as clear as with the other patterns. A rounding bottom looks like asaucer on a chart as prices edge down in a series of lower lows and then begin tocreep higher with a series of higher lows (see Figure 2.14). When prices on theright side of the chart move above the lip of the saucer formation, it’s a signal tobuy. One well-known long-term saucer bottom occurred in gold futures, formingover more than two years and staying within about a $40 range. In some cases,prices reach the lip, then drop lower again before rallying to move above the lip inwhat some analysts call a cup-and-saucer formation.V Tops and V Bottoms These look just like what the letter describes: Pricesmake a sharp move and spike to a high or a low, then immediately turn around to
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FIGURE 2.13 Head-and-shoulders top. In this classic reversal pattern, prices breakingbelow the neckline suggest a sell-off to the objective. (Source: eSignal, www.esignal.com)
move in the opposite direction (see Figure 2.15, page 41). This formation is moreevident on a chart in hindsight and doesn’t provide good places to establish a position. The sudden reversal of trend has few if any areas of consolidation. Somemarkets, like meats and currencies, may be more likely than others to form Vtops and V bottoms.
Other Chart PatternsYou may have realized by this point that the study of chart patterns can involvequite a bit more complexity and insight than what has been discussed so far. Thischapter serves only as an introduction to the subject, but several other importanttechnical analysis topics need to be considered.Gaps Gaps are price areas on a chart where no trading takes place. For example, the market hits a high of, say, 100 one day and then opens the next day at 105,leaving a five-point gap where no trades occurred. Gaps happen quite often in mar-
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THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 2.14 Rounding bottom, also called a saucer bottom. Prices breaking above thesaucer lip suggest the lows may be in place. (Source: eSignal, www.esignal.com)
kets that trade for only part of a day because price-moving events and announcements take place during times when markets are closed. However, not all gaps areevident on a chart because follow-up price action covers them up or “fills the gap”in trader talk.In general, gaps are considered to provide support below or resistance above,although some gaps may have little or no significance, depending on where theyappear on the chart. Gap analysis focuses on several categories of gaps:• Breakaway gaps. After an extended move, a market suddenly reverses direction with a strong burst, leaving a gap. A breakaway gap can sometimes indicate the beginning of a significant new trend.• Measuring gaps. This gap occurs about halfway through a move and is a continuation signal. It may not be clear at the time that it is a measuring gap, butas price action leads you to that conclusion, you can measure the distancefrom the start of the move to the beginning of the gap and then add or subtractthat distance to or from the gap to project a price target.
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• Exhaustion gaps. After an extended move, a market expends one last gasp ofenergy to continue the move, exhausting all the buying (at a top) or selling (ata bottom) that is left. The exhaustion gap may be a reversal signal, and a driveto new highs or lows is sometimes followed several bars later by a breakawaygap in the other direction. The combination of an exhaustion gap and a breakaway gap may leave what is called an “island reversal.” On the chart, it lookslike isolated price action that is not connected to other price action on eitherside of the gap area.Figure 2.16 illustrates all of these types of gaps on a soybean futures chart.You can see what happens to prices after the gaps appear, although prices in thiscase did not fall as low as the target projected by the measuring gap.Support, Resistance Support is a price area that tends to lift the market orprevent prices from going lower. Resistance similarly suppresses prices and actsas a ceiling that prices have difficulty penetrating. Previous lows or highs, trend
FIGURE 2.15 V top. Characterized by a sudden reversal of trend, this pattern has withinit few if any consolidation areas. (Source: eSignal, www.esignal.com)
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THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 2.16 Gaps. Gaps are often categorized as either breakaway, measuring, orexhaustion. (Source: eSignal, www.esignal.com)
lines, moving averages, or other key price points may provide support or resistance to a price move, causing prices to bounce off of them rather than gothrough them (see Figure 2.17). Often, if a market does get through a resistancearea, that resistance turns into support on a decline, or a broken support area becomes resistance.Retracements A subject closely related to the concept of support and resistance is the matter of retracements. Markets seldom move straight up or straightdown but tend to make a move, then a countermove. The countermove may result in one of the congestion patterns mentioned earlier or may go to a pointwhere support or resistance exists from, say, a previous high or low. If traders seea countertrend move developing, they try to forecast how far this correctionmight take prices.A popularly identified retracement amount for technical analysts is 50 percent—that is, if prices rally and then decline, analysts might expect the decline toend at the 50 percent mark of the up move. Depending on the extent of the re-
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FIGURE 2.17 Support and resistance. Areas of support are found beneath chart prices,and resistance is identiﬁed as being above prices. (Source: eSignal, www.esignal.com)
tracement, traders determine the strength of an existing trend. If prices retraceless than 50 percent of a previous move and then continue the trend, the market isconsidered by some to still be strong; if prices correct more than 50 percent, themarket looks weak and may be ready to move in the opposite direction.If you were trading gold futures in early fall 2004, you watched prices rallyfrom roughly $397 to $426 an ounce and then begin to drop (see Figure 2.18). Youmight wonder how low prices could go. A 50 percent retracement target of the previous $29 rally would take prices back down to $411.50, one point where youmight look for the setback to stop. In this case the gold market did find support atthat point and resumed its longer-term rally.In addition to the 50 percent rule, you have available another, more extensiveretracement tool called Fibonacci retracements. This discussion of pullbacks, support and resistance would be incomplete without exploring the topic further.Fibonacci Numbers and Ratios Leonardo Fibonacci was a thirteenth-centuryItalian mathematician who discovered the significance and unique properties of a
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THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 2.18 Retracement. This pullback holds support at 50 percent of the previousrally. The 50 percent retracement level can be the critical turning point for whether a trendremains intact. (Source: eSignal, www.esignal.com)
simple number series, now called the Fibonacci series. Fibonacci numbers, andmore significantly the ratio of those numbers to each other, can be found in numerous examples throughout nature and cycles (for instance, the structure of pinecones, nautilus shells, sunflower bursts, sprouts along a plant stalk, and even thereproduction of rabbits).The series, beginning with 0 and 1, simply adds one number in the series to theprevious number. Ratios of the numbers to themselves approach certain Fibonacciratios, like 14.6 percent, 23.6 percent, 38.2 percent and 61.8 percent. Notice inTable 2.1 that each Fibonacci number is about .618 of the one that follows and1.618 (the so-called golden ratio of mathematics) of the preceding number.Many believe that markets are simply a reflection of human nature and sharetraits common in the natural environment. Indeed, certain principles of physicsand mathematics—like momentum, rate, acceleration, cycles, fractals, linear regression, and probability—seem to have application in markets.
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Becoming a Futures Trader
TABLE 2.1 Fibonacci Numbers and RatiosFibonacci Series
Fibonacci Ratios
0+1=1.5001+1=2
.333.666
1+2=3
.200.400
.6002+3=5
.125.250
.375.625
3+5=8
.154.231
.384.615
5 + 8 = 13
.143.238
.381.619
8 + 13 = 21
.147.235
.382.618
13 + 21 = 34
.145.236
.382.618
21 + 34 = 55
.146.236
.382.618
34 + 55 = 89
.146.236
.382.618
55 + 89 = 144. . . ad inﬁnitumNote: Fibonacci numbers and retracement ratios are in bold.
For the Fibonacci analyst, the numbers and ratios in the table indicate important areas on a chart, both in price and, more controversially, in time. The numberscan be used to predict retracement areas during pullbacks, as well as targets,called “extensions,” for projected price moves. They can also be used to help determine the strength of a trend. In Figure 2.19, for example, after an extendeddown move in soybean prices, the market is able to recover only about 38.2 percent of the down move when it bounces in August. A less strong downtrend mighthave allowed the market to retrace back 61.8 percent or more.Elliott Wave Elliott Wave analysis is a study in itself, but the basic premise isthat markets tend to move in a series of waves within waves—three impulsewaves in the direction of a trend separated by two corrective waves. Specific criteria define the numerical sequence of waves, with the middle impulse wave (called“Wave 3”) generally the strongest wave, as the weekly chart of Swiss franc futuresillustrates (see Figure 2.20, page 47). That’s the wave trend followers try to identifyand catch early in its development. Corrective waves can unfold in a number ofdifferent forms and are more difficult to trade.
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THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 2.19 Fibonacci retracements. In this downtrend the market recovers about 38percent, an important Fibonacci number. (Source: eSignal, www.esignal.com)
The waves essentially reflect the psychology of the marketplace as it makes itsnormal thrusts and corrections. It takes a trained eye to detect the myriad of Elliott Waves that make up a market, but advocates of this approach point out thatElliott Wave analysis, often in conjunction with Fibonacci ratios, is one of the fewmethods that attempt to predict future price and time targets rather than waitingfor price action to produce indicators that lag the market.Up to this point, you may be thinking that technical analysis focuses on chartsonly, but more accurately, it is the study of prices. Accordingly, you have availableother means of examining the market price action.
Studies and IndicatorsAnalysts have developed a number of technical indicators to give them more insight into what is happening inside a market beyond what may be obvious with theprice pattern itself. Studies and indicators involve complex computations, but, fortunately, today’s analytical trading software programs include many of these indicators. So if it seems like too much of a challenge to calculate and monitor any of
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FIGURE 2.20 Elliott Wave. Elliott Wave analysis attempts to predict future action ratherthan waiting for price action to reveal itself after the fact. Speciﬁc criteria deﬁne thenumerical sequence of waves. (Source: eSignal, www.esignal.com)
the indicators mentioned here, remember that the computer will do much of thework for you.Several other comments should be made about using indicators in general:• Many indicators are based on past price action. Although they can give you asense of what could happen, they are not always predictive because of thislag effect.• Indicators should not be used in isolation but should be used in conjunctionwith other analytical techniques to provide confirmation for trading decisions.No indicator alone is likely to provide a magic clue as to what the marketmight do.• Many indicators are based on only one thing, price. Therefore, the corollary tothe preceding item is that looking at too many indicators may not be helpful,either, as they all will generate essentially the same signal at the same time.• Indicators often require some interpretation that can only be gained with experience observing and using them.
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THE COMPLETE GUIDE TO FUTURES TRADING
• If you don’t see what you like in an indicator, it can be tempting to adjust theparameters until you get what you want. In other words, it is easy to curve-fitthe indicator to prices. Manipulating an indicator and overoptimizing may giveyou some misleading results when it comes to actual trading. The indicatorson the charts shown here use basic parameters that are intended only to showthe concepts of the indicators and not necessarily the parameters you shoulduse. You can spend considerable time researching what works best for you.Indicators can be divided into two general categories—those that identifytrends and the strength/weakness of the trend and those that spot potential market turns. This section provides an introduction to these techniques and how theycan be used. Serious traders will want to go beyond this overview to study themany books and other resources available on these subjects to discover whatmight be most useful in their own trading.Detecting the Trend A market is trending either upward, downward, or sideways. And the same market may have different trends in place on different timeframes. For example, a 60-minute chart may show sideways action, while a dailychart of the same market is trending higher. You may be able to see a trend in a series of price bars or candlesticks, but the longer-term direction may not be so clearwhen trading becomes volatile and erratic.Determining the trend is one of the most important tasks technical analystshave in deciding how to position themselves to profit from price action. Let’s consider now a technician’s first set of tools for determining the trend.Moving Averages This indicator is probably the simplest and most widely usedby traders of all sizes. All you need to do is add up the prices for a specific numberof periods and then divide the total by the number of periods to get a moving average reading that changes with each new price input. Closing prices are often used,but you can also incorporate the open, high, or low into the calculation.There are three main types of moving averages—simple moving average(SMA), weighted moving average (WMA), and exponential moving average (EMA).The last two place more emphasis on recent prices. Whichever type you use, youwind up with a single smoothed line that flows across the chart, removing much ofthe noise from the chart (see Figure 2.21).Moving averages can be used in a variety of ways:• Just look at the slope of the moving average line to determine the trend visually, and position yourself accordingly.• Note where the current price is relative to the moving average. If the price isabove the moving average, the trend is up and you should be long; if the priceis below the moving average, the trend is down and you should be short.• Use the moving average line as a point for potential support or resistance.
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• Use several moving averages together to refine your analysis. When theshorter moving average (which responds quickly) crosses above the longermoving average (which responds less quickly), the trend may be defined as up.When the shorter moving average drops below the longer average, the marketmay be in a downtrend phase (see Figure 2.22).Analysts use moving averages in a multitude of other ways, but these basicprinciples should provide you with a strong foundation on the subject. Followingis an introduction to a few other common methods for determining the trend. Thefirst is actually a fancy manipulation of moving averages.Moving Average Convergence/Divergence Better known as simply MACD,(pronounced “Mac D”), this adaptation of moving averages can also provide several signals, depending on how early you want to get in on a potential move—ortake the risk that a move will develop. MACD uses three moving averages, often
FIGURE 2.21 Simple moving average. This 10-day SMA is calculated by averaging theprevious 10 closing prices, plotting each point on the chart, and connecting the points tocreate the smoothed line. (Source: eSignal, www.esignal.com)
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THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 2.22 Moving average crossover. The 10-day SMA moves faster than the 20-daySMA. Each crossover may indicate a new direction in trend. (Source: eSignal,www.esignal.com)
exponential—two of them based on the number of price periods used and thethird an average of the difference between the two moving averages.The difference between the readings of the two moving averages is usuallyshown as a histogram, while the average of that difference is shown as a movingaverage line plotted on top of the histogram (see Figure 2.23). When the histogramis above zero, the market may be considered to be in an uptrend. Below the line, adowntrend may be at hand. You may find earlier indications of the trend by watching changes in the length of the histogram bars.An important part of the analysis involving MACD is how its movements compare with price movements. When prices make a high and then another high whileMACD makes a high and a lower high, this is divergence—the two are going in different directions. Divergence indicates underlying weakness in the market (in thecase of an uptrend) and a potential market turn, and is a technique often used withother studies as well.
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FIGURE 2.23 MACD histogram. The MACD (seen on the bottom portion of the chart) is aplot of the difference between two moving averages. Values above zero suggest an uptrendand below zero suggest a downtrend. Divergence (between market prices and theindicators) can foretell a reversal of trend. (Source: eSignal, www.esignal.com)
Directional Movement Index and ADX This indicator has three components, one for upward price movement, one for downward price movement, and athird that measures the difference in these up and down market forces to arrive atan index showing the strength of a trend. Figure 2.24 adds just this third index line,the Average Directional Index (ADX), to the bottom of Figure 2.23. ADX does notindicate the specific direction of the trend, just the strength. Note that the readingis at 30 during the downtrend at the left side of the chart and during the strongrally on the right side of the chart. As long as a trend is in place, ADX readings willget higher until reaching a point where it is difficult to sustain the angle of ascent.When a market shifts from trending to choppy, ADX readings decline. The mainuse of ADX is in reinforcing ideas about whether a trend will continue and in gauging the strength of a trend.
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THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 2.24 Directional movement indicator. The bottom of this chart shows only theAverage Directional Index (ADX) component of this directional movement indicator. ADXindicates the strength of the trend and not the speciﬁc direction. Notice also divergence inthis indicator. (Source: eSignal, www.esignal.com)
Detecting the TurnMarkets do not always spend their time trending nicely, but rather will often vacillate back and forth in choppy price action. In many cases, these fluctuations arewide enough to be quite tradable for investors who can discern where the turnswill occur.Analysts use a number of indicators to determine the support and resistance areas that define the trading range within which prices will move. Theseindicators fit into a general category known as market oscillators, which work
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best in nontrending trading range situations but can lead to many false signals ifa market moves from a trading range into an extended trending condition. Notein the chart examples that some indicators can hang in overbought or oversoldterritory for some time while a trend continues, making them less useful inthese conditions.These oscillator-type indicators typically are shown at the bottom of a pricechart and have a scale of 0 to 100. If the indicator is above a certain level near thetop of the scale, say 70 or 80, the market is considered to be overbought and duefor a turn lower; if the indicator is near the bottom of the scale, say 20 or 30, themarket is considered to be oversold and ripe for a turn higher.Stochastics As markets move up, closes tend to be near the high end of theprice range for a given period; when closes begin to slip to the lower end of theprice range for a given period, a market loses its upward momentum. Stochasticsmeasures the closing price relative to the low of the range for a selected period toindicate rising or falling momentum, providing trading signals when its lines crossinto overbought or oversold territory.To show the relationship among indicators, Figure 2.25 adds the stochastic indicator to the bottom of the previous figure. When %K (the faster, black line)crosses above %D (the slower, gray line) in the oversold area (below 20 level), it’sa signal to buy; when the crossover occurs when the lines are in the overboughtarea (above 80 level), it’s a signal to sell. However, the stochastic indicator doesnot provide specific price signals.As with the MACD indicator just described, some of the best clues from thestochastic indicator do not come from the crossovers of its two indicator lines butfrom the convergence or divergence of those lines with prices. Regardless, as anoverbought/oversold indicator, the stochastic indicator attempts to forecast turnsin market action.Relative Strength Index The Relative Strength Index (RSI) compares periods with up closes with periods that have down closes to produce an index reading reflecting the strength of price changes on a scale of 0 to 100 (see Figure 2.26,page 55). Like other indicators, the number of periods can be adjusted to get readings that are more or less sensitive. The index provides overbought and oversoldsignals, and divergence/convergence with prices again is an important part of theanalysis.%R This indicator is similar to stochastics except that, instead of comparingcloses against the lows of a range, closes are compared with the highs of therange, and the index scale is reversed so that 0 is at the top and 100 at the bottom.(%R is not illustrated within any of the figures of this chapter.)Rate of Change There are several variations, but the basic concept is to divide the current close by the close from N periods earlier to get a reading on mo-
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THE COMPLETE GUIDE TO FUTURES TRADING
FIGURE 2.25 Stochastics. The bottom of this chart shows a stochastic oscillator. Pricesabove the 80 percent area are considered to be overbought and below the 20 percent areaindicate an oversold condition. Notice again the divergence in this indicator. (Source:eSignal, www.esignal.com)
Becoming a Futures Trader
FIGURE 2.26 Relative Strength Index. Similar to the stochastic indicator, the RSIprovides overbought and oversold signals, as well as divergence with prices. (Source:eSignal, www.esignal.com)
55
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THE COMPLETE GUIDE TO FUTURES TRADING
mentum. If the current price is the same as the price 10 days ago, for example,the reading is 0. If the reading is above the 0 line and rising, prices are accelerating to the upside; if the reading is above the 0 line and declining, the market isstill advancing but running out of momentum. Similarly, readings below the 0 lineassess the momentum of a downtrend. (Momentum and other rate-of-change measures are not illustrated within any of the figures of this chapter.)Analysts look at many other technical indicators and variations of indicators;there is no one indicator that has all the answers and is right for every trader. Further, many of the indicators are redundant; they provide similar ways of evaluatingthe price action.Your task as a trader may be to find those indicators and settings that provideyou with the most comfortable method of investing in futures markets.In this chapter, you have reviewed some issues important to making a tradingdecision. In the process, you gained a basic introduction to both fundamental andtechnical analysis. This last section will step back a bit to consider how these elements fit into the big picture.
PUTTING IT ALL TOGETHERThis chapter is about developing the analytical skills to make trading decisions.But, with all of the potential ways to analyze markets, you may be a bit overwhelmed by the possibilities and might have a difficult time deciding which methods to study further and use in your trading. As we have emphasized throughoutthis chapter, the best approach is to capitalize on the skills and the interests youalready have and build your trading program around them.
Develop Your Own StyleIt’s best to approach trading methodically. Determine in advance where youwould like your trading to be in a few years. Are you in a position to quit your current job and sit in front of a screen all day? Maybe you prefer to analyze the markets at the end of each day and leave your orders working during the followingday. The first method implies a higher level of activity. The second method wouldlikely have a longer-term point of view. The point is that the objectives you set foryourself now will dictate what course of action is best to follow in developingyourself as a trader.Once you know your trading goals, establish a trading plan for getting there.Don’t try to conquer every type of analysis at once. Instead, focus on masteringone item at a time—maybe concentrating only on chart patterns such as bull andbear flags, for instance. As you become more skilled with that pattern, add othertechniques to your studies. You’ll discover over time the style of trading that is
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right for you, and your methods of trading will evolve as you develop and refineyour approach.For instance, fundamental analysts focus on specific markets and become specialists in the news and events that influence those markets. Technical analystsmix and match patterns, indicators, and time frames to create specific methodologies. In the same manner, you may find the best way to achieve your goals is to explore and combine your favorite fundamentals and technicals.So the answer to the question posed at the beginning of this chapter may represent not just a final goal. Perhaps the answer may also be found in the journeyitself—in the process of realizing that answer. Start the process now and buildyour trading program one step at a time, and you’ll be on your way to craftingyour trading methods before you even realize it.
CHAPTER 3
Trading witha Broker asa Partner
A
re you ready to jump in and start trading? Buy-and-hold, the foundation ofstock trading for generations, may not work as well in today’s marketplace.Stocks have proven to be vulnerable to tremendous price swings—both upand down. In this environment futures and options on futures can be attractive alternatives for those investors who are seeking speculative opportunities in bothbullish and bearish market scenarios as well as for those who are simply trying toprotect current exposure via a hedge.However, you still have a few decisions to make, starting with an honest assessment of your ability and confidence to trade and the amount of help you needto pursue your trading program.
WHAT A BROKER CAN OFFERDepending on your trading knowledge and experience, one of the most importantdecisions you might make is what type of brokerage relationship to have. Brokerage firms offer a variety of arrangements, from self-directed where traders makeall the decisions independently to professionally managed accounts where tradershave no involvement in the trading decision other than providing the money andselecting the money manager.Many traders prefer a broker-assisted program, which is a hybrid of selfdirected and managed accounts offering key aspects of both service levels. Brokerassisted programs can benefit a wide spectrum of traders, whether they arenovices seeking guidance at almost every level or seasoned veterans looking foran extra edge on execution or the monitoring of contingency orders. Many traders59
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simply don’t have time to watch markets carefully and want the advice and support of a professional who knows what’s happening or can serve as a crediblesounding board for trading ideas.Once you have determined that the broker-assisted route makes sense for you,your next big decision is selecting a broker who fits your needs. You might beginby identifying what you consider to be your basic needs for trading. Remember,these needs will change as your experience grows and your strategies and marketcoverage expand.Next, you need to identify which of the services that a broker-assisted program offers are relevant to your style and level of trading. Broker-assisted programs offer much more than just trade recommendations, and a careful review ofthe various services available will ensure that you are optimizing the relationship.The broker’s role can be significant or minor, depending on your input when youfirst interview a potential broker. Allowing the broker to evaluate and analyze yoursituation will require a two-way dialogue, with you providing as much backgroundinformation as possible to ensure that appropriate services are rendered.Following are some added values a broker can offer a trader. Review and consider which of these issues strike a chord with you:• Education about the industry. Especially if you are new to futures, brokerscan tell you about exchanges, products, margin requirements, and all theother details traders should know.• Education about market analysis. Brokers may be able to explain chartingtechniques or the fundamentals of a market, depending on their expertise andwhat markets they follow. You may be able to get some of this informationfrom the firm’s newsletter or online, but the broker can elaborate on important points and keep you up-to-date on the latest developments.• Education about the trading process. Buying or selling may seem simpleenough, but you may have several alternatives. A broker can explain the various orders you can use and direct you to the best order to use in different situations to accomplish what you want.• Security/comfort. You may be more at ease if a broker helps you with orderplacement procedures to make sure you get it right. The broker can adviseyou about the risks of a trade and suggest where to put stops. Getting helpwith placing orders may be reason enough to choose a broker-assistedapproach.• Trading advice and recommendations. You may not have the time or skillto spot good trading opportunities or the knowledge to best trade them. Brokers are plugged into the market day in and day out and are constantly sifting through data, determining what is relevant and what is simply noise.Armed with this information, they can offer timely, strategic advice about amarket to trade and/or a specific strategy to utilize. Equally important, brokers are available to provide feedback about existing trades, given recentmarket developments.
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Many profitable traders attribute their success to guidance they received from amentor. A broker can be an ideal mentor who can help you learn how to identify trading opportunities, accurately access risk/reward ratios, read and interpret charts, determine appropriate levels to take profits or losses, what kind of order to use, howand when to place stops, how to review your account statement, and much more.The broker’s job is ultimately to help you achieve bottom-line results along with trading independence, if that’s what you seek, and to make you a more confident trader.Like traders, brokers have different personalities, different levels of experience, and different areas of expert