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  • Technical analysis of futures markets

    Chapter 4 - Cotton trading - Trading in futures

     
     
    Technical analysis is the study of the market itself rather than an evaluation of the factors affecting the supply of, and demand for, a commodity. The important components of technical analysis are prices, market volume and open interest. As this technical approach only considers the market, it must take into account fluctuations that reflect traders’ actions and that are not necessarily associated with supply-and-demand cycles. The basic assumption of all technical analyses is that the market in the future can be forecast merely by analysing the past behaviour of the market (although many in the cotton trade find this hard to accept).

    Detailed technical analysis is not possible for all or even most traders. The most important elements for accurate decision-making are close contacts with the markets and with knowledgeable individuals in the trade. However, if charting specialists supply the analysis within a usable period of time, technical analysis can provide useful additional information, particularly for medium-term forecasts.

    The main tools of analysis are past price patterns that are shown in various forms of charts or graphs. The changes in the volume of open positions (i.e. the number of futures or option contracts outstanding on a given commodity) and the total volume of operations in the market are also examined. Charts often use a moving average to record and interpret price trends. In most charts, an average moves with time as the newest price information is incorporated into the average and the oldest price is discarded. For example, a simple three-day moving average of the daily closing price of a commodity changes as follows: on Wednesday, the sum of closing prices on Monday, Tuesday and Wednesday is divided by three; on Thursday, the sum of closing prices for Tuesday, Wednesday and Thursday is divided by three; and so on. Analysts can average prices over a period of hours, days, months or even years, depending on their needs.

    The value of the moving average always lags behind the current market price. When prices are rising in bull markets, the moving average will fall below the current price. However, the moving average in a bear market will be higher than the current price. When the trend in prices is reversed, the moving average and the current price cross each other.

    While advocates of charting accept that fundamental factors are the prime determinants of commodity prices, they point out that these factors cannot predict prices. They argue that the graphs incorporate all the fundamental factors that shape prices and also reflect the subjective market reaction to these factors. The alternative argument holds that although the price curve and other elements of the graph are real and objective, the interpretation is necessarily subjective. Thus the same graph can give contradictory signals to different readers.

    In reality there is likely to be substantial overlap between the fundamental approach and the charting approach. It is common for operators to determine the market trend by studying fundamental factors and to then select the right time to enter the market by referring to the charts. Similarly, chart advocates also study other factors beyond the limit of technical analysis. They may consider the number of marketing days left before a position expires, the amounts notified for delivery on the exchange, the situation of the longs, and the possibility of accepting deliveries on the exchange without adverse results.

    Many companies specialize in producing charts for various commodities and most have their own websites where charting information such as price history, volumes, open interest and technical studies can be accessed.

    Open interest and volume of operations

    The total of a clearing house’s outstanding long or short positions is called the open interest. If a broker who is long in a futures contract sells his or her position to another trader who wants to be long on futures, the open interest does not change. However, if he or she sells that position to a trader who is short and is therefore closing out his or her position, the open interest is reduced. The total size of the open interest indicates the degree of current liquidity in a given market.

    At the end of December 2006, the open interest for the Cotton No. 2 contract was 170,511 contracts (equivalent to 3.87 million tons) compared to 105,414 one year earlier. The open interest for cotton options was 213,415 contracts (equivalent to 4.84 million tons), sharply up on the year (127,789 contracts).

    Volume of operations

    The volume of operations, or turnover, is equivalent to the number of trades in all futures contracts for a particular commodity on a given day. Technical analysts regard volume and open interest as indicators of the number of people or weight of interest in the market and thus of the likelihood of a price rise. A gradual increase in volume during a price upturn could suggest that the trend will continue.

    The rise in volume could also result from an anticipation of higher prices in the future, but, in fact, it may indicate that long or short positions are leaving the market because of a fall in prices. In general, the volume of trade is a good guide to the breadth of the outside support for a price movement on the market.

    The total volume of operations on cotton in New York has been rising, from 3,156,018 futures contracts in 2004 to 3,848,990 in 2005 (+22%) and 4,490,407 in 2006 (+17%). On average, about 19,000 contracts (equivalent to 430,000 tons) were traded daily in 2006 compared to only 13,500 in 2004.

    The total volume of operations on cotton options in New York reached 1,820,259 contracts in 2006, up 6% from 2005 (1,709,345), and 1,726,982 in 2004. An average of 7,750 options contracts (equivalent to 175,000 tons) were traded daily in 2006.

    Relationship between open interest, volume and price

    The elements of charting must be interpreted together as they are meaningless on their own. When changes in open interest and volume are analysed in conjunction with the price charts, they may indicate several trends, which are described in the paragraphs that follow.

    When both volume and open interest are expanding against a background of rising prices, a bullish trend is indicated. A rise in open positions is a consequence of the ongoing entry of new long positions and new short positions into the market. However, with every subsequent upward movement in prices, the shorts that previously entered the market will incur worsening losses that will be increasingly difficult to sustain. Eventually, traders with short positions will be forced to buy, which will add more buying pressure to the market.

    A persistent rise in both volume and open interest with prices rising is a good indicator of a bull market. In this scenario more new participants are willing to enter the market on the long side, looking for higher levels. When the volume and open interest start to decline, this could be a signal of a trend reversal. As mentioned earlier, for the New York market, the commitment of traders (COT) report published by CFTC (www.cftc.gov) yields a great analysis of the open interest, not only by trader category, but also by weekly change.

    If daily volume and open interest are falling and prices are declining, a bearish trend is confirmed. When there are more sellers than buyers in the market, long positions suffer increasing losses until they are forced into a selling position. Declining volumes together with declining prices in turn mean that it will be some time before the lowest price of the bearish trend is reached.

    An explosion of volume can also signal a turning point in the market if a day’s trading at very high price levels is recorded against a very large volume and if subsequent price movements, either up or down, are accompanied by lower levels of volume. This is a good sign that a reversal is imminent. Similarly, a collapse in prices after a severe downtrend, recorded against a high volume, can signal an end to the bearish trend.

    Charting

    The two most commonly used charts in technical analysis are the bar chart, and the point and figure chart. Many technical studies can be added to these charts such as trend lines, moving averages and stochastics (probabilities).

    Bar charts use a vertical bar to record the high and low range of a price for each market day. The length of the bar indicates the range between the highest and lowest quotations. The vertical line is crossed by a small horizontal line at the closing price level. Therefore, in just one line per day it is possible to show the closing price as well as the minimum and maximum quotations registered for that day. A record is made daily, forming a pattern that may cover several weeks, months or even years.

    Some chartists insist that a new bar chart should be started as soon as a new futures position is opened. However, it is common to continue the original chart with the new position following the position that has just expired. As the new position may have discounts or premiums in relation to the old position, the chart should be clearly marked to indicate where the new position starts and where the old position ends.

    Continuous plotting
    can be done in various ways. One way is to show the first position until it expires and then to continue with the new first position. Another way is to show only one position until it expires and then to continue with the same month of the following year. The drawback of the second method is that if a position expires, for example, in December 2004, and the next position taken is December 2005, prices may have changed significantly and the chart may therefore show either a large increase or decrease.

    Trend lines on charts reveal significant trend changes but obscure subtle changes in supply and demand factors. The trend line is best suited for recording long-term changes in indices or other financial and economic data. The market registers three types of trends: a bullish trend when prices are rising; a bearish trend when prices are falling; and a steady or lateral trend when prices are neither rising nor falling. A steady trend sustained for a comparatively long period is known as a congestion area. The larger this area, the greater the possibility that the market will begin a definite trend, either bullish or bearish.

    The simplest patterns to recognize are those formed by the three types of trend lines. These are: the support line, which is drawn to connect the bottom points of a price move; the resistance line, which is drawn across the peaks of a trend; and the channel, which is the area between the support and resistance lines that contains a sustained price move.

    The point and figure chart differs from the bar chart in two important respects. First, it ignores the passage of time. Unlike a bar chart, where lines are equidistant to mark distinct time periods, each column of the point and figure chart can represent any length of time. Second, the volume of trade is unimportant as it is thought merely to reflect price action and to contain no predictive importance. The measurement of change in price direction alone determines the pattern of the chart. The assumptions underlying the point and figure chart primarily concern the price of a commodity. It is assumed that the price at any given time is the commodity’s correct valuation up to the instant the contract is closed. This price is the consensus of all buyers and sellers in the world and is the result of all the forces governing the laws of supply and demand. No other information needs to be included in this chart because the price is assumed to reflect all the essential information on the commodity.

    Daily and monthly cotton price futures charts (along with information on volume and open interest) are offered free of charge by TFC Commodity Charts at www.futures.tradingcharts.com and are easy to access. 
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