X
O
X
O



+
+
+
+
+
X
O
X
O

O

O

$25
X

X

X

X
O
X
-
-
-
-
O


X
O
X
O
X
O
X
O
-




O
X

X
O
X
O
X
O
X
-





O
X

X
O

O

O
-






O
X

X
-
-
-
-
-







O
-
$20































We have added, as a convention, plus signs (+) to signify resistance levels and minus signs (-) to signify support levels. Generally speaking, if a security's price moves upward past a resistance level, that's a bullish sign and an investor might consider buying more of that security. Conversely, if it moves downward past a support level, that's a bearish sign that an investor might take as a signal to sell.

Ultimately, these graphs are all just tools to display exactly the same thing: the likely direction of a security's price movement given its recent history.

SEE:
Testing Point-And-Figure Patterns



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