-war going on betweenequally matched teams of bulls and bears. The breakout of the boxis usually valid and usually goes in the direction prevalent at thetime prices entered the box.The flag formation (see Figure 6.15) is similar to the box, butthe channel is on an angle. If the angle is down, it is an up flag because that is the way prices will be headed when they break out ofthe formation. A down flag has the channel angles headed up andprices will be going down. The flag formation looks like a parallelogram with the top and bottom on a 45-degree angle.Some analysts claim that the tighter and neater the flag formation is, the more reliable it will be. Flags formed quickly are moredependable than slowly, sloppily formed ones. The length of theflagpole supporting the formation can also be an indication of howfar the price trend will continue after it breaks out.Pennants fly from “poles,” like flags, but they look like symmetrical triangles. The up pennant forms out of bull moves and signals a continuation of the uptrend. Again, the tighter the pennant,the higher its level of reliability.The diamond formation develops during a period of wideswings in price. It is an exciting time, with traders wildly bullish oneminute and bearish the next. Prices seesaw back and forth withgreater and greater swings on high volume. Then the excitement
MD6988.123-162
9/28/01
10:55 AM
Page 150
CHAPTER 6
150
F I G U R E
6.15
Flag Formation
Flag formations can be bullish or bearish depending on the direction in which itis “flying.” The flagpole gives clues to the length of the next price move.
Chart courtesy of “Pocket Charts.”
ends and the prices taper off. Thus the diamond is formed. Diamondformations are hard to predict. They can just as easily alert you to areversal of the price trend as a continuation of the trend.As always, pay close attention to volume when analyzing theformations just described. It usually dips as the formation developsand then increases as the breakout occurs. These formations are notas reliable as the head-and-shoulder formations discussed earlier.Use them as guides only. Find confirmation from other sources.PRICE SMOOTHING AND FILTERING TECHNIQUES
When a major trend takes hold of the market, all the commoditiesare usually affected. It’s rare that an individual commodity canmove in the opposite direction of a major trend.
MD6988.123-162
9/28/01
10:55 AM
Page 151
Understanding Analysis
151
That’s why it is so important to have the trend at your back,moving your position in the desired direction. But commodityprices often make very jerky and erratic moves. Trends are not always clear-cut.Changes in trends can be equally difficult to spot early. If youact too soon when you’re anticipating a trend change or planning totake profits out of a position, you may miss a good deal of the movebecause you mistake minor corrections for major trend changes.Technical traders who face choppy, sawtooth price charts havedeveloped some techniques to overcome this roadblock. One of themethods they use is moving averages.SIMPLE MOVING AVERAGES
Moving averages combine the price activity of a commodity over aperiod of time and smooth it out. For example, to calculate a 4-daymoving average, you would:1. Select the first 4 days’ prices.2. Total them.3. Divide by 4.4. Subtract the first day and add the fifth day.5. Divide the new total by 4.6. Subtract the second day and add the sixth day.7. Divide the new total by 4.8. Continue doing this with each day’s price.Refer to Figure 6.16 for an example of a 4-day moving averageusing the closing prices for 12 trading days of a corn contract. Youcan use the high, low, and open price, as well as the close. You mustbe consistent in your choice to keep the data meaningful.Once the moving averages are calculated, you simply chartthem on a graph. Some analysts like to chart them right on their daily commodity price charts so they can compare them with the actual price activity. In a downtrending market, the moving averageusually remains above the current price. In an uptrend, it tends tostay below the current market price. The point at which the movingaverage crosses the actual price is a critical point.Some technical analysts use moving averages to simply indi-
MD6988.123-162
9/28/01
10:55 AM
Page 152
CHAPTER 6
152
F I G U R E
6.16
Moving AveragesDay
Price
Total
123456789101112
282.25283.75280.25279.25277.75271.75273.75273.25265.00268.50259.00262.00
1,125.501,121.001,108.751,102.251,096.251,083.501,080.501,065.751,054.50
4-Day MovingAverage
281.38280.25277.19275.56274.06270.88270.13266.44263.63
cate the trend. The 4-day moving average described above wouldprovide the short-term trend. An analyst looking for a bigger picture might use a 200-day moving average to represent the long-termtrend.Other analysts use moving averages to generate specific buyand sell signals. It becomes a mini-trading system within itself. Todo this, you need to chart two different moving averages. Commonones are the 4-day and the 9-day moving average.The slower one, the 9 day, requires more days in its calculationand determines the long-term trend. The faster one, the 4 day, signals the short-term trend.If you want to buy a market, both moving averages shouldbe moving higher. Place buy orders in the price range between theaverages. Place stops below the slower moving average. Wait forprices to dip into the zone below the slower moving average to buy.If you want to sell a market, both moving averages should bemoving down. Sell orders are placed in the price range between theaverages. Stops are placed above the slower moving average.Wait for the market price to rally into this zone. Sell short onlywhen this occurs. When you’re placing a long-term trade or tradingoptions, you want to make sure both moving averages are headed
MD6988.123-162
9/28/01
10:55 AM
Page 153
Understanding Analysis
153
in the same direction. You’ll also want to use a long-term movingaverage, perhaps a 50- or 100-day moving average.A WEIGHTED MOVING AVERAGE
Some analysts like to give more emphasis to the current price. Theybelieve it helps them anticipate trend changes sooner.To calculate a weighted average, you would:1. Arrange the numbers to be averaged in chronological order, the most recent number last.2. Multiply the oldest number by 1, the next by 2, the next by3, and so on, until you reach the most recent.3. Multiply the most recent by a factor that is the total number of entries. (If you are averaging 5 numbers, the mostrecent number will be multiplied by 5.)4. Now, add all the results and divide by the sum of the multipliers. This will give you the weighted average. (See Figure 6.17.)Notice that the weighted average is greater than a simple average because greater emphasis is placed on the most recent valuesF I G U R E
6.17
Weighted Moving Average Table
Day
Price
12345
$2.52$2.57$2.56$2.60$2.61
Totals
$12.86
WeighingResultFactor

15
Weighted moving average Simple moving average 
12345
$38.79 $2.5915
$12.86 $2.575
$2.52$5.14$7.68$10.40$13.05$38.79
MD6988.123-162
9/28/01
10:55 AM
Page 154
154
CHAPTER 6
in this rising market. No matter how you do it, moving averages arean excellent tool to use to confirm trends, but like all our tradingtechniques, they need to be tempered with experience and commonsense.STRUCTURAL ANALYSIS
The ancient Greek philosophers developed the concept of naturallaw. All the religions of the world reaffirm that some known or unknown force has implanted an order on the physical world. Thegreat advances of science have been predicted on the concept thatthe laws of physics, chemistry, biology, geology, etc., can be understood. Man’s mind seeks out structure in every activity.Several very successful technical traders have developed theories about the market that begin with the assumption that the universe, in general, and the markets, in particular, work in very precise patterns. More importantly, these theorists believe that thesepatterns can be discovered and exploited for profit. Four of the mostprominent theories are (1) seasonals, (2) cycles, (3) Elliott Waves,and (4) Gann numbers.Seasonal patterns are the easiest to understand, especially ifyou consider the agricultural commodities. The seasonal price trendsthese commodities undergo reflect the regular annual changes thattake place in their supply-demand equation. Think about a typicalcrop year. What will impact the planting schedule? How will weather affect the growing season? Will there be the usual abundant supply at harvest? Studies have shown that 70 percent of all seasonaltops occur between April and July for soybeans, but 80 percent ofthe time soybean prices bottom between August and November.How can you use this information? If you know the seasonalpatterns for the futures contracts you trade, you can use these patterns to confirm signals you get from other methods of analysis.Some traders will not trade against reliable seasonal patterns without having a very strong reason for doing so.Seasonal patterns have been uncovered for virtually all futuresmarkets. Learning the ones for the markets you trade is as basic aslearning which chart formations are most reliable for those markets.Cycles are similar to seasonal patterns, but they can be longerthan 12 months or extremely short in duration. Cycles are built on
MD6988.123-162
9/28/01
10:55 AM
Understanding Analysis
Page 155
155
the observed phenomenon that events have a tendency to repeatthemselves at more or less regular intervals.As mentioned earlier, much of life is governed by repeatablepatterns or cycles. Since people invest in and control the markets, itseems fair to assume that the markets would also possess definablecycles. Understanding these cycles within the price trends of themarkets is another key to successfully trading the markets.Cycles measure the time between each high and low (peak andtrough). By knowing the time span between each high and low andthe previous high and low, you are in a better position to anticipatethe next high or low. Time is often measured in calendar days, as opposed to trading days used by some systems. Calendar days areused for the simple reason that people and nature do not take weekends off—money continues to change hands and events affectingcycles continue.A long-term cycle generally lasts a year or more, an intermediate cycle less than a year, and a short-term cycle a few weeks or days.As a general rule, allow approximately 10 percent leeway in thelength of a cycle when establishing your expectation for the next topor bottom.The wave principle was named after Ralph Elliott, who contended that the stock market tends to move in discernible and predictable patterns, reflecting the basic harmony of nature. These patterns or waves reoccur. Prices unfold in “five waves” of crowdpsychology when moving in the direction (up or down) of the primary trend. Then they move against the trend in “three waves.” Thewave pattern reflects life’s starts, stops, false starts, and reversals.Progress is made in a jerky, sawtooth pattern, rather than a smoothuptrend or downtrend. By isolating the exact position of the currentprice activity within the wave patterns, the trader can profit by anticipating the market’s next move. Once your trading becomes synchronized with the wave pattern, you can successfully ride the economic waves of the market, or so the theory goes.Gann numbers are based on a premise of W. D. Gann, the bestknown structural analyst. His book How to Make Profits Trading Commodities, published in 1942, was the first important treatise on thissubject. He believed that precise mathematical patterns governeverything, particularly the commodity market. More importantly,he believed these patterns could be uncovered and exploited. Since
MD6988.123-162
9/28/01
10:55 AM
Page 156
156
CHAPTER 6
his price predictions became legends in his own time and he claimsto have made millions in the market, he seemingly discovered manypatterns. Integral to his trading system are Fibonacci numbers, athrowback to natural law, and angles of price-trend movement. Hisnumbering system uncannily alerts traders to highs, lows, supportresistance areas, and reversal points. His work must be studied byevery serious trader.CHARACTER-OF-MARKET ANALYSIS
With character-of-market analysis, the technician seeks what areknown as “overbought” or “oversold” conditions. If the market isfound to be overbought, it is sold. If it is found to be oversold, it isbought. This approach is a 180-degree turn from the trend-following approaches. This approach works best in choppy, zigzaggingmarkets. If you use them in a long-trending market, you may getburned badly.You need many tools on your technical analysis workbench.These are excellent ones to have when the market appears to be confused or erratic—but never rely on just one approach to analyzingthe market. The psychology behind character-of-market analysis issimply that when a market becomes too top heavy, it falls. Or wheneveryone gives up on prices ever rising again, they will. It is a contrarian approach to technical analysis.The trick is determining when a market is overbought or oversold.This can be done through general oscillator systems or themore sophisticated Williams’ %R, and Wilder’s relative strengthindex.Oscillators are concerned with price changes over a period oftime. Simple oscillators utilize the difference between two movingaverages. The departure between them indicates overbought andoversold conditions. More complicated ones use the difference between daily prices. It can be the settlement, high-low, or openingprice. Take a simple 5-day settlement price oscillator as an example.It is computed by subtracting the settlement price of the fourthprevious trading day from the current settlement price. If the settlement price has risen, you get a positive remainder. A negativeremainder occurs if the price has fallen. If the remainder is exceptionally high or low, the analysts will consider the market over-
MD6988.123-162
9/28/01
10:55 AM
Page 157
Understanding Analysis
157
bought or oversold and take the opposite position. Analysts usingoscillators usually use more complicated ones than this simple example, but the basic concept is the same.Williams’ %R, copyrighted in 1979 by Larry R. Williams, is anexample of a more complex approach. A 5-day %R is computed asfollows:Subtract the settlement price of the latest trading day from thehigh price of the 5-day period. Then divide that difference (i.e., the“change”) by the difference (i.e., the “range”) in the high price andthe low price of the 5-day period. Finally, multiply that result by 100.The range of %R is 0 to 100 percent.According to Williams, when the value of %R enters the 90–100 percent range, the market is considered to be oversold. Whenthe value enters the 0–10 percent range, the market is considered tobe overbought.Wilder’s RSI, copyrighted in 1978 by J. Welles Wilder, Jr., is another example of this intricate approach to the market. The relativestrength index is a system that measures the change in price over aperiod of time to determine overbought-oversold situations and canbest be described using the following formula:RSI  100  [100/(1  RS)]where RS  Up Avg/Dn AvgUp Avg  Up Sum/1Dn Avg  Dn Avg/1L  number of days in RSI
To calculate a 15-day RSI, the Up Sum is first computed by tabulating the positive changes in the settlement prices of successivetrading days over the 15-day period and adding those changes. TheDn Sum is computed by tabulating the negative changes in settlement prices over the period and adding those changes. Then, the UpAvg is computed by dividing the Up Sum by 14, similarly for the DnAvg. Next the Up Avg is divided by the Dn Avg to get the RS. And,finally, the RSI is computed by adding 1 to the RS, dividing this suminto 100, and subtracting that result from 100.According to Wilder, when the RSI exceeds 70, the market isconsidered to be overbought. When the RSI is less than 30, the market is considered to be oversold. Clearly these are not calculationsyou can do on your fingers. These very complex mathematical cal-
MD6988.123-162
158
9/28/01
10:55 AM
Page 158
CHAPTER 6
culations are available on computer software, allowing the averagetrader to exploit them. Many of today’s electronic quotation systemsinclude them as special features.OTHER TYPES OF TECHNICAL TRADING SYSTEMS
There are many other technical trading systems besides those already described. Three most notable are (1) rate of price change, (2)countertrend, and (3) countercyclical systems.The theory behind rate-of-price-change systems is simple.Mathematical formulas are devised which indicate to the traderwhen a market is about to change directions. Think of it as the momentum in a football game. As one team moves the ball down thefield, it has the momentum. Yardage gained on each successful playis longer, and successful plays become more frequent. Then something happens, and the defense tightens. Gains per play becomesmaller and less frequent. Eventually, the defense holds, and the offense is forced to give up the ball. This activity is often accompaniedby a switch in momentum.Rate-of-price-change systems evaluate price changes on a periodic basis, usually on the day’s closes. As the rate of change diminishes, the trader prepares to close out the current positions andopen new ones on the opposite side of the market. In other words,if long positions are closed out, short positions are entered. In theoptions market, you would offset calls and open puts. In certainvery orderly markets, these systems perform wonderfully. But likeall systems, they are not loss-proof. For example, when the marketsare highly volatile and choppy, these systems have problems.The rate-of-price-change calculations can be used to develop acountertrend system. This is a system that attempts to buy at the lowand sell at the high. Traders try to anticipate the next market moveand hope to catch all major moves early or just before they begin.When using this type of system, you must use protective stop-lossorders. It’s not like a trend-following system that eventually correctsitself by establishing an offsetting position. With a countertrendingsystem, you are net long or net short until you close out your position. That’s why stops are recommended.There are several types of countertrend systems. The fadingminimum-move system is a typical example. A sell signal is trig-
MD6988.123-162
9/28/01
10:55 AM
Understanding Analysis
Page 159
159
gered when the market rallies by a predetermined amount abovethe low point after the last countertrend buy was signaled. The reverse is true for buys. The size of the price change required to generate a signal can be either a percentage or a nominal figure arrivedat through testing or analysis of past moves. The size also determines how sensitive the system is.The countertrend system, like any other system, allows you torequire confirming signals before a buy or sell signal is taken. It’scommon with countertrend systems to wait a day to make sure thetrend has changed before placing a trade.The use of oscillators is also common with countertrend systems. Oscillators, as mentioned before, are technical indicators thatmeasure market momentum.The popular RSI attempted to solve one of the big drawbacksof these tools. How much is too much? When does an oscillator indicate a change in trend—60 percent or 90 percent? Wilder’s RSIpegs tops when its values are above 70 percent and lows when theypenetrate 30 percent.Countercyclical counting uses cycle analysis to develop acountertrending system. By plotting the anticipated highs or lows,entry and exit signals can be generated. You position yourself on theshort side of the market when your cycle analysis indicates a top isdue. You position yourself long if a low is anticipated. Stops arestrongly recommended for this type of trading system.Another approach to forecasting price trends is known as contrarian investment strategy or buying into fear! The phrase “buyinginto fear!” was coined by Bernard Baruch. He strongly believed thatonce you determined what most of the marketplace was going todo, you should do the exact opposite. This philosophy worked wellfor him.Options are an excellent tool for the contrary trader. You cantake a position opposite to what everyone else is doing and limityour risk of the cost of the premium plus the transaction costs (salescommission and exchange and NFA fees). Never forget as you tradefutures that not only must you be right but you must be right at theright time! Buying options that do not expire for 60 to 90 days provides some time to “become” right.Basically, this is the concept of going against the crowd—trading the opposite side of the market from the popular thinking of all
MD6988.123-162
160
9/28/01
10:55 AM
Page 160
CHAPTER 6
traders as a group. Your first question might be, “Where can I getthis kind of information?” A good place to start is the Wall StreetJournal. Three important pieces of data are published daily on theCommodity Page: (1) estimated volume for the current trading day,(2) actual volume for the previous day, (3) and open interest. You’llalso find the high, low, settlement, change, and lifetime high andlow. It is very critical in estimating market sentiment to grasp whatthese numbers mean.Another good source of contrarian information is the Consensus Index of Bullish Market Opinion (www.consensus-inc.com).The index provides indications of potential market directions. Contrary opinion would hold that when a predominant number ofmarket analysts are bullish, it is quite likely that the market is approaching an overbought condition and that a reversal in trend maybe imminent. The same theory would hold if a predominant number of market participants were bearish.
UNDERSTANDING VOLUME AND OPEN INTEREST
Volume and open interest figures benchmark the degree of activityand the amount of trader participation in the individual futuresmarkets. As noted earlier, volume is the velocity of trading, andopen interest measures the number of contracts held at the conclusion of a trading session.Volume reported daily by the commodity exchanges and published in the Wall Street Journal indicates the number of contractstraded during that day, not the sum of the buyers and sellers. Forevery contract traded, there is one buyer and one seller. To determine the volume of trading, simply count either all the buyers or allthe sellers. The number of contracts traded includes the creation ofnew contracts, the transfer of either the buy or the sell side of a contract, and the liquidation of a contract.Open interest is a measure of the number of contracts outstanding at the completion of the trading day. Many transactionsmay occur in a given day without initiating any new contracts oreliminating existing contracts. Existing futures contracts may merely change hands. To understand open interest and volume, followthe example below:
MD6988.123-162
9/28/01
10:55 AM
Page 161
Understanding Analysis
161
Day 1: Trader A buys one contract.Trader B sells one contract.Trader C buys one contract.Trader D sells one contract.If these were the only transactions on the first day, the open interest would be two contracts. Volume is two contracts also.Day 2: Trader E buys one contract.Trader A sells to offset one contract.If these were the only transactions taking place on the secondday, the open interest would still be two contracts. Volume would beone contract. Trader A simply transferred the position to trader E.Day 3: Trader F buys one contract.Trader G sells one contract.Trader B buys to offset one contract.Trader C sells to offset one contract.Trader E sells to offset one contract.Trader D buys to offset one contract.At the end of the third day, only one contract survives; the openinterest is one, but volume is three contracts.After the dust clears, open interest indicates the number of contracts that are held by participants in the market. Notice that forevery buyer, there was a seller. The next step is to analyze the interrelationship of these statistics. Once you know how all the othertraders are calling the market by their actual trading activity, youcan determine what position you wish to take. (See Figure 6.18.)For more clarification, take this situation. Everything—openinterest, volume, and prices—is up, up, up. If you go with the crowdand purchase a call, your premium is high if the option is in-themoney or near-in-the-money. By the time the underlying futureincreases enough to bring your option to breakeven or a modestprofit, the market has begun to retrace. Would you have had moresuccess if you had purchased a put? You can buy them economically when everyone else is wildly bullish. Then you sit in ambushwaiting for a retracement.
MD6988.123-162
9/28/01
10:55 AM
Page 162
CHAPTER 6
162
F I G U R E
6.18
Interrelationship of Interest, Volume, and PricesOpenInterest
Volume
Prices
Interpretation
Up
Up
Up
Down
Down
Down
Up
Down
Up
Up
Down
Down
Up
Up
Down
Down
Down
Up
Very bullish (strong participation andvolume with higher prices)Slightly bullish (weak participation andvolume with lower prices)Mildly bullish (strong participation butweak volume with higher prices)Mildly bearish (strong participation butweak volume with lower prices)Very bearish (strong participation andand volume with lower prices)Slightly bearish (weak participation andvolume with higher prices)
MD6988.163-194
9/28/01
10:56 AM
Page 163
C H A P T E R
7
Breaking into FuturesTrading with Options
Key Concepts◆ Using Options on Futures Contracts as a Risk Strategy◆ Buying Options into a Bull Market◆ Developing an Options Trading System◆ Knowing the Dangers of Liquidity◆ Recognizing the Four Major Types of Spreads, plusStraddles and Strangles◆ Calculating the Premiums and Value of Options,Breakeven, and Delta Factors
Believe it or not, trading options on futures contracts is a goodway to break into the world of futures trading. Trading options canhelp a new trader gain familiarity with the markets and the toolsnecessary for effective trading while limiting the financial risk to theprice paid for the option.USING OPTIONS ON FUTURES CONTRACTSAS A RISK STRATEGY
An option is the right, but not the obligation, to buy or sell an underlying futures contract at a specified price (called the strike price)during a specified period of time. Just like futures contracts, all options on futures are bought and sold at competitive auctions in the
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
163
MD6988.163-194
164
9/28/01
10:56 AM
Page 164
CHAPTER 7
options pits on the floors of the futures exchanges. Also, just like futures contracts, at the end of each trading day all options transactions are accepted and cleared by the clearing association, assuringperformance on all contract obligations. This frees buyers and sellers of any direct obligation to each other.A call option conveys the right, but not the obligation, to buy afutures contract at a specific price during a specified time period.You would buy a call option if you expected prices of an underlying futures contract to rise.A put option conveys the right, but not the obligation, to sell afutures contract at a specific price during a specified time period.You would buy a put option if you expected prices of an underlying contract to decline.The strike price of an option is the price at which you may buy(in the case of a call option) or sell (in the case of a put option) theunderlying futures contract. The various exchanges that offer options determine the strike prices for put and call options. Additional strike prices are added by the exchanges in accordance with futures price movements by applying a formula.As futures prices rise or fall, options with higher or lower strikeprices are introduced according to the formulas. The result is to create new options on the same futures contract. This allows optionstrategies and opportunities to reflect current market conditions.Strike prices can be at-the-money, in-the-money, or out-of-themoney. At-the-money is an option with the strike price that is nearest to the current underlying futures price. In-the-money is a put option whose strike price is higher than the current underlying futuresprice, or a call option whose price is lower than the current underlying futures price. An out-of-the-money option is a put optionwhose strike price is lower than the current underlying futuresprice, or a call option whose strike price is higher than the currentunderlying futures price.The length of time an option on futures runs until expirationvaries, depending upon the underlying futures contract and the exchange upon which it is traded. You can trade some futures optionsa year or more before the options expire. It is important to note thatthe option month refers to the futures contract delivery month andnot the month in which the option actually expires. Options expirebefore the underlying futures contract, often several weeks before.
MD6988.163-194
9/28/01
10:56 AM
Page 165
Breaking into Futures Trading with Options
165
For example, a call option on July soybean futures expires in lateJune. Options’ expiration dates vary from commodity to commodity and exchange to exchange.Premiums (the value of an option) vary according to the size ofthe option, the price of the underlying futures contract, the strikeprice of the option, the length of the option, and market conditions(volatility). Generally, out-of-the-money options with less time toexpiration tend to cost less than options with more time to expiration and that are at- or in-the-money. The cost of