2 = 70.82829.12 ÷ 12 = 69.09
Year
Price
Index
12345678
22.66 ÷ 22.66 × 100 =25.39 ÷ 22.66 × 100 =25.86 ÷ 22.66 × 100 =25.58 ÷ 22.66 × 100 =27.13 ÷ 22.66 × 100 =29.95 ÷ 22.66 × 100 =29.64 ÷ 22.66 × 100 =32.35 ÷ 22.66 × 100 =
100.0112.0114.1112.8119.7132.1130.8142.7
This would give us a rough but handy single number to indicate these relative price changes.Indexes are particularly useful in analyzing seasonal patterns. In grain prices,for example, seasonal indexes can aid in estimating the profitability of storing acrop versus selling it immediately.
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Seasonal indexes also can be used to estimate specific price levels duringthe year but only when reliable annual price forecasts are available. For example,if the average price of fed steers at Omaha for a particular year is reliably estimated to be $50 per hundredweight and the seasonal price index for June is 97.80,the estimated June price would be $50 × .9780, or $48.90 per hundredweight.Through additional simple statistical techniques, you could also estimate the probability of achieving the price.The main point of all this is simply that indexes properly constructed and usedcan be very powerful projection tools.
CorrelationEarlier we said that an analyst must fit together supply and demand to determinehow they relate to market prices. Correlation analysis is often used to identifythese important factors for inclusion in a supply and demand model.Correlation is nothing more than a measure of the degree of association (notnecessarily cause and effect) between two or more factors. Most fathers, for example, would find a high correlation between a teenage son’s request to use the carand Saturday nights.Correlation may be determined and expressed either mathematically or graphically. Correlation studies are classified as “simple,” meaning the study of relationships between only two factors, and “multiple,” the study of the relationshipof one factor to a group of other factors. We’ll deal here only with “simple” correlation as shown on a graph.Suppose we want to measure the relationship between the price of lumber andthe number of housing starts in the U.S., assuming the preceding data.The first step is to put the data on a “scatter” diagram, as shown in Figure10.4. The vertical scale represents lumber prices and the horizontal scale representshousing starts. Dots are inserted in the diagram representing price and housing startsfor each month. That is, the dot for any one month is opposite the point on the horizontal scale corresponding to the houses started and opposite the lumber price onthe vertical scale. After all the data have been plotted, a line is drawn through thefield of dots representing the average relationship between the two factors.If the level of lumber prices depended only on the number of housing starts,all of the dots would be on the line, and you would have a very powerful forecasting tool. If you know the number of housing starts, you would then be able todetermine fairly accurately the level of lumber prices. But many other factors affectthe price, which is why the dots are “scattered” around the line. Therefore, you haveto look at other factors, such as other uses for lumber, to help improve your priceforecasting accuracy. The closer the dots are to the line, the stronger the relationship between the two factors and the more reliable the forecasts on the graph.
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Figure 10.4 Scatter Diagram of Correlation
Average MonthlyPrice/1,000 Bd. Ft.2 × 4sJanuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember
$ 8295989796109118119119106108110
U.S. HousingStarts (thousands)1,8101,7941,9381,9512,0462,0082,0912,2192,0292,0382,2282,433
If the relationship is positive, the line will run upward to the right and the twovariables tend to increase together. If it is negative, the line will run downward tothe right and the two variables tend to move in opposite directions.
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This is a good technique to use at the beginning of analysis, because it suggests which relationships and variables are worth exploring in depth and which onesare really mirror images of each other.
ANALYZING THE DATAOne last work of warning. Don’t confuse fundamental analysis with statisticalanalysis. And don’t use one without the other. The mechanics of statistical analysis alone would be quite insufficient for effective price analysis. In fact, many successful commodity traders do not use formal statistical techniques. Qualitative ordeductive reasoning plays an important role in price analysis, because many relationships or causes and effects cannot be statistically measured. Fundamentals areessential in filling the gaps. Using both, you won’t fall into the common trap of arriving at erroneous conclusions drawn from purely statistical manipulations.
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Technical Analysis
Technical analysts approach commodity price analysis in much the same manneras cryptographers attempting to decipher a code. They have no less expectationthat “written” in those squiggly lines is a message containing the ultimate secretto forecasting commodity prices, if only the code could be broken.Their reasoning? That even if you knew where to find all the fundamentalinformation about the supply and production of a commodity . . . even if you hadthe time to add it all up and also allow for such fleeting factors as weather, strikes,and crop disease . . . you still wouldn’t have the clue to market response. Becauseit is not these things that affect futures prices, but how traders react to them thatdetermines price movement. And, according to the theory of technical analysis, theonly place where all the factual supply and demand data plus the mass moods,hopes, fears, estimates, and “guesstimates” of everyone in the market are crystalized is in a commodity’s price, volume, and open interest.Technical analysts thus believe that by studying how prices have acted, youcan obtain more insight about prospective futures price movements than you canby studying why prices have acted a certain way. They believe one can learn moreby studying the price movements than by studying the factors that affect prices.105Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
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There are two basic types of price charts used in technical analysis: bar chartsand point-and-figure charts. (Candlestick charts used in Japan are a third popularchoice.) Both kinds of charts are easily constructed. All you need are the priceinformation, some graph paper and a pencil, or a computer and some software.If you don’t want to be bothered or don’t have the time to build and maintain your own charts, there are numerous chart services available that provideready-made charts for a fee. Some of these provide only one type of chart, whileothers such as Commodity Price Charts, provide a combination of all types ofcharts and also offer interpretation of the data. Ask your broker or check Futuresmagazine’s annual reference guide.The first step in constructing any chart is to decide on the frequency of theprices to be plotted—that is, hourly, daily, weekly, or monthly. Normally, if you areinterested in short-term trading you would keep your charts on an hourly and dailybasis. If you’re interested in intermediate or longer-term analysis, weekly pricecharts may be more suited to your purpose.This chapter will help you understand the basics of chart building and pattern identification and interpretation. Knowing how the charts are built can be veryhelpful in interpreting them. Knowledge of construction reveals the flaws andhelps avoid misinterpretations. The last section of this chapter covers chart services and software vendors who supply ready-made charts or allow you to use yourhome computer to build your own systems.
THE BAR CHARTIf you’ve ever seen a commodity price chart, chances are it was a bar chart. Theyare by far the most popular, because they’re easier to keep than point-and-figurecharts and because all the information needed to update them can be found in mostlocal newspapers.Figure 11.1 is a typical bar chart. The numbers running up the right side ofthe chart are the prices in cents per pound. Similar charts for other commoditieswould use price scales in keeping with those commodities. For example, a wheatchart would show prices in cents per bushel with minimum variations of 1/4-centper bushel, a hog chart in cents per pound with minimum variations of 1/40 of acent (or 21⁄2 “points”) per pound.Across the bottom of the chart is a daily calendar with the weekends left out.That is, each square contains only the five weekly trading days. This prevents a twoday “gap” in the chart between each two sets of weekly data, making the charteasier to read.At the end of each trading day, a vertical line is drawn on the chart directlyabove that date on the calendar. The top of this line marks the point of the day’shighest price.106
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Figure 11.1 Chicago December Wheat
The bottom of the line marks the lowest price at which that commodity traded that day. The closing price is shown by a short horizontal “tick” extending tothe right.
THE POINT-AND-FIGURE CHART“All well and good,” say the point-and-figure chartists, “but look at what you’vemissed. That one little line stands for thousands of trades and price fluctuations.It doesn’t tell you nearly enough.”And they have a case. In a sense, a point-and-figure chart is to a bar chart whata moving picture is to a still photograph. Depending on the scale to which it isbuilt, a point-and-figure chart can show you every single price fluctuation in acommodity throughout the entire trading period.As with bar charts, the vertical axis of the point-and-figure chart shows prices(see Figure 11.2). This time, however, the spaces—not the lines—represent theprices. The reason for this is that prices are marked on the chart by filling in theboxes with an “X” or an “O.” Because point-and-figure charts display price changeswithout regard to time, the bottom scale has no calendar.107
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Figure 11.2 Point and Figure Chart
Entries are made on a point-and-figure chart whenever a predetermined pricechange occurs. The best way to understand this is with an example, so let’s builda point-and-figure chart for December New York silver.The minimum price fluctuation for silver is 1/10 of a cent per ounce, or 10points, so we’ll mark off the point scale in 10 point increments. To record everyone of the 10 point jiggles in silver prices, however, would make our chart extremely sensitive . . . so, let’s agree not to take any action until the price moves at least20 points in the same direction.To begin charting, let’s say that right now—right at this very moment—December silver is quoted at 470.50. To show this, we’ll put an “X” in the 470.50box in the first column as our starting point. Then, after jumping around between470.60 and 470.40 for a few minutes, the price of December silver touches 470.70.This is a 20-point move, so we add another “X” to the first column at 470.70 andthen—only then—fill in the 470.60 box to show the travel of the price. If the pricecontinues up and reaches 470.90, another “X” is added at that price and at 470.80.And so forth.Now, for reversal. Even though we decided that a 20-point change in theprice of silver in one direction was worth recording, we now have to decide howfar it must go against the trend to be significant. Let’s say that it has to reverse atleast 40 points to be meaningful. In charting jargon that’s called a “four-box reversal.” This means that if December silver drops from 470.90 (our last “X”) to 470.50,we must make a new mark on the chart. We used “X” to show up-moves, so let’suse “O” for down-moves. We place an “O” opposite 470.80, 470.70, and 470.60108
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for continuity. We have to move to the next adjacent column to do this, becausethose boxes in the first column are already filled.Then, if December silver continues down to 470.30 (remember, we’re charting 20-point moves in one direction), we mark an “O” in the boxes for 470.30 and470.40. And so on.You can readily see that a point-and-figure chart this sensitive would almostrequire your presence on the trading floor or having a ticker in your office for youto keep it accurate and up to date. Of course, most people cannot be on the floorof the exchange and, besides, one does not need such a sensitive chart to tradesuccessfully. These types of charts can be made less sensitive to the little wigglesin price and more useful in identifying major turning points in price trends byadjusting the size of the price change recorded and the size of reversal neededbefore the change is recorded. Realistically, for example, a point-and-figure silverchart in recent markets probably would have boxes measured in 10 cents or perhaps even 30 cents per box, not tenths of a cent, and it might take a price changeof $.60 per ounce to mark a reversal, not .4 of a cent, as in our example.But there are some guidelines that apply to all point-and-figure charts, regardless of values assigned to boxes or reversals. For example, suppose you want to builda three-box reversal chart which notes only large significant moves and can bedeveloped from the daily high-low price data carried in your local newspaper. Thegeneral rules for developing such a chart are:A. “X”s represent price increases; “O”s represent price decreases.B. The spread (difference) between the high and the low for the day is theimportant figure to get from the newspaper.C. To start the chart, begin with a day in which the spread between the highand the low represents at least three boxes on the chart.1D. If the most recent entry is an “X” (“O”), review the daily high (low) first.If the high (low) is at least one box higher (lower) than the last entry, addthe appropriate number of “X”s (“O”s).E. If the daily high does not require drawing more “X”s, then consider thelow. If today’s low is lower than the highest “X” by three boxes or more,begin a column of “O”s beginning one box below and one box to the rightof the highest “X”.F. If the daily low does not require drawing more “O”s, then consider the high.If today’s high is higher than the lowest “O” by three boxes or more, begin1.
You will need to decide how sensitive you want the chart to be and select the size of box andnumber of boxes for reversal accordingly. The procedures for charting are the same, irrespectiveof what box you select.
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a column of “X”s beginning one box above and one box to the right of thelowest “O”.G. A simple buy signal occurs when the current column of “X”s rises one boxhigher than the top “X” in the prior column of “X”s.H. A simple sell signal occurs when the current column of “O”s falls onebox lower than the lowest “O” in the prior column of “O”s.To demonstrate this charting method, consider several actual contracts overa period of time (Figures 11.3 and 11.4). There are a number of buy and sell signals, several of them false. Can you find them?Although the point-and-figure technique can be applied in any market, amongthe most useful times to apply the method are those in which good fundamentalanalysis is difficult to accomplish and where the price moves are subject to a broadspectrum of political and economic factors, e.g., currency, Treasury bills, bonds,etc. Point-and-figure charts become especially powerful tools when combined withgood fundamental analysis.
Figure 11.3 September Eurodollars Point and Figure 10 × 3
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Figure 11.4 July Cotton Point and Figure 40 × 2
INTERPRETING BAR CHARTS—BASIC CHART PATTERNSBy recording price movements as they develop, charts provide a continuous picture of how prices are reacting to market forces. The objective of chart analysis isto discern the trend of prices, and to ascertain when that trend changes. Althoughit is not the intent here to provide a comprehensive discussion of chart formationsand their interpretation, a few of the basic formations will be reviewed in order togive you an idea of how many chart analysts think and how they interpret picturesof price moves.A bit of reflection makes it obvious that there are only three things prices cando: They can go up, they can go down, or they can stay where they are. Whicheverhappens, it is meaningful to a technical analyst.If prices are in an uptrend, it is because buyers are more aggressive than sellers at that general price level, and the market is said to be characterized by buying power. When prices trend downward, it is because sellers have the upper hand,and selling pressure predominates. When prices move in a seemingly random,111
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sideways fashion, it is construed that buying and selling pressures are about equaland the market is considered to be in a congestion area.
DEFINING A TRENDAn uptrend in the price of a commodity is characterized by a series of higher andhigher lows, i.e., attaining levels above previous highs and lows. A market is in adowntrend when the highs and lows get progressively lower, when each pricedecline reaches lower than the immediately previous low price and each increasefalls short of the previous high price.To mark an uptrend in prices, a chartist draws a straight line connecting twoor more low points in the price move. As long as prices remain above this trendline, the uptrend is considered to be intact (buying power is stronger than sellingpower) and one should be long (Figure 11.5).To identify a downtrend, a line is drawn connecting two or more high pointsin the price move, as shown in Figure 11.6. So long as prices stay below this downtrend line, the trend remains down; selling pressure is deemed to hold the day, andone should be short.
Figure 11.5 September Soybean Oil
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Figure 11.6 September Corn
The end of an uptrend is signaled when a new high “wave” fails to reach orexceed the previous high recorded in the formation of that trend. The end of adowntrend is indicated when a new low wave fails to penetrate a previous lowmark. The ending of a trend, however, does not necessarily imply the start of anew trend in the opposite direction. It could mark the beginning of a sidewaysmovement or congestion area.No market ever starts in one direction and keeps going in that direction without some backing and filling along the way. There are price swings within priceswings. There are reactions (short-term price declines) within bull markets, and rallies (short-term price rises) in bear markets. These intermediate moves do not alterthe trend of the market but merely interrupt it for a time.When a trend is broken and prices move sideways for a while, the congestionarea so formed can have an effect on price movements at a later time. A congestionarea made during an uptrend can tend to act as a “support” for prices during a laterdowntrend. A congestion area formed during a downtrend may offer “resistance”to the upward movement of prices when they turn up again. Generally speaking, a113
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support area is a price range where buying pressure increases rather abruptly, anda resistance area is one where selling pressure suddenly appears in force.
CYCLESCycles are common in agricultural markets and can be very useful trading tools forprojecting potential trend changes. Whole books have been written on this subject. Probably the best is Jake Bernstein’s The Handbook of Commodity Cycles,published by John Wiley & Sons.Figure 11.7 shows the overlay of an approximate half-month cycle with anapproximate two-month cycle on corn prices. Note how well the two cycles workedtogether in picking short-term trend tops and bottoms with longer-term trend topsand bottoms. Cycle analysis can be a powerful trading tool.
CHART FORMATIONSAs we have stated, one of the major objectives of all technical market analysis isto identify the end of an old trend or the start of a new one. A number of chart formations have come to be accepted by chartists as important indicators of trendchanges, as they have in the past marked the top of an uptrend or the bottom in adowntrend.A price “bottom” is a level where buying power begins to absorb all offerings, the demand for futures contracts begins to exceed the supply, and prices rise.Conversely, a price “top” is an area where selling pressure intensifies, buyingpower is not sufficient to absorb all offerings, and prices turn downward.Various chart formations have over time become associated with these important turning points in the market. Perhaps one of the most reliable and easily identifiable is the so-called “head-and-shoulders” formation. When you find this formation, it usually means a major market move is beginning.The head-and-shoulders top formation looks like a “W” with an extended middle leg. As shown on the accompanying chart, it begins with a sharp rally and a following sharp reaction to form the left shoulder. The head is formed by another, moreextended rally and decline. Then a third, smaller rally and decline form the rightshoulder. The formation is considered to be completed and considerably lowerprices in store when prices decline out of the right shoulder and penetrate the“neckline” (see Figure 11.8).The head-and-shoulders bottom formation is simply the inverse.Other important chart formations include the ascending triangle, the descending triangle, and “gaps.”114
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Figure 11.7 Corn Price Cycles
A descending triangle formation results when the market is unable to makeconsecutive highs at higher levels. As prices approach previous highs, increasedselling pressure appears . . . while at the same time prices encounter strong support at a particular price level each time they descend to that level. Thus, buyingpower is limiting the decline; but because offerings get progressively weaker oneach rally, each rally falls short of the one before it.Descending triangles often develop at the end of extended advances. Whenprices finally break through the bottom of the triangle, it is frequently an indication that a further decline is imminent (See Figure 11.9).115
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Figure 11.8 “Head and Shoulders” Formation
An ascending triangle is indicative of a market bottoming out, and suggestsan advance in prices. This formation results when consecutive market lows strikeprogressively higher, while highs run into repeated resistance at about the same pricelevel. Although selling pressure limits the advance at a certain price level eachtime, buying power gets stronger and stronger with each reaction . . . and eachprice dip is therefore shallower than the one before. If prices finally break out onthe upside, it is often an indication of higher prices to come (see Figure 11.10).A gap is simply a price area where no trading takes place. In an uptrend, agap occurs when the day’s lowest price is higher than the previous day’s highestprice. In a downtrend, the case is reversed.Gaps can be “read” in a variety of ways. A gap out of a top or bottom formation is sometimes called a “breakaway” gap, indicative of a surge in buying orselling power that causes price(s) to abruptly break away from the formation. Gapsformed in steep price moves are often referred to as “runaway” gaps, implyingthat prices have run off and left all opposing factors far behind. A gap at the endof a long move may be an “exhaustion” gap, the last lunge of an expiring price move(see Figure 11.11).To a beginning analyst, the subject of charts may seem almost incomprehensible, and you may wonder if the whole thing is nothing more than a figment116
Technical Analysis
Figure 11.9 Comex December Silver
of a hyperactive imagination. As a matter of fact, a good imagination is an assetin identifying price formations. The patterns are seldom as symmetrical as thosechosen for our examples, and it does take some imagination to see them. But withexperience, you will find it easier to identify not only the basic formations notedhere but also many of their variations.Of course, interpretation of chart formations is only part of the technical analyst’s job. You must use your knowledge of past price action, along with considerations of other important factors, such as trading volume and open interest, to fullyevaluate the relative strength of buying and selling pressure in the market.
TECHNICAL ANALYSIS, CHART SERVICES,AND SOFTWAREUntil a few years ago when the use of computers became widespread, technicalanalysis primarily meant hand-drawing charts of prices, and analyzing patterns117
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Figure 11.10 October Soybean Meal
and formations on those charts. In recent years, analysts with backgrounds inphysics, statistics, engineering, etc. began applying higher mathematical techniques, statistical analysis, and probability analysis to the price data. Today, a widevariety of indicators have evolved as trading tools to help traders make betterbuy/sell decisions. These tools can really only be used in conjunction with a reliable data base and a computer to analyze the data and display results. They are fartoo complex to create through hand-calculations.One’s choice of software and data is important, and there is a dizzying arrayof products from which to choose. Be wary. You can spend thousands of dollars onsystems that don’t meet your expectations or simply don’t work. While this chapter won’t review specific software packages (that is done on a regular basis byFutures magazine as well as other publications), we intend here to give only a shortchecklist of suggested criteria you should keep in mind when looking for a system.Perhaps the first thing a novice trader should consider is subscribing to a chartservice that delivers weekly a book of charts covering the major markets. They usually cost a couple of hundred dollars per year. These chart books usually contain118
Technical Analysis
Figure 11.11 July Lumber
daily price charts, weekly charts, and monthly charts, along with special charts dealing with spread relationships. Usually, they also contain a number of graphs depicting several popular technical analysis tools. During the week, the trader can updatethe price bar charts, do continual analyses of the unfolding price patterns, and makebuy/sell decisions. When the new packet arrives the next week, a new set of priceformation lines will need to be drawn and the price patterns analyzed anew. Mosttraders start this way, and a lot of seasoned and very successful traders still do theiranalyses this way.Those traders who are more experienced, have the money, are active traders,and are “computer literate” may want to buy a computer and either link it to an outside data base that is updated daily, or even go on-line. Reliable data are necessaryfor successful trading. Bonneville, Knight-Ridder, CIS, and several other services provide automatic delivery of quotes to your home computer at the end of eachday for as little as $50 a month. These data services may be delivered via satellite,FM radio channels, or sometimes even cable TV lines. This sort of service is ahuge time-saver and usually well worth it for anyone actively involved in the market. Periodically, of course, one will get some bad data transmissions, so you haveto be alert, do some editing, and clean up such dirty data points.119
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It is a good idea when purchasing software to talk to someone who is a currentuser of the system and to obtain the software on a trial basis before paying for it.Once you have reliable data, the next task is selecting trading software. Thereis lots to choose from, some of it very good, some just very expensive.➥ Good trading software should include a library of popular technical trading indicators such as moving averages, relative strength indexes, stochastics, Fibonnaci numbers, etc. See the next chapter for definitions.These technical indicators should be automatically calculated by the trading software.➥ Good software allows the user to adjust the design of the indicators in thelibrary. For example, switching from a five-day stochastic to a nine-daystochastic, or a nine-day RSI to a 14-day RSI.➥ Trading software can be purchased very inexpensively, but usually suchsoftware covers only a few trading indicators and has very limited ability for user interaction to make changes in parameters on indicators. Moreelaborate and expensive trading software will allow you to develop yourown technical indicators and to test them under a variety of scenarios andassumptions. Such software will usually run $1,000 or more and requireannual payments in addition.➥ Good trading software should allow the user to simultaneously comparetwo or more items in the data base; i.e., allow spread analyses, ratio analyses, options volatilities calculations, etc.➥ Good trading software should allow you to divide your screen into several windows in order to review several markets or indicators at the sametime.➥ Good trading software should allow you to design your own bar charts andpoint-and-figure charts.➥ Lastly, good trading software should allow you to keep track of your tradesand monitor the profit and loss in your positions by automatically updating the closing prices on those positions.It is fair to say that the personal computer has changed our lives and ourlifestyles. It also has changed the markets. Technology has made the markets moreefficient. Information of all types from all over the world gets reflected in the market price faster than ever. At the same time, a well-educated, computer literategeneration of traders has emerged and married technology with scientific (and lotsof pseudo-scientific) methods of analysis.
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Technical Analysis—The Tools and How They Work*
The last chapter covered the basic chart patterns associated with traditional technical analysis. We now turn our attention to some of the contemporary tools oftechnical analysts, namely, statistical measures of price activity that have becomepopular and within reach of virtually everybody due to the affordability of the personal computer and modern communications technology.The basic arithmetic tools covered previously are fundamental for doinggood price analysis. This chapter covers extensions or refinements of those tools.Most of these refinements involve substantial data-calculation effort and, hence,make using a computer imperative. Almost all of these refinements are designedto do one of three things:
*
For an excellent exposition on this topic, see a Futures magazine article by Jon Stein entitled,“The Trader’s Guide to Technical Indicators,” August 1990. This chapter was inspired by Jon’swork and reflects some of his thoughts.
121Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
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1. Identify and confirm trends.2. Evaluate the gathering strength or impending weakness of a trend.3. Identify potential timing and levels of turning points in trends.
MOVING AVERAGESMost moving average techniques work best in trending markets. The lagging natureof moving averages makes them useful for at least confirming a change in trend.However, they can yield as many false signals as correct signals, especially if youare using shorter-term moving averages.Some traders try to filter out the minor aberrations (false buy/sell signals) ina moving average model by establishing a moving average channel. They averageand graph the closes, the highs, and the lows. This creates a band or channel.Problems can arise when the band becomes so wide that some of the aberrationsfiltered out are actually substantial moves. At some point, “breakouts” become“turning points” within a band, and a trader who misses it not only