FuturesTechs Blog

Let’s go back to basics: technical analysis is the study of market action, i.e. the interactions of buyers and sellers. Rather than the merits of what is being bought and sold, we analyse these interactions in search of patterns and trends that will identify profitable opportunities.

But the information available to the technical analyst does not need to consist merely of price movements; technical data is anything related to market action. The level of participation in the market, then, is also an important component of this data. We measure it by the number of stocks or futures contracts which are traded over any given period, and call it volume. The reason for the name is fairly simple: in a trading pit, it would be directly proportional to the noise!

Volume is available for nearly any market, except for Forex, whose decentralised structure makes a measurement impossible!

So what’s useful about volume?

Volume tells us where the majority of people are taking and covering their positions, so has big implications in terms of market memory.

For example, suppose that during a rally in a stock we notice that there is a price range where volume is particularly high. What does this mean? It means that there are particularly many positions originating and closing here. Going foward, then, there are lots of participants who have a “stake” in this particular price region.

If the price gets back here, people who bought in the first time might use this as an opportunity to pick up more of the stock at what they still consider to be good value. This is manifested in the price finding support here instead of falling back down.

On the other hand, what happens if sellers do come out in enough force to take us through this region? In that case, anybody who went long there is now offside and may be tempted to exit their positions. Lots of stops can get triggered, resulting in an acceleration of the decline.

So that’s the significance of volume: it tells us where most people are taking their positions. You could almost say that the market “remembers” levels in direct proportion with the level of volume seen when it trades around those levels.

Volume has long been a key component of technical analysis. One of the tenets of Dow Theory is that “Volume must confirm the trend”. High volume demonstrates mass participation in a move, and hence widespread acceptance of the new price levels. Price moves without volume were subject to suspicion, since it was possible that only a small number of rogue traders were moving the price. In that case the price  would revert back to where it came from as soon as they stopped participating.

It should be noted that sometimes, volume will be so light that the relevance of the price levels becomes negligible. This is true, for example, in the overnight session for the Agricultural commodities. Here’s a sample:

While the overnight price action will be visible to traders, some of whom may give it some small consideration, the volumes are so small that the levels can generally be ignored.

One common way in which volume is used is in the confirmation of price patterns. This is in the same spirit as Dow Theory: just as volume should confirm a trend, it should equally confirm a reversal or continuation pattern.

For example, consider the famous Head and Shoulders pattern. This begins with a series of higher highs and higher lows, a classic Dow Theory uptrend. But then we get a high below the prior high, and then a fall through the “Neckline” connecting the previous two lows.

There are definite patterns in volume which we may seek to accompany the Head and Shoulders. These may not always appear, but that’s ok: volume is only an additional piece of the jigsaw, and not the most important piece of evidence we look at when analysing the markets. Volume is always secondary to price. That said, we are encouraged when we see volume acting in a way that confirms the price action: for a Head and Shoulders pattern, that means cooling off as the market runs into resistance, and then expanding as the market decisively changes direction.

The above Head and Shoulders pattern for Silver shows volume declining on each successive peak, and then expanding as it completes the pattern with a severe breakdown.

Volume can also be incorporated into momentum indicators, usually in combination with some price information.

For example, “On Balance Volume” (OBV, see below) is a type of running sum of the volume. The trick is that we add the volume when the market has gone up, but subtract it when it goes down.

We can treat the OBV like any other indicator: adding moving averages, trendlines, etc. The trendline added to OBV above illustrated how the market was struggling.

So that’s an overview of Volume: as a core componenent of technical analysis, it confirms trends and price patterns, and can be incorporated into momentum indicators. An essential tool of the technician and trader!

Graham Neary, MSTA (graham@futurestechs.co.uk)

Below are some “general thoughts” on the FTSE that I sent out to our “Pro” client base this morning:

I was sticking with the trend until yesterday, and looking for levels like 5400 in FTSE Futures and 1127 in the S&P Futures to hold firm. Alas they didn’t.

Obama changed all that.

At the same time as being bullish at the start of this year, I have mentioned to many of you that I’m looking for a pullback some time this year that will take us back to somewhere like 4750 or even 4250.

Is this it? Let’s look at the last two sell offs; the 23^rd October – 3^rd November move, and the 23^rd-27^th November sell off. The first of these shed 317 points on the Futures, the latter 299.

So far from high to low this time we’ve lost 314 points - very similar, suggesting we could be in dip buying territory.

We won’t need to wait long to find out, and for now I would be getting defensively positioned because the risk of a swift move is with the bears. In the coming sessions we will likely either grind higher (and the bear threat alert will lessen considerably once 5341 is retaken) or we will sell off through 5245 which will make this move bigger than anything we’ve seen so far, and therefore “the real deal”…

The latest appearance by Clive on CNBC:

This is a quick summary of important candlestick patterns. It’s presumed that you know the basics of candles: if you don’t, see the article links in our Members Area.

Without further ado, let’s begin.

1. Bullish Marabuzo

Number of candles: 1.

Description: long green candle which opens near its low, and closes near its high.

Implications: BULLISH.

2. Bearish Marabuzo

Number of candles: 1.

Description: long red candle which opens near its high, and closes near its close.

Implications: BEARISH.

3. Doji

Number of candles: 1.

Description: candle which closes near where it opened.

Implications: REVERSAL.

4. Shooting Star

Number of candles: 1.

Description: candle which closes near where it opened, at the bottom of the period’s range.

Implications: BEARISH REVERSAL (in an uptrend).

5. Hammer

Number of candles: 1.

Description: candle which closes near where it opened, at the top of the period’s range.

Implications: BULLISH REVERSAL (in a downtrend).

6. Hanging Man

Number of candles: 1.

Description: candle which closes near where it opened, at the top of the period’s range.

Implications: BEARISH REVERSAL (in an uptrend) (only weak effectiveness)

7. Inverted Hammer

Number of candles: 1.

Description: candle which closes near where it opened, at the bottom of the period’s range.

Implications: BULLISH REVERSAL (in a downtrend) (only weak effectiveness)

8. Bullish Engulfing Pattern

Number of candles: 2.

Description: green candle with a lower open and a higher close than the previous candle.

Implications: BULLISH REVERSAL (in a downtrend)

9. Bearish Engulfing Pattern

Number of candles: 2.

Description: red candle with a higher open and a lower close than the previous candle.

Implications: BEARISH REVERSAL (in an uptrend)

10. Harami

Number of candles: 2.

Description: candle with a real body contained within the range of the prior real body (which must have moved in the direction of the prior trend).

Implications: REVERSAL (only weak effectiveness)

11. Dark Cloud Cover

Number of candles: 2.

Description: red candle with a higher open than the previous candle, but a close in the bottom half of that prior candle.

Implications: BEARISH REVERSAL (in an uptrend)

12. Piercing Pattern

Number of candles: 2.

Description: green candle with a lower open than the previous candle, but a close in the top half of that prior candle.

Implications: BULLISH REVERSAL (in a downtrend)

13. Morning Star

Number of candles: 3.

Description: long red candle followed by a small-bodied candle which gaps lower. The third candle closes in the top half of the first candle.

Implications: BULLISH REVERSAL (in a downtrend)

14. Evening Star

Number of candles: 3.

Description: long green candle followed by a small-bodied candle which gaps higher. The third candle closes in the bottom half of the first candle.

Implications: BEARISH REVERSAL (in a downtrend)

Graham Neary MSTA (graham@futurestechs.co.uk)

Last week’s big highlight was meant to be the US Employment Report. As it turned out all the action was before this, and the numbers were a bit of a damp squib (like the topical analogy there?).

Equity markets have caught a fresh bid, and we were early to catch this as there were several reversal patterns on major indices at the start of last week. We were bullish from Wednesday onwards, so have reaped some firm rewards on the back of that timely change of sides.

Most of our readers are short term traders so they benefit from these timely “calls”. Longer term traders and Investors may be on the sidelines waiting for an opportunity to get in, and coming out of a dip or retracement is an ideal opportunity. Often, as was the case last week, our charts can tell us nice and early if it’s likely that a pullback has come to an end.

We are now looking to see if resistance at 5300 in the FTSE Index will be seen off. If this  happens the next upside target is 5650, a failure high from last August.

Gold is on another big run at the moment and has traded up to a high of $1111 as of yesterday morning. Yesterday’s candlestick (A “Shooting Star”) gave a warning that things may be getting toppy at these levels but so far we haven’t seen any downside moves to confirm this, so we’re sticking to the idea of higher prices going forward, targeting $1192 next, then $1250.

Oil is stuck in a range for now. Brent Crude has traded between $75 and $80 for weeks now. We expect this range to get broken with a move higher, and we would then target $90 and beyond. We have been suggesting to our clients to buy the dips to $75, and whatever their timeframe this has worked out well. Longer term holders would never have been offside, whereas those who trade in and out should have been able to jump out at $78 to $80 on several occasions then buy again at £75 next time it comes off.

If you are uncertain of any of the terminology used or methodologies discussed in this report you could swot up on our website. Feel free to ask for a Free Trial by clicking here.

Yours,

The FuturesTechs Team

Every week we send out a weekly round up e-mail to our database, and we figured it would probably be useful to post it here as well, so here goes!

FuturesTechs Weekly Round up - 19th October.

Here is your latest roundup of price movements on the major asset classes in the Investment arena. As regular readers will know by now we at FuturesTechs only look at the price action to determine what trend an instrument is in, and where this suggests it can head in the future. Many technicians use Cycle analysis to make longer term calls, and this is what allowed us to make the “call” that we were near a bottom back in March for Equity markets like the FTSE and DAX. Currently our analysis suggests there is a pullback imminent, but so far each time the market has threatened this sort of move the buyers have stepped back in and bought into the dips. There was some price action towards the tail end of last week that was slightly worrying, but once again the bulls appear to have averted the threat.

The Dow may be above 10000 as we write, but it’s failing to convince and we prefer maintaining a cautious stance for now. I heard a great line on the financial news channels last week. Someone said they were “at the party, but dancing near the door”. That sums up how we feel about the present state of things.

So we’d warn against getting too complacent about this recent rise, and we’d warn against worrying that you’ve missed the boat. Generally tops are formed when people pile in thinking they’ve got to get in because they’ll miss out otherwise!! If our analysis is right there will be a pullback soon, and it could even be a deep one, and just when people think we’re heading back to those March lows is just the time you want to be buying!

Gold has been front and centre on people’s minds of late, and the amount of mainstream press it’s been getting (all bullish) worries us, as far as whether this rally can sustain itself is concerned. BUT it has held above some important technical support levels like the $1027 to $1034 region, so we are happy to stay with the trend and back it to keep heading higher for now.

Oil has been the one that has surprised us. We weren’t expecting to see $75 again in a hurry but we’re above here at present, so now there’s scope for higher prices and we’ve been forced to readjust our thinking.

The Dollar’s weakness is the other big topic that many have had on their minds of late. We are keeping a particularly close eye on Dollar/Yen, actually, and want to see a move through 91.15 to take further pressure off the dollar.

Finally just a reminder that we are exhibiting at the World Money Show this year. It takes place at the QE2 Conference Centre in London (bang opposite Big Ben) on October 30^th and 31^st. Admission is free, so register and be sure to come along and say hello. Click here to register

If you wish to benefit from our analysis on a daily basis it is just £50 a month (+VAT). You can become a member by clicking here.

Have a good week,

The FuturesTechs Team.

As part of our continued efforts to explain the major technical indicators to our clients, what follows is a simple explanation of the Stochastics momentum indicators often used in our analysis.

Originally devised by George C. Lane in the 1950s, the Stochastic oscillator is one of the easiest indicators to interpret. It tells us where the price sits in relation to its recent trading range, in a fixed 0 – 100 range and using different degrees of smoothing to provide some stability. Coming in a few different versions, their interpretation rests on the sensible assumption that price pressure is on the upper end of the range in an uptrend, and on the lower end in a downtrend.

Before we create a Stochastic oscillator, we need to decide what time parameter to use. Ten periods is our preferred choice for our daily charts, capturing the range of the previous two weeks.

The simplest one, the Fast Stochastic, has two lines: %K and %D, calculated as follows:

•    %K = [close – low (N-range)]/[high(N-range) – low(N-range)]
•    %D = SMA (%K)

So %K is the position of the most recent close in the range of the last N days; if the close was the low, we get 0, while if the close was the high, we get 100. And %D is the simple moving average of this series (we also need to choose a period for this moving average; typically, we use 3).

Fig 1. Fast Stochastics

It’s always helpful for an indicator to be bounded in a constant range, such as this is between 0 and 100. For one thing, we don’t need to worry about long-run matters like inflation: you’d get a similar pattern for an uptrend in the Dow whether you were looking at it in 1950 or 2000, without any need to rescale it. This means we can easily look for recurring patterns in a market over a period of decades.

It also means that we can easily use the indicator for intermarket analysis. Since the oscillator is bounded as it is, the patterns have the same size regardless of whether you’re watching a stock that trades for £1.00, £20.00 or £50.00, a currency pair or an interest rate future!

Getting back to the main topic, the only major problem with the Fast Stochastic is the lack of smoothing. Note how jagged the %K (blue) line is in the FTSE Index chart above. It reaches extreme readings quite frequently, jumping about and making it hard to interpret.

The solution is easy: we use the smoother red line of the Fast Stochastic as our blue %K line instead, and then average it and use the new average as our new red line! So the new red line is the average of the average of the old blue line (simple, isn’t it?!) And this is how we construct the “Slow Stochastic”.

Fast Stochastic:

• %K = position in N-range
• %D = SMA (%K)

Slow Stochastic:

• %K = %D (Fast Stochastic)
• %D = SMA (%D (Fast Stochastic))

Fig 2. Fast Stochastics vs. Slow Stochastics

We can compare the different Stochastics in the chart above. Observe that the slower red line in the Fast Stochastic is identical to the faster blue line in the Slow Stochastic.

Now we can see the advantage of the Slow Stochastics: they don’t reach the overbought/oversold levels so easily, meaning that we are whipsawed less frequently.

What are these overbought and oversold levels? Generally, we consider anything above 80 to be overbought, and anything below 20 to be oversold.

This system of lines provides a bunch of easily observed buy/sell signals. The simplest of these is simply to take a buy signal when % K crosses the slower % D line from below and a sell signal when it crosses from above. However, this generally happens much too frequently to provide useful signals.

The solution most commonly used is to wait until the slower %D line makes it into one of the extreme overbought/oversold regions, and only use crossovers which occur there. This gives us fewer false signals, with those we do get more likely to be at genuine market turning points.

Another technique, which Stochastics have in common with other indicators, is divergence: when the oscillator moves in the opposite direction to price. This is a warning sign that a trend is running out of momentum. So, for example, if we have an uptrend on the price chart with a sequence of higher highs being formed, but the Stochastics are forming a sequence of lower lows, then we can say that the uptrend is losing momentum and that we will give extra weight to any argument that a reversal is underway. The chart below illustrates one of those divergence scenarios with a resultant sell-off.

Fig 3. Divergence of Price and Slow Stochastics

As with other oscillators, the biggest danger when using it is to assume that a reversal is imminent simply because it is at an extreme measurement. This isn’t necessarily true! Price pressure will remain on the upper end of the range, and hence the Stochastic will stay at elevated levels, for as long as the market is trending.

Fig 4. Sustained “overbought” Stochastics measurement.

In the Soybeans futures market recently, for example, the Slow Stochastics remained in the overbought region from May 6th to June 11th. Why wait for a reversal through all of time, instead of just running with the trend? The Stochastic crossover signal is an excellent counter-trend signal, but that’s not much use when the market just keeps on trending.

This would have been a better market to trade with the Stochastics:

Fig 5. Ranging market with useful Stochastic signals.

We weren’t so strict as to wait for the %D (red) line to get into overbought/oversold territory before we accepted a signal, but most of them worked pretty well. The two signals in red font weren’t successful (we were mostly flat after the red buy signal, and the market rallied after the red sell signal), but six of the eight crossovers were followed by decent moves in the direction of the signal.

The lesson: always adapt your indicators to the market you’re trading, and remember that even when it appears to be working, no signal is infallible!

Graham Neary MSTA (graham@futurestechs.co.uk)

The MACD indicator is one of the most popular tools in technical analysis, and it’s another tool that we occasionally use in our reports.

Developed by Gerard Appel in the 1960s, the basic idea of MACD histogram is to follow the trend in the market under consideration, with a special hybrid of two different moving averages.

We take two exponential moving averages (typically with periods 12 and 26) and subtract the slower (26 period) from the faster (12 periods) to get the “MACD line”, given in blue in the chart below.

Observe that in this market the faster (brown) moving average is always higher than the slower (pink) moving average, so that the MACD line is always positive.

When the moving averages are closest together, MACD is at its lowest level. As the moving averages get further apart, MACD rises accordingly. And since the faster (brown, 12-day) moving average is always greater than the slower (blue, 26-day) moving average, MACD – the latter subtracted from the former - is always greater than zero.

So what’s the red line beside the MACD line? That’s the Trigger or Signal line, and is the 9-period exponential moving average of the MACD line. That makes it the average of a difference between two averages!

The red line provides us with a handy way to interpret MACD, providing easily recognised buy and sell signals. For example, a trader could take a buy signal whenever the MACD line crosses the signal line from below, or a sell signal whenever it crosses from above. This is really just a more advanced version of taking buy and sell signals whenever moving averages of different periods intersect with each other.

To help isolate the distance between MACD and the signal line, some people plot this distance as a histogram along with the line, like this:

With the histogram in place, we can spot the buy and sell signals whenever it crosses from positive to negative, or vice versa. We can also get early warnings of the signal as we watch the histogram reach highs and lows. When it reaches a high, and starts declining, we know that the sell signal is getting closer; when it forms a low, and starts rising, we know that a buy signal is imminent.

Another way to use MACD is to look for any divergence it has with the price action. This helps us to identify situations where a trend is running out steam – where the price is continuing to move in the direction of the trend, but without the conviction it had before. This principle provides us with early clues of a reversal.

Above is an example of a reversing bull market where the price reached a higher high, but the falling MACD line hinted that all was not well.

As a word of warning, here’s an example of a ranging market where the choppiness means that getting useful buy or sell signals is impossible. In this case we’ve placed the Buy and Sell signals on the days after MACD and the trigger actually intersected, to give a more realistic “worst case” scenario, where we don’t get to execute our trade until the signal is confirmed on a closing basis. As you can see, the results aren’t impressive:

As with everything else, the MACD is not a cure-all. As a trend-following indicator though, it is certainly a useful tool and helps to place any market in a bullish/bearish context, as well as providing us with interesting signals. Whether we are looking for specific crossover trade signals, or just watching how elevated or depressed the MACD line is to tell us how bullish or bearish the market is, it’s something that’s worth keeping an eye on in a wide variety of situations.

Some principles to bear in mind here and with indicators in general:

1. Parameters can be adjusted to take into account the particular market you’re trading. If the market you’re in is alternating trend too fast for the MACD to provide profitable signals, adjust the time parameters down to make it more responsive.
2. Indicators are always of secondary importance to the price action itself: that means simple support and resistance levels, trendlines, etc.
3. All technical tools can and should be used in conjunction with each other. If the MACD signal agrees with each of your other tools of analysis, then you could be onto a winner. But if MACD is telling you one thing, and a candlestick pattern is telling you another, then think twice! (this is a whole subject in itself which we’ll have a go at covering in later blogs).

Graham Neary MSTA (graham@futurestechs.co.uk)