FuturesTechs Blog

Market Profile (c) is a distinct way of charting and analysing price action. It has a very different feel to normal methods of charting, so be prepared to look at markets in a very different way after reading this tutorial! Hopefully you’ll see why there are so many traders who swear by it.

Let’s jump straight in and have a look at one of these creatures:

The above represents a single day’s trading in FTSE futures. It could equally be represented by 30-minute candlesticks like this:

So what’s going on here?

Each letter corresponds to a 30-minute period. “m” is 8:00-8:30, “n” is 8:30-9:00, etc. The m’s are drawn in each price interval where this contract traded during the first half hour of trading, the n’s for the second half hour, etc.

Each letter is called a Time Price Opportunity (TPO). These form the building blocks of Market Profile.

Looking at the FTSE Profile above, we can see that the letters are sat next to each other from left to right, forming a “heap” . Where the price bulges out the most tells us where the price traded in the most time intervals, giving a sense of “value” for the day.

With that said, let’s introduce some more terminology.

Initial Balance Period (IBP): this is the range of the first hour’s trading. In the FTSE, then, it is represented by the price range covered by the m’s and n’s. CQG draws a blue line to the left of the Profile to highlight this, and we’ll put it in bold below:

The IBP is often important, depending on which market you’re trading, since volatility on the open can sometimes bring about a “Comfort Zone” within which people will trade with a sense of safety for the rest of the day. Breaking out of the IBP then, is something that Profile watchers will keep an eye on.

Point of Control (POC): This is the price region with the most TPO’s, i.e. which has been traded during the most time periods. If there is a tie for which price has the most TPO’s then we choose the one closest to the middle of the day’s range.

In the above Profile, we see that 5220 and 5190 both have eight TPO’s. But 5190 is closest to the centre of the range, so it is the Point of Control.

This is a useful price because it tells us quite precisely where the market traded most frequently. Above there could be considered poor value for the day, while below there could be considered good value for the day.

This notion of “value” is expanded with the concept of the Value Area. This is the price range containing 70% of the TPO’s, split evenly around the Point of Control. (The reasoning behind this is that in the “Normal” distribution, around 70% of observations are contained within one standard deviation of the mean.)

This gives us a wider range of value for the day. This range can then be overlaid onto a candle or bar chart; we can use it to provide suggestions for support and resistance levels, or just to see how the market’s perception of value is evolving. Here’s an example:

In the above chart, we have the folowing key:

Green: High of Value Area

Blue: Point of Control

Brown: Low of Value Area

That completes our discussion of Profile construction. Now let’s consider some of the ways to intepret what’s happening (this will involve some extra terminology!)

Initiative and Responsive Price Action: we can classifying buying and selling as “Initiative” or “Responsive” depending on whether it takes place above or below the previous day’s value area.

So if the price is expanding above the previous day’s value area, then we can call that “Initiative” buying. And if those gains are being sold back down, that selling can be described as “responsive”.

Similary, selling down below the previous day’s value area is called “initiative” selling. As you might guess, gains back through those levels would be called “responsive” buying.

Much of the philosophy behind Market Profile is to do with the fact that different types of market participant move the market in different ways. On the one hand, there are “liquidity providers”, the local or proprietary traders, who profit by making small gains on lots of trades every day.  Their purpose is to facilitate the actions of the institutional traders.

The institutions are the ones who, thanks to their size, are truly capable of moving markets. In the context of  commodity futures, these would be the commercial hedgers.

For example, the below chart shows a market which was fairly stable on the first day, and then made a big shift on the second:

Without looking at the volume figures, we could surmise that much of the action in the first day took place with traders and a relatively small number of evenly matched institutions. The second day, though, took us out of that day’s range, with the gains being accepted by the market. That makes it Initiative Buying, and we can surmise that it was institutional demand which created it.

Single Print Tails: time periods with just a single TPO, mostly at the extremes of the Profile.

In the above Profile, we can see that this market had two such tails: for period “D” at 5300, and period “E” at 5440. The price moved into those regions, but the move was rejected. The move back from 5300 is probably “responsive buying”, while the move back from 5440 is probably “responsive selling”.

In the next article on this topic, we’ll categorise different types of trading day according to their Market Profile. There’s lots more to be covered here, so stay tuned!

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

WHAT DO WE THINK NOW?

At FuturesTechs we analyse 28 different markets each day and give our trading clients regular up to date analysis on the current thinking and market’s state of mind. We look at Bonds, Forex, Commodities and Equities. At the moment Stock Markets are the most interesting, providing the biggest conundrum for traders and operators.

We believe that Fundamental analysis is flawed (by not taking into account sentimenrt), and that most Economists get it wrong. A far more sensible way to look at the markets is to work out what the trend is, and stick with the trend, then do your best to spot (as early as possible!) any changes in trend.

One thing we’ve learnt over the years is that the market usually tops out when most people are getting bullish, and dashing in to get long, afraid to miss out. In other words when people are getting greedy. This could definitely be applied to Gold at present, and probably also to Equities!

The opposite situation creates bottoms and emerged in March when Equities bottomed out  -

Fear gripped the market and everyone ran for the door. We didn’t. We took a step back, and realised that many in the market had given up, that there were plenty of doomsayers talking the FTSE down to 2500. Our analysts said at the time that the market was nearing a bottom. In fact we said it on CNBC, so if you don’t believe us click below link to have a look.

There is a saying that “Harry Hindsight is the best trader in the world”, and we would suggest that if anyone says “I got long back in March” ask them to prove it!

In recent weeks we have been concerned that this up move is coming to an end, and despite the fact there is usually a “Santa Claus rally” we are still erring on the side of worrying about downside risk. We really haven’t gone very far since September, if you take a step back and look at things.

I used a Warren Buffett line last week in one of our reports and it sums up quite well everything I’ve said above.

“Be fearful when others are greedy and be greedy when others are fearful”.

He’s done quite well out of it!

We follow the trend, but are always looking out for when the market’s psychology gets to an extreme.

Feel free to ask for a Free Trial by clicking the link below. Don’t forget to click below as well to view our comment on CNBC back in March.

Trial FuturesTechs here.

Check out Clive Lambert’s March 4th CNBC appearance here.

With this article I will introduce Point and Figure charts: how to understand them, and how to recognise some simple patterns. My main source will be Jeremy du Plessis’ The Definitive Guide to Point and Figure, which you might be interested to purchase from the Global Investor Bookshop (in association with FuturesTechs).

Point and Figure is a very old method of charting price action, which originated when traders were simply recording the prices as they saw them happen: 14.50, 14.55, 14.60, 14.55, etc.

This gradually evolved to the point where traders were filling out boxes on a graph corresponding to price levels which the market had crossed, moving to the right each time that the price retraced over an old price level. Eventually, we got the modern Point and Figure chart.

Here’s the most recent NASDAQ chart:

As indicated, the X’s are drawn when the price has increased, while the O’s are drawn whenever the price has decreased.

In the example above the intervals used are just a point wide (the “box sixe”), meaning that we change from X to O (or O to X) and move to the next column whenever the price moves by just a point in the opposite direction to the previous move.

That makes this a very short-term chart, of course. With one-point reversals happening all the time, a couple of hours’ trading will quickly fill up the chart.

The two ways we can make it longer-term are:

• Increase the box size
• increase the reversal size

Increasing the box size should be obvious enough; instead of recording 1-point movements, we’ll record 10-point movements, for example. Here’s the first chart modified in this way:

These boxes stretch back a couple of weeks now, instead of a couple of hours.

Now let’s change the reversal size, the size of the reversal which needs to take place before we change between x’s and o’s and move into the next column. This is measured in terms of boxes, and is set to 3 in the below chart:

The above chart stretches back a couple of days. For a bigger picture view combining both changes, we could require 3-box reversals for 10-point boxes, i.e. requiring 30-points reversals before changing direction on the chart. The below chart represents the price action of a year:

One thing you might have noticed at this point is that we don’t really have a proper time axis. That’s true. While it’s true that time is progressing as we move from left to right on the chart, it’s not doing so on a constant basis. The chart only moves right when we get a sufficiently large change in direction (as defined by our parameters). The chart only changes when the price does. So, instead of being a traditional time vs. price chart, Point and Figure is instead an original way of drawing the price action.

We’re going to look at some patterns now, focusing on charts with 3-box reversal sizes. Any box reversal size can be used, and some care should generally be taken to choose the one that leads to the most favourable chart for the desired timeframe.

That said, we usually don’t like to use 1-box reversals. Charts look very different with 1-box reversals, being of a much shorter timeframe and with very different-looking patterns. Much of the difference is related to the fact that a 1-box reversal chart can have columns with just a single entry of , i.e. when we get two reversals in quick succession.

Check out the Difference between the CAC futures charts below. The top is a 10 x 1 (10 points, 1-box reversal) chart, while the bottom is 10 x 3.

Besides being of a much shorter timeframe in the same space, we can see that the one on the top does indeed have many columns with just a single X or O.

The advantage of sticking with reversal sizes of 2, 3 and more, is that we get to take advantage of the resulting asymmetric filter. The chart is biased to ignore movements in the opposite direction to the prevailing trend that do not satisfy the box size criterion. While a move of, say, 10 points in the prevailing trend will be charted, a move in the other direction won’t be plotted until it reached, say, 30 point.

So let’s have a look at some simple patterns.

The double-top buy is seen when the price reverses off a high, then comes back and breaks through it on the second attempt. It’s an awkward name since the Double Top bearish reversal pattern in mainstream bar/candlestick analysis, but the context is usually clear enough. Here’s an example of it in an uptrend:

Equally, the double-bottom sell occurs when we get the creation of a lower low:

These can be reversal or continuation patterns, depending on the previous trend. As continuation patterns, they tend to be a little more reliable (in accordance with the general principle that trends have a universal tendency to continue!)

In a similar vein to the above, we can have triple-top buy and triple-bottom sell signals. Indeed, we can have any number of tests before the breakout, with all manner of compound patterns.

The first of these buy signals comes after a failed attempt by the bulls to break through the previous highs (indeed, the correction causes a failed reversal triple-bottom sell signal. Our bias is to trade with the prevailing trend, so hopefully we would not have seized on that false signal):

In our next post on this topic, I’ll cover a selection of more advanced patterns and have a look at the price targets we can derive from them.

For now, this has been an introduction to Point and Figure charting. If you have any questions or comments, please don’t hesitate to get in touch. To subscribe to our daily technical analysis of the futures and FX markets, please sign up for a free trial.

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

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)