Technical Indicators Demystified
by Jeffrey Friedman
NOV 2006
If you are just getting started trading futures, you may be trying to figure out which of two types of analysis you should use to help you make your trading decisions: fundamental, or technical. I believe there are merits to incorporating both. Fundamental analysis examines the supply and demand factors that influence price, such as economic data, weather, or geopolitical events. Technical analysis is the study of price and price behavior using various chart techniques. Pure technicians study prior price patterns, rates of change, and volume and open interest in attempt to predict future market moves, without regard to fundamental influences.
I'm not going to focus on fundamental factors, which vary depending on which market you trade. Rather, I'll help demystify the world of technical analysis, which can be applied to virtually any market. There are literally hundreds of different patterns and indicators that traders claim to have success with, and many ways to interpret price behavior. For that reason, the study of technical analysis has been as much an art as a science. I'll introduce you to a few very basic types of price charts and technical analysis tools, and I'll help you recognize some popular basic chart patterns.
What Is Technical Analysis?
Using charts as a primary tool, commodity traders who employ technical analysis look for peaks, bottoms, trends, patterns and other factors that affect price movement, which they then use to make buy or sell decisions. Technical analysis goes back hundreds of years. Japanese rice traders used candlestick charting techniques as early as 1750, and the approach remains popular among technical analysts today.
Technical analysis includes such principles as the trending nature of prices, prices discounting all-known information, moving averages, volume mirroring changes in price, and the identification of support and resistance levels.
The price of a commodity represents a consensus between buyers and sellers of all the information about that commodity at any given point in time. It is the price at which one person agrees to buy and another agrees to sell. The price at which a trader is willing to buy or sell depends primarily on expectations.
Technical analysis reflects on historical prices in an effort to determine probable future prices. This is done by comparing current price action (i.e., current expectations) with comparable historical price action in order to predict a reasonable outcome. The technician might observe that history repeats itself in price behavior because human behavior repeats itself.
Technical analysis is a method of evaluating commodities by analyzing statistics generated by market activity, past prices, indicators and volume. Technical analysts do not attempt to measure a commodity's intrinsic value; instead they look for patterns and indicators on the charts that will determine a future performance.
Two Basic Chart Types
Bar charts are some of the most popular charts used in technical analysis. They display the open, close, daily high and daily low for a specified time period. Bar charts can be used for any time frame. The daily chart, which is the most popular time period, is often used to study price trends for the most recent six months. For longer-range trend analysis going back five or 10 years, weekly and monthly charts are more useful. Intraday charts can be used by day traders to plot prices for periods as brief as one minute.
Each time period is a vertical line, with the top of the vertical line indicating the highest price the commodity traded at during the time period, and the bottom representing the lowest price. The closing price is displayed on the right side of the bar and the opening price is shown on the left side of the bar. A single bar represents one time period of trading. See example below.
Candlestick charts, which have been around for hundreds of years, are similar to bar charts in that they also display the open, close, daily high and daily low. The primary difference is that if the closing price is above the opening price, the body is usually clear, white or green. If the closing price is below the opening price, the body is usually solid, black or red. See example below.
Technical Indicators You Can Use
A moving average is one of the easiest indicators to understand. For example, to calculate the 50-day moving average, you would add up the closing prices from the past 50 days and divide them by 50. Because prices are constantly changing, the moving average will move as well. Moving averages are most often compared or used in conjunction with other indicators such as Moving Average Convergence Divergence (MACD) or the Relative Strength Index (RSI), discussed below.
While you can choose any time period you wish, the most commonly used moving averages are of 10, 20, 40, and 50 days. Each moving average provides a different interpretation of what the commodity price will do. There is no one right time frame to use. The longer the time spans, the less sensitive the moving average will be to daily price changes. Moving averages are used to emphasize the direction of a trend and smooth out price and volume fluctuations (or "noise") that can confuse interpretation. Typically, when the price moves below its moving average it is a bad sign because the commodity is moving on a negative trend.
The Moving Average Convergence Divergence is one of the simplest and most reliable indicators available. MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics. These lagging indicators are turned into a momentum oscillator (a measure of how much prices have changed over a given time period) by subtracting the longer moving average from the shorter moving average. The resulting plot forms a line that oscillates above and below zero, without any upper or lower limits. MACD is a centered oscillator, which fluctuates above or below a center point, and the guidelines for using centered oscillators apply.
When we talk about the strength of a commodity futures contract, there are a few different interpretations, one of which is the Relative Strength Index. The RSI compares the number of days that the contract finishes up with the number of days it finishes down. This indicator is a big tool in momentum trading.
The RSI ranges from 0 to 100. A market is considered overbought around the 70 level and you should consider selling. This number is not written in stone. In a bull market, some believe 80 is a better level to indicate an overbought price, since prices often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30, price is considered oversold, and you should consider buying. Again, make the adjustment to 20 in a bear market.
The shorter the number of days used, the more volatile the RSI is and the more often it will hit extremes. A longer-term RSI is more rolling, fluctuating a lot less. Different commodities and futures contracts have varying threshold levels when it comes to the RSI. Prices in some futures contracts will go as high as 75-80 before dropping back, and others have a tough time breaking past 70. Below is an example using the moving average and RSI as a trading signal, in U.S. Dollar Index futures.
Using 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 future price movements. Support is a price level 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 is a price level 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. In the example below of the euro futures contract, you can see resistance is at 130 – 131, while support is at 127.30 – 126.20.
One of two things can happen when a futures contract price approaches a support or resistance level. It can act as a reversal point, or in other words, when the futures price drops to a support level, it will go back up. Or, support and resistance levels can reverse roles once they are penetrated. For example, when the market price falls below a support level, that former support level then becomes a resistance level when the market later trades back up to that level.
Popular Charting Patterns
Many of us believe that history repeats itself. Using successful and proven price patterns from price charts is a method technical analysts widely use. Here are just a few examples:
Head and Shoulders.
The head and shoulders is perhaps the best known and probably the most reliable of the reversal patterns. A head and shoulders top is characterized by three prominent market peaks. The middle peak or the (head) is higher than the two surrounding peaks (the shoulders). A trend line (the neck line) is drawn below the two intervening reaction lows. A close below the neck line completes the pattern and signals an important market reversal.
Double Top.
Another one of the reversal patterns, this chart formation resembles an "M" at the top in which a price rises to a peak and then declines, then rises around the former peak and again declines. A trend line (the neck line) is drawn below the two intervening reaction lows. A close below the neck line completes the pattern and signals an important market reversal. In this next chart, you can see double-tops and a head-and-shoulders neckline outlined in the natural gas futures. The tops are indicated at $15 and $15.25 mmBtu.
Double Bottom.
A double bottom occurs when a price drops to a similar price level twice within a few weeks or months producing a pattern that resembles a "W." You should buy when the price passes the highest point in the handle. In a perfect double bottom, the second decline should normally go slightly lower than the first decline to create a shakeout of jittery traders. The middle point of the "W" should not go into new high ground. This can be a very bullish indicator. This type of chart would look like an inversion of the natural gas chart above.
Triangles, Pennants and Flags.
These are called continuation patterns. Instead of warning of market reversals, continuation patterns are usually resolved in the direction of the original trend. Triangles are among the most reliable of the continuation patterns. These continuation patterns mark brief pauses, or resting periods, during market trends. An example of a bullish triangle/pennant formation in the Treasury bond futures market follows, as well as a bear flag formation.
There are entire volumes of textbooks written on technical analysis. It's one of those fields where everyone has a different theory on what works and what doesn't. I suggest you do some homework and back test your desired strategy. Back testing means looking back at several years' worth of charts to see how a particular futures contract reacts. Different markets do different things.
Jeffrey Friedman can be reached at 866-231-7811 or via email at jfriedman@lind-waldock.com if you have questions on this topic or to discuss specific trading strategies for your unique situation.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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