Futures Education

It's a Function of Trend

If you could predict the direction of prices with perfect accuracy, you would obviously have no trouble making a fortune in the futures markets. Assuming that you can't, however, an alternative would be to learn the forecasting techniques used by successful traders.
There are two primary techniques used by traders use to forecast future price trends: Fundamental Analysis and Technical Analysis. Both types of analysis are interested in establishing the direction of price movement over time or the trend. We will explore both types of analysis and explain their importance in establishing a position (long or short) in your futures trading.

Fundamental Analysis

Fundamental analysis is based on market economics, or factors that affect the supply and demand of the underlying commodity. Fundamental analysis applies to all futures markets including commodities, financials, and equities.

Supply & Demand

Most significant price move in the history of futures trading has been the result of fundamental factors. At the most basic level, the fundamental analyst tries to estimate how much of the commodity will be available and how much demand there will be for it. In other words, the fundamental analyst tries to measure supply and demand.
The basic rules for understanding supply and demand are simple. When supply, or the availability of the commodity is high, and the demand for the commodity is low, prices trend lower. When the supply is low and the demand is high, then prices will trend higher.
It is much easier to quantify supply than it is demand. Supply is a function of crop rates per acre, or amount of dirt that is processed in a mine, or the number of crates of oranges sitting in a warehouse.
We assume that demand doesn't change as quickly as supply. Assuming there are no innovations in the use of the underlying commodity, we assume that the demand curve is fairly consistent month over month, year over year. In other words the demand for orange juice won't change much between 2008 and 2009 unless there is a revolutionary innovation like a car engine that runs on orange juice.
By focusing on one side of the supply and demand equation, it is easier to understand the level or degree by which price will change. By holding demand constant you can construct a model that can reasonably forecast prices. Consider the following chart showing the current supply and demand for orange juice. By holding the demand curve constant you can see where price should go given any changes in supply.
The supply of a commodity is determined by three basic factors: current production levels, the number of imports, and any supply inventory currently available. Supply levels change based on consumption, which is the sum of domestic use and exports.
The fundamental analyst who is considering the supply side of the equation would consider all factors affecting production, imports and current inventory. For example, in the agriculture industry, plant intentions, yield per acre, probability of crop disease, price of competing commodities, distribution of government loans and grants, and the current supply on hand would all be factors to consider. These same data would also be considered for foreign growing areas to evaluate the potential U.S. imports or exports.

Government Reports

The primary source of fundamental data is the government. Days on which key reports are released can present real trading opportunities due to the resulting dramatic swings in price. If these official reports are in line with the market's expectations, the impact on market prices will be minimal. When actual figures vary from expectations, market prices can respond dramatically.
To take advantage of these opportunities, you must understand the meaning and potential impact of the report, as well as the market's prior expectations. Some brokers pride themselves on their ability to assist you in assessing this information. Some exchanges provide intraday market commentary, which usually includes information from the reports and the impact on the markets.
It's also important to keep in mind that price volatility is usually higher on release dates. Even if you don't intend to trade based on a given number, you may find the value of any open positions changing significantly on these days. Of course, this could work to your benefit or your detriment. In any event, it's important to understand the impact of the major reports and other critical events, regardless of whether or not you intend to trade on fundamental information.
Like any trading method, fundamental analysis has its limitations. Key statistics can be reported inaccurately, resulting in your subjective interpretation of the information being incorrect. New data is always filtering through the markets and creating price changes. Opportunities can come and go before you even have a chance to react. And while one piece of information may point clearly in one price direction, other factors can combine to drive prices the other way.
Although forecasting futures prices is clearly tricky business, all traders face the same set of challenges. It's probably best to concentrate at first on only one or two related futures markets. Since so many factors can influence prices, limiting your efforts in this way will make fundamental analysis a much more manageable task.

Technical Analysis

Technical analysis is another technique. There are two primary differences between using technical analysis and fundamental analysis to measure price trends. First, fundamental analysis is characterized by a great deal of subjective information, and second, it is used to forecast price movement over a longer time period. Technical analysis deals with only three pieces of information: price, volume and open interest and can be used to forecast prices over the short or long term.
Some traders use technical analysis exclusively to make trading decisions, while others use some combination of fundamental and technical analysis to determine if they want to be long or short and to time their trades.
The technical analyst works on the primary assumption that all available information is already reflected in the price. In simple terms, this means that if there is any information released to the public, traders will assimilate this new information immediately and take action to adjust their positions. They use the resulting changes in price to understand what is likely to happen in the future. To understand this principle, think of how a driver uses the reaction of other drivers to interpret what is coming up on the road. If the driver ahead of you quickly swerves, you immediately interpret this to mean that there is an obstacle coming up and you prepare to swerve yourself.
Unlike the fundamental analyst, the market technician is not concerned with understanding the underlying fundamental news surrounding why the market moved. Rather, the technical analyst, or technician, attempts to predict future price direction by looking at previous patterns of price behavior. For instance, if selling continually occurred at a certain price, the technician would conclude that price point represented "resistance" where sellers would likely emerge in the future to drive prices down. The technician would then sell at that point on the assumptions that prices would drop.
Whereas reports and opinions are tools for the fundamental analyst, the technician uses charts, tables and graphs as his tools of choice. Technicians are able to organize and analyze market data to generate an opinion on the direction of price trends. Traders use charts to identify price trends, special patterns or formations, and areas of support and resistance. Price support occurs where there is sufficient buying of the futures contract to halt a price decline. Resistance, on the other hand, refers to a ceiling where selling pressure can be expected to stop a rally. When the market trades sideways for an extended period of time, it is said to be in a consolidation phase.
Technicians have developed a well-documented study of technical analysis all of which is intended to interpret two things: which direction prices are trending and where the price trend will end (where the market will find support or resistance.)

Price Trends

Trends constitute the most basic and oft repeated pattern in technical analysis. There is little wonder why the age old adage "trade with the trend" still holds its claim on sound investment advice.
In simple terms, analyzing the trend means identifying where the price is currently heading. Futures move in cycles - over different periods of time, the commodity prices could be surging upward, plunging lower, or drifting in a sideways direction giving you the three descriptions of a trend: up, down or sideways.
The simplest, least complicated way to analyze trend is to draw a line starting at a point on the left side of the chart to a point on the right side of the chart (as shown in the chart above.) If the resulting line is angled up, prices are described as trending higher. If the resulting line is angled down, prices are described to be trending lower. If the line is neither up nor down the trend is sideways.
A second, more effective, method of drawing trendlines is to connect market lows or highs - kind of like the dot-to-dot puzzles you played when you were a kid. The markets are always fluctuating between extreme highs and extreme lows. By connecting the extreme conditions you filter out the day-to-day "noise" that distorts a trend. If the last low point is higher than the previous low point, then prices are trending higher (see chart).
If the low points are getting consecutively lower over time, the trend is down (see chart below).

Support and Resistance

Support and resistance are price levels at which movement should stop and reverse direction. Think of support and resistance as levels that act as a floor or a ceiling to the price trend. Positive price trends begin at support levels and end at resistance levels. Negative price trends begin at resistance levels and end at support levels.
Support levels are found below the current market price, where buying interest should be able to overcome selling pressure and thus keep the price from going any lower.
Resistance levels are found above the current market price, where selling pressure should be strong enough to overcome buying pressure and thus keep the price from going any higher.
One of two things can happen when a futures contract price approaches a support or resistance level, it can act as a reversal point as in the example below. The futures price drops to a support level reverses and goes back up.
Or, support and resistance levels can reverse roles once they are broken. For example, when the market price rallies up and breaks a resistance level, the former resistance level then becomes a support level when the market later trades back down to that level as in the following chart.
Technicians use two primary reference tools to help them interpret price trends and support and resistance: indicators and price patterns.

Indicators

Traders have used technical indicators since the birth of technical analysis. An indicator is a mathematical calculation that uses a commodity's price data to forecast future prices. Most indicators are used to help determine price trends or points where the trend will reverse, forming support or resistance levels. Common technical analysis indicators in the futures market include the moving average, MACD, and the RSI.

Moving Average

Simply looking for the commodity's overall direction on a chart will give you an idea of its current trend. However, it is a bit subjective and leaves plenty of room for interpretation and faulty analysis. A better, more accepted, way to determine price trend is to use a moving average.
In its simplest form, a moving average is an average of prices calculated over a given period of time. For example, a 10-day moving average takes the last 10 closing prices, adds them up, and divides by 10. On the next day, the oldest price is dropped and the newest price is added. The sum of the "new" set of data is then divided by 10 to obtain a new value. This process is repeated every time new data is introduced to the price chart. The resulting values are either higher, lower or the same as the previous values resulting in an increase, decrease or sideways trend in prices over time. See chart above.
Like the second method of using trendlines, moving averages are said to take the "noise" out of the price movement. This is due in large part to the smoothing effect of a moving average. If an upward trending market suddenly has one day of lower prices, a moving average would factor that day's price in with several other days thus lessening the impact of one trading day on the moving average.
To help identify entry and exit points, moving averages are frequently superimposed onto bar charts. When the market closes above the moving average, a buy signal may be generated. As well, a sell signal may result when the market moves below the moving average. Some traders prefer to see the moving average line actually change direction before declaring a buy or sell signal.
The sensitivity of the moving average line relates directly to the length of time chosen for the average. For instance, a 5-day moving average will be more sensitive and will potentially prompt more buy and sell signals than a 20-day moving average. If the average is too sensitive, you may find yourself jumping in and out of the market too often paying excessive transaction costs. If the moving average is not sensitive enough, you may miss opportunities by identifying buy and sell signals too late.
Moving averages are the basis of many popular trading strategies and tactics. Whether you use moving averages as the basis of your buy or sell signals or whether you simply use them to form a general bias of direction, you will find moving averages a useful companion in your trading.

MACD: Moving Average Convergence and Divergence

Building on the concept that moving averages of different durations provide different levels of sensitivity, traders began using multiple moving averages to quantify a commodity's direction and momentum. The most commonly used indicator using multiple moving averages is the MACD, which stands for Moving Average Convergence and Divergence.
The MACD is a useful indication of a commodity's momentum. Momentum is the result of a daily struggle between buyers and sellers to control a commodity's price direction. Momentum not only measures trend direction but strength as well. When buyers far "outweigh" sellers, then prices will shoot up dramatically. When buyers marginally outweigh sellers, then prices will go up, but slowly. Being able to gauge the general momentum of the market can give you a leg up on validating the likely strength or weakness behind a commodity's trend. Look at the following chart:

The MACD is constructed using two moving averages, which are technically referred to as the "fast line" and the "slow line". These moving averages (MA) can carry different time periods depending on the trader's preference; the most common periods used are 8 and 17 days, or 12 and 26 days, respectively.
Technicians compare the relative direction of both moving average lines to help determine momentum. If the "fast MA" or the moving average with the shorter period, is moving higher with the "slow MA," or the moving average with the longer period, then momentum is strong bullish. Similarly, when the fast MA and the slow MA are moving lower, the market is considered strong bearish. Both MA's heading in the same direction is considered strong momentum.
What if you observe the moving averages moving in different directions? This is your first indication that the momentum of the price trend is weak and the trend is in danger of ending.
A significant interpretation of the MACD is the point where the two moving average lines cross. The crossovers represent major shifts in the commodity's direction and trend. One of the reasons MACD is so useful is because it is relatively straightforward in its interpretation.

• When the fast line crosses above the slow line, momentum has begun to shift in a bullish direction.
• When the fast line crosses below the slow line, momentum has begun to shirt in a bearish direction.

Let's see how the MACD's movement corresponds to a commodity's price chart. Look at the following chart:

The commodity experienced a significant downturn from March through the beginning of August. At the same time, the MACD's concurrent downward trend should have been a clear indicator that selling was the order of the period, and that buying in this environment was a dangerous move. This helps careful investors avoid the common trap of thinking the commodity is a bargain just because it has dropped in price. Remember, price tends to follow its trend, so when price is in a downward trend is likely to continue in that direction - we don't know how long that trend could last.
From mid-August through late October, the commodity made a significant move to the upside. At the same time, the MACD also made a clear move from below its zero line to well above it - providing a strong validation of a trader's opinion that buying the commodity at that time was a good decision.

Stochastic

Stochastic is another technical indicator that is designed to give traders insight to the type and level of sentiment in a commodity. Momentum, as we discussed earlier, can also be equated to sentiment: as the battle between buyers and sellers rages, who is more anxious or eager to win? When buyers are more bullish (or optimistic) than sellers are bearish (or pessimistic), commodities will go up, while increasing pessimism in the face of decreasing optimism leads commodities to drop. In this context, Stochastic is designed to measure how investors in general feel about a commodity. Look at the chart below:

In similar fashion to the MACD, Stochastic uses two moving averages, defined as the "Fast Line" and the "Slow Line". Rather than using the zero line for reference, however, Stochastic uses the upper and lower bands to identify points at which a commodity's trend may be likely to reverse.
As a sentiment indicator, these extremes are referred to by investors as "overbought" or "oversold" areas. Generally speaking, when stochastic moves above the 80 line, the commodity in question is considered overbought; this simply means that buying pressure has pushed the commodity up to the point that buying demand may begin to slow. When stochastic moves below the 20 line, the commodity has dropped into oversold territory, suggesting that anybody that wants to be out of the commodity by now probably is.
Traders often also use a cross above the 20 line as a buying signal, and a cross below the 80 line as a selling signal. This often gives traders the ability to wait until the commodity has actually reversed and confirmed its new direction before taking a trade. The following chart gives us a good look at the correlation between a commodity's movement and stochastic signals.

In Example 1, the commodity has reached the top of its trend; the stochastic cross below 80 would provide a good opportunity for investors who owned the commodity at this time to take their profit before the commodity began a steeper, more dramatic drop in Example 2. Example 4 is significant not only for the fact that the commodity crossed all three of its major moving averages to begin a new trend, but also for the cross above the stochastic 20 line, providing another piece of confirmation and greater confidence in the upward trend. Example 6 isn't as dramatic, but the stochastic cross above 20 also corresponds to a good bounce off of the $26 level and a strong move to the upside.
Stochastic crosses around the 80 and 20 line, when compared against a commodity's existing trends, can give you important confirmation of a likely trend reversal. Be careful, however, to make sure that your analysis of the trend gives you the opinion the trend is about to change before checking stochastic. Also, remember that just because stochastic has dropped below 20 or risen above 80 doesn't automatically mean a reversal is imminent. Commodities can maintain upward and downward trends for extended periods of time; in such cases you will often see stochastics oscillate and hover around these lines throughout the duration of the trend. Remember to wait until you see the price of the commodity begin to move in the direction you want with confirmation from the commodity's trend and technical indicators before you try to enter a trade.
Examples 3 and 5 are significant because they don't fit into the traditional stochastic interpretation we have just discussed, but are good examples of how stochastic movement can provide information not only about new trends, but also the strength of existing trends. Notice that in both examples, stochastic never reaches either extreme, instead reversing direction in the middle of its band. In Example 3, stochastic rises to about the 50 line before reversing and moving back towards the 20 line three different times; these mid-band reversals correspond to repeated price bounces lower along the commodity's 20-day moving average, or short-term trend. Example 5 is similar but in the opposite direction: stochastic crosses below the 80 line and heads downward only to reverse and move up between the 80 and 20 line on three separate occasions. These stochastic reversals also correspond to price bounces to the high side of the commodity's upward trend. These can give good indications of opportunities to enter trades in commodities that have already developed a clear trend.

Price Patterns

Do you believe that history repeats itself? If so, you will love using price patterns to help analyze futures. In technical language, a price pattern is a unique formation created by the movement of prices over time. Price patterns are identified using lines that connect common price points (closing prices, highs, lows) over a period of time. Technicians assert that by identifying a price pattern, they are able to forecast the direction and magnitude of the next trend.

There are entire volumes of textbooks written on common price patterns found in the futures market. Here are just a few examples:

Double Top & Bottom

A double bottom occurs when a price drops to a similar price level twice within a certain time period produc ing a pattern that resembles a "W." This is a bullish pattern, and you should buy when the right leg of the "W' passes the middle of the "W" (see chart). In a perfect double bottom, the second decline should normally go slightly lower than the first decline to create a shakeout of jittery traders.
Double bottoms are similar to double tops only instead of forming a pattern that looks like a "W" it forms a pattern that looks like an "M." The double bottom formation is a bearish formation indicating a good time to initiate a short position or to get out of long positions.

Head and Shoulders Top

In this price pattern, the futures price rises to a peak and then declines, then rises above the former peak and again declines, and then rises again, but not to the height of the second peak and again declines a third time. The first and third peaks are shoulders, and the second peak forms the head. This pattern is considered a very bearish indicator.

Cup and Handle

In this pattern price forms a u-shaped cup over a period of time. As price drifts higher on the right side of the u-shaped cup it reaches a resistance level that matches the left brim of the cup. The price starts seeing some selling pressure that forms the down leg of the handle, only to reverse quickly breaking out above the brim completing the handle. This is a bullish price pattern and is used to initiate long futures positions.