years has been consistent with the overall results. The Profit factor,Avg trade (win and loss) and Max intraday drawdown are all excellent.Appendix D: Continuous
Futures Contracts*ae ere
With a clean database of “raw” commodity data, there arenumerous types of contracts that can be gleaned from the rawdata, such as: Nearest Contracts, Next Contracts, GannContracts, and Continuous Contracts. Following, are ideas forconstructing these futures contracts derivatives. The symbolsused are for illustration purposes only. These continuous con-tracts can be created through the Dial Data Service (56 PineStreet, New York, NY 10005, [212] 422-1600.)
*This appendix was prepared by Greg Morris.
505506 Appendix D
 
NEAREST CONTRACT
A nearest contract is primarily used by traders who just want alarge file of continuous data made up of actual trading prices.They are content with the data going to expiration and thenrolling over automatically.
It is quite probable that no one trades the nearest contractwithin 15 to 30 days of expiration. This is because the liquiditydries up very fast in the latter days of a contract. The number ofdays before expiration that an individual rolls over to the nextcontract is a function of the commodity that is being traded (thenumber of months till the next contract), and the individual’strading style. It is quite conceivable that the same individual willrollover at different times for different commodities.
When to rollover to the next contract will more than like-ly be based upon the current contract’s volume. When it begins toerode, that is the time to roll forward.
Therefore, one should have available a choice as to when torollover his Nearest Contract. Remember, Nearest Contracts aremade up of actual data. Here are some examples: PortfolioManager A is content to rollover at expiration; so all he wants isthe “standard” Nearest Contract with symbol TRNEOO (TreasuryBonds). Manager A is probably managing money and needs equi-ty calculations which he can derive from the data. Trader B feelsthat trading in the month of expiration is not liquid enough forhim; so he wants his Nearest Contract to roll over 15 days prior toexpiration—the symbol could be TRNE15. Analyst C would like toevaluate different roll-over dates, so he might like to downloadmultiple Nearest Contracts, such as: TRNEOO, TRNEOS, TRNE12,and TRNEZ21 (which roll-over 5, 12, and 21 days before expiration).
Keep in mind that all of these contracts are NearestContracts and contain actual contract data. The only difference iswhich actual contract the data comes from.
NEXT CONTRACT
A Next Contract is a unique offspring of the Nearest Contract. Itis exactly the same as the Nearest Contract except that it is alwaysContinuous Futures Contracts 507
the contract that follows the Nearest Contract. In other words, ifthe Nearest Contract is using December data for T-Bonds (TR),then the Next Contract is using data from the March T-Bond con-tract. When the December contract expires, the Nearest rolls tothe March and the Next rolls to the June contract. This is definedas the Next-l contract.
From this concept, another Next Contract is available,called a Next-2. Here, the data is always coming from the contractthat is two contracts away from the Nearest Contract. Keepingwith the above example, if the Nearest is using data from theDecember contract, the Next-2 Contract is using data from theJune contract. When the December contract expires, the Nearestbegins to use data from the March contract and the Next-2Contract uses data from the September contract and so on.
Ticker symbols for the Next contracts are: TRNXT1 andTRNXT2. Of course, the actual futures ticker will be used insteadof the TR used in this example.
GANN CONTRACT
Gann Contracts refer to the use of a specific contract month androlling over only to the same contract in the next year. For exam-ple, July Wheat would be used until the July contract expires,then the Gann Contract would start using data from the JulyWheat contract of the next year.
Examples of ticker symbols for Gann Contracts are:WO7GN, GCO4GN, JY12GN, etc. (representing July Wheat, Aprilgold, December Japanese yen).
CONTINUOUS CONTRACTS
Continuous Contracts were developed to help analysts overcomethe problem of liquidity dry up and premium (or discount) gapsin futures data. This becomes a problem whenever an analyst istesting a trading model or system over many years of data. Itallows for a continuous stream of data with compensation beingmade for rollover jumps in price trends.508 Appendix D
 
CONSTANT FORWARDCONTINUOUS CONTRACTS
A Constant Forward Continuous Contract looks a constant lengthof time into the future. It uses more than one contract to do this.A common method is to use the nearest two contracts and do alinear extrapolation of the data. (See Figure D.1.)
 
12 weeks
 
 
 
 
 
Figure D.1 A visual representation of a continuous contract.
One possibility is to give the futures trader (as with theNearest Contracts) the ability to construct his own ConstantForward Continuous Contract. Three things are needed to do this:The commodity symbol, the number of contracts he wants usedin the calculation, and the number of weeks into the futures hewants to look. For instance, if he wanted T-Bonds, using 3 of theContinuous Futures Contracts 509
nearest contracts, and looking 14 weeks into the future, the sym-bol could be: TRCF314. TR is the symbol, CF is for Continuous(Forward Looking), 3 is the number of contracts used, and 14 isthe number of weeks the price is projected.
The mechanics of this are fairly simple. First, a fixed rolloverdate would need to be set for each commodity. A good one to startwith could be 10 days prior to expiration. What is important is thatthere is a rollover sometime prior to actual expiration. Second, thenumber of contracts used will never be less than 2 and probablynever greater than 4. The number of weeks used should probablyalways be greater that 3 and could go up to 40 in some cases.
Example: This is the method used by Commodity Systems,Inc. (See Perpetual Contract in Chapter 8.)
T-Bonds will be used again, because they have a uniformexpiration cycle of every 3 months. Let’s say a trader wants aContinuous Contract of T-Bonds using the 2 nearest months andlooking 12 weeks into the future (symbol = TRCF212). Today’sdate is December 1. A graphical portrayal makes this easier tounderstand (see Figure D.1). The vertical axis is price and the hor-izontal axis is time. Today’s date is marked on the horizontal axisand the expiration dates of the two nearest contracts (Decemberand March), are also marked. He wants to look 12 weeks into thefuture so a mark is made 12 weeks from today which is aboutFebruary 25. The close price of the December contract was 88.25and the close of the March contract was 87.75 These points arethen put above their expiration dates at the corresponding prices.Then a linear extrapolation is made by merely drawing a linebetween the two points. The slope of this line will vary up anddown depending upon the outlook for long term interest rates (inthis T-Bond example). In this particular example the outlook is forhigher rates because the March futures price is lower than theDecember price.
To find the value of the TRCF212 close price for today, findthe point on the horizontal axis that is 12 weeks from today (Feb25th) and go up to the line drawn on the chart. Then from theline go to the right and that is the price of the close for thisConstant Forward Continuous Contract (about 87.91). You can510 Appendix D
also visually see from the chart that the March contract is carry-ing more weight than the December contract because the point ofinterception is closer to March. This method can be done on theOpen, High, Low, and Close in the exact manner. Of course, acomputer does it mathematically; this is just a visual explanationof how a Perpetual Contract is constructed. 
Advance-decline line: One of the most widely used indicators
to measure the breadth of a stock market advance ordecline. Each day (or week) the number of advancingissues is compared to the number of declining issues. Ifadvances outnumber declines, the net total is added to theprevious cumulative total. If declines outnumber advances,the net difference is subtracted from the previous cumula-tive total. The advance-decline line is usually compared toa popular stock average, such as the Dow Jones IndustrialAverage. They should trend in the same direction. Whenthe advance-decline line begins to diverge from the stockaverage, an early indication is given of a possible trendreversal.
Arms index: Developed by Richard Arms, this contrary indicator
is a ratio of the average volume of declining stocks divided bythe average volume of advancing stocks. A reading below 1.0
$11S512 Glossary
indicates more volume in rising stocks. A reading above 1.0reflects more volume in declining issues. A 10 day average ofthe Arms index over 1.20 is oversold, while a 10 day averagebelow .70 is overbought.
Ascending triangle: A sideways price pattern between two con-verging trendlines, in which the lower line is rising while theupper line is flat. This is generally a bullish pattern. (SeeTriangles.)
Bar chart: On a daily bar chart, each bar represents one day’sactivity. The vertical bar is drawn from the day’s highest priceto the day’s lowest price (the range). A tic to the left of thebar marks the opening price, while a tic to the right of the barmarks the closing price. Bar charts can be constructed for anytime period, including monthly, weekly, hourly, and minuteperiods.
Bollinger bands: Developed by John Bollinger, this indicatorplots trading bands two standard deviations above and belowa 20 period moving average. Prices will often meet resistanceat the upper band and support at the lower band.
Breakaway gap: A price gap that forms on the completion of animportant price pattern. A breakaway gap usually signals thebeginning of an important price move. (See Gaps.)
Channel line: Straight lines drawn parallel to the basic trendline.In an uptrend, the channel line slants up to the right and isdrawn above rally peaks; in a downtrend, the channel line isdrawn below price troughs and slants down to the right.Prices will often meet resistance at rising channel lines andsupport at falling channel lines.
Confirmation: Having as many market factors as possible agree-ing with one another. For example, if prices and volume arerising together, volume is confirming the price action. Theopposite of confirmation is divergence.Glossary 513
Continuation patterns: Price formations that imply a pause orconsolidation in the prevailing trend. The most commontypes are triangles, flags, and pennants.
Descending triangle: A sideways price pattern between two con-verging trendlines, in which the upper line is declining whilethe lower line is flat. This is generally a bearish pattern. (SeeTriangles.)
Divergence: A situation where two indicators are not confirmingeach other. For example, in oscillator analysis, prices trendhigher while an oscillator starts to drop. Divergence usuallywarns of a trend reversal. (See Confirmation.)
Double top: This price pattern displays two prominent peaks. Thereversal is complete when the middle trough is broken. Thedouble bottom is a mirror image of the top.
Down trendline: A straight line drawn down and to the rightabove successive rally peaks. A violation of the down trend-line usually signals a reversal of the downtrend. (SeeTrendlines.)
Dow Theory: One of the oldest and most highly regarded tech-nical theories. A Dow Theory buy signal is given when theDow Industrial and Dow Transportation Averages close abovea prior rally peak. A sell signal is given when both averagesclose below a prior reaction low.
Elliott wave analysis: An approach to market analysis that is basedon repetitive wave patterns and the Fibonacci numbersequence. An ideal Elliott wave pattern shows a five waveadvance followed by a 3-wave decline. (See Fibonacci numbers).
Envelopes: Lines placed at fixed percentages above and below amoving average line. Envelopes help determine when a mar-ket has traveled too far from its moving average and isoverextended.514 Glossary
Exhaustion gap: A price gap that occurs at the end of an impor-tant trend, and signals that the trend is ending. (See Gaps.)
Exponential smoothing: A moving average that uses all datapoints, but gives greater weight to more recent price data.(See Moving average.)
Fibonacci numbers: The Fibonacci number sequence (1, 2, 3, 5,8, 13, 21, 34, 55, 89, 144...) is constructed by adding the firsttwo numbers to arrive at the third. The ratio of any numberto the next larger number is 62 percent, which is a popularFibonacci retracement number. The inverse of 62 percent,which is 38 percent, is also used as a Fibonacci retracementnumber. The ratio of any number to the next smaller num-ber is 1.62 percent, which is used to arrive at Fibonacci pricetargets. (See Elliott wave analysis).
Flag: A continuation price pattern, generally lasting less thanthree weeks, which resembles a parallelogram that slopesagainst the prevailing trend. The flag represents a minorpause in a dynamic price trend. (See Pennant.)
Fundamental analysis: The opposite of technical analysis.Fundamental analysis relies on economic supply anddemand information, as opposed to market activity.
Gaps: Gaps are spaces left on the bar chart where no trading hastaken place. An up gap is formed when the lowest price on atrading day is higher than the highest high of the previousday. A down gap is formed when the highest price on a dayis lower than the lowest price of the prior day. An up gap isusually a sign of market strength, while a down gap is a signof market weakness. Three types of gaps are breakaway, run-away (also called measuring), and exhaustion gaps.
Head and shoulders: The best known of the reversal patterns. Ata market top, three prominent peaks are formed with themiddle peak (or head) slightly higher than the two otherGlossary 515
 
peaks (shoulders). When the trendline (neckline) connectingthe two intervening troughs is broken, the pattern is com-plete. A bottom pattern is a mirror image of a top and iscalled an inverse head and shoulders.
Intermarket analysis: An additional aspect of market analysisthat takes into consideration the price action of related mar-ket sectors. The four sectors are currencies, commodities,bonds, and stocks. International markets are also included.This approach is based on the premise that all markets areinterrelated and impact on one another.
Island reversal: A combination of an exhaustion gap in onedirection and a breakaway gap in the other direction withina few days. Toward the end of an uptrend, for example, pricesgap upward and then downward within a few days. Theresult is usually two or three trading days standing alonewith gaps on either side. The island reversal usually signals atrend reversal. (See Gaps.)
Key reversal day: In an uptrend, this one day pattern occurswhen prices open in new highs, and then close below theprevious day’s closing price. In a downtrend, prices openlower and then close higher. The wider the price range onthe key reversal day and the heavier the volume, thegreater the odds that a reversal is taking place. (See WeeklyReversal.)
Line charts: Price charts that connect the closing prices of a givenmarket over a span of time. The result is a curving line on thechart. This type of chart is most useful with overlay or com-parison charts that are commonly employed in intermarketanalysis. It is also used for visual trend analysis of open endmutual funds.
MACD: Developed by Gerald Appel, the moving average conver-gence divergence system shows two lines. The first (MACD)line is the difference between two exponential moving aver-516 Glossary
ages (usually 12 and 26 periods) of closing prices. The second(signal) line is usually a 9 period EMA of the first (MACD)line. Signals are given when the two lines cross.
MACD histogram: A variation of the MACD system that plots thedifference between the signal and MACD lines. Changes inthe spread between the two lines can be spotted faster, lead-ing to earlier trading signals.
McClellan oscillator: Developed by Sherman McClellan, thisoscillator is the difference between the 19 day (10% trend)and the 39 day (5% trend) exponentially smoothed averagesof the daily net advance decline figures. Crossings above thezero line are positive and below zero are negative. Readingsabove +100 are overbought while readings below -100 areoversold.
McClellan summation index: A cumulative sum of all dailyMcClellan oscillator readings that provides longer rangeanalysis of market breadth. Used in the same way as anadvance-decline line.
Momentum: A technique used to construct an overbought-over-sold oscillator. Momentum measures price differences over aselected span of time. To construct a 10 day momentum line,the closing price 10 days earlier is subtracted from the latestprice. The resulting positive or negative value is plottedabove or below a zero line. (See Oscillators.)
Moving average: A trend following indicator that works best ina trending environment. Moving averages smooth out priceaction but operate with a time lag. A simple 10 day movingaverage Of a stock, for example, adds up the last 10 days’closing prices and divides the total by 10. That procedure isrepeated each day. Any number of moving averages can beemployed, with different time spans, to generate buy andsell signals. When only one average is employed, a buy sig-nal is given when the price closes above the average. WhenGlossary 517
 
two averages are employed, a buy signal is given when theshorter average crosses above the longer average. There arethree types: simple, weighted, and exponentially smoothedaverages.
On balance volume: Developed by Joseph Granville, OBV is arunning cumulative total of upside and downside volume.Volume is added on up days and subtracted on down days.The OBV line is plotted with the price line to see if the twolines are confirming each other. (See Volume.)
Open interest: The number of options or futures contracts thatare still unliquidated at the end of a trading day. A rise or fallin open interest shows that money is flowing into or out ofa futures contract or option, respectively. In futures markets,rising open interest is considered good for the current trend.Open interest also measures liquidity.
Oscillators: Indicators that determine when a market is in anoverbought or oversold condition. When the oscillatorreaches an upper extreme, the market is overbought. Whenthe oscillator line reaches a lower extreme, the market isoversold. (See Momentum, Rate of change, Relative strengthindex, and Stochastics.)
Overbought: A term usually used in reference to an oscillator.When an oscillator reaches an upper extreme, it is believedthat a market has risen too far and is vulnerable to a selloff.
Oversold: A term usually used in reference to an oscillator. Whenan oscillator reaches a lower extreme, it is believed that amarket has dropped too far and is due for a bounce.
Pennant: This continuation price pattern is similar to the flag,except that it is more horizontal and resembles a small sym-metrical triangle. Like the flag, the pennant usually lastsfrom one to three weeks and is typically followed by aresumption of the prior trend.518 Glossary
 
Percent investment advisors bullish: This measure of stock mar-ket bullish sentiment is published weekly by Investor'sIntelligence of New Rochelle, New York. When only 35% ofprofessionals are bullish, the market is considered oversold. Areading of 55% is considered to be overbought.
Price patterns: Patterns that appear on price charts and that havepredictive value. Patterns are divided into reversal and con-tinuation patterns.
Rate of change: A technique used to construct an overbought-oversold oscillator. Rate of change employs a price ratio overa selected span of time. To construct a 10 day rate of changeoscillator, the last closing price is divided by the closing price10 days earlier. The resulting value is plotted above or belowa value of 100.
Ratio analysis: The use of a ratio to compare the relative strengthbetween two entities. An individual stock or industry groupdivided by the S&P 500 index can determine whether thatstock or industry group is outperforming or underperformingthe stock market as a whole. Ratio analysis can be used tocompare any two entities. A rising ratio indicates that thenumerator in the ratio is outperforming the denominator.Trend analysis can be applied to the ratio line itself to deter-mine important turning points.
Relative strength index (RSI): A popular oscillator developed byWelles Wilder, Jr. and described in his self published 1978book, New Concepts in Technical Trading Systems. RSI is plottedon a vertical scale from 0 to 100. Values above 70 are consid-ered to be overbought and values below 30, oversold. Whenprices are over 70 or below 30 and diverge from price action,a warning is given of a possible trend reversal. RSI usuallyemploys 9 or 14 time periods.
Resistance: The opposite of support. Resistance is marked by aprevious price peak and provides enough of a barrier abovethe market to halt a price advance. (See Support.)Glossary 519
Retracements: Prices normally retrace the prior trend by a per-centage amount before resuming the original trend. The bestknown example is the 50% retracement. Minimum and max-imum retracements are normally one third and two thirds,respectively. Elliott wave analysis uses Fibonacci retrace-ments of 38% and 62%.
Reversal patterns: Price patterns on a price chart that usuallyindicate that a trend reversal is taking place. The best knownof the reversal patterns are the head and shoulders and dou-ble and triple tops and bottoms.
Runaway gap: A price gap that usually occurs around the mid-point of an important market trend. For that reason, it is alsocalled a measuring gap. (See Gaps.)
Sentiment indicators: Psychological indicators that attempt tomeasure the degree of bullishness or bearishness in a market.These are contrary indicators and are used in much the samefashion as overbought or oversold oscillators. Their greatestvalue is when they reach upper or lower extremes.
Simple average: A moving average that gives equal weight toeach day’s price data. (See Exponential smoothing andWeighted average.)
Stochastics: An overbought-oversold oscillator popularized byGeorge Lane. A time period of 14 is usually employed in itsconstruction. Stochastics uses two lines—%K and its 3 periodmoving average, %D. These two lines fluctuate in a verticalrange between O and 100. Readings above 80 are overbought,while readings below 20 are oversold. When the faster %Kline crosses above the slower %D line and the lines are below20, a buy signal is given. When the %K crosses below the %Dline and the lines are over 80, a sell signal is given.
Support: A price, or price zone, beneath the current market price,where buying power is sufficient to halt a price decline. Aprevious reaction low usually forms a support level.520 Glossary
Symmetrical triangle: A sideways price pattern between two con-verging trendlines in which the upper trendline is decliningand lower trendline is rising. This pattern represents an evenbalance between buyers and sellers, although the prior trendis usually resumed. The breakout through either trendlinesignals the direction of the price trend. (See Ascending andDescending triangles.)
Technical analysis: The study of market action, usually withprice charts, which includes volume and open interest pat-terns. Also called chart analysis, market analysis and, morerecently, visual analysis.
Trend: Refers to the direction of prices. Rising peaks and troughsconstitute an uptrend; falling peaks and troughs constitute adowntrend. A trading range is characterized by horizontalpeaks and troughs. Trends are generally classified into major(longer than a year), intermediate (one to six months), orminor (less than a month).
Trendlines: Straight lines drawn on a chart below reaction lows inan uptrend, or above rally peaks in a downtrend, that deter-mine the steepness of the current trend. The breaking of atrendline usually signals a trend reversal.
Triangles: Sideways price patterns in which prices fluctuate with-in converging trendlines. The three types of triangles are thesymmetrical, the ascending, and the descending.
Triple top: A price pattern with three prominent peaks, similar tothe head and shoulders top, except that all three peaks occurat about the same level. The triple bottom is a mirror imageof the top.
Up trendline: A straight line drawn upward and to the rightbelow reaction lows. The longer the up trendline has been ineffect and the more times it has been tested, the more signif-Glossary 521
icant it becomes. Violation of the trendline usually signalsthat the uptrend may be changing direction. (See Downtrendline.)
Visual analysis: A form of analysis that utilizes charts and marketindicators to determine market direction.
Volume: The level of trading activity in a stock, option, orfutures contract. Expanding volume in the direction of thecurrent price trend confirms the price trend. (See On-balancevolume.)
Weekly reversal: An upside weekly reversal is present when pricesopen lower on Monday and then on Friday close above theprevious week’s close. A downside weekly reversal opens theweek higher but closes down by Friday. (See Key reversal day.)
Weighted average: A moving average that uses a selected timespan, but gives greater weight to more recent price data. (SeeMoving average.)Bibliograph
   
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