Futures Intermediate — When To Buy, When To Sell
If you consider yourself ready to start taking active positions in the futures markets, make sure you know the difference between a long position and a short position. Those that are not familiar with the financial trading environment usually assume that you can only make money when markets are rising. Real futures trading is a lot more complicated than that, and those “in the know” regularly profit when trading in asset types that have reached a climax and are ripe for failure.
When you want to bet against an asset, you will be “selling it short.” In practice, this means that you will buy rights to an asset from your broker and then “sell it back” later — preferably at a lower price. In a real world analogy, this could mean that you buy apples from the market at $2 a pound on Monday — and then sell it back to that same merchant for $1.50 a pound on Wednesday. Here, you would pocket the $0.50 differential in the transaction. In the futures markets, that small amount could easily be maximized into something much larger.
In this article, we look at scenarios where futures should choose to take a positive stance on an asset (long positions) or a negative stance (short positions).
If you are ready to take a “long position” in an asset, it means you are ready to buy it. This means you will only benefit from market activity if that asset rises in value. So the real question is this: How do we know in advance if an asset is ready to rise in value?
To answer this, we will need to know if the underlying fundamentals support decreasing supply and rising demand. Each asset market operates by its own rules in determining positive or negative momentum. For example, those trading in currency futures might wait for an important central bank decision before taking an active stance. Currency valuations are closely tied to the interest rate that is associated with that currency. So if you see that a central bank is ready to raise interest rates, it might be a good idea to go “long” on that currency. Higher interest rates create an added incentive for holding long positions in the currency, so these types of events will often lead to an increase in demand for that currency.
For those trading stocks, most of the attention is focused on corporate earnings. Each quarter, companies release their most recent earnings performance and expectations for the future. When these results come in higher than the initial analyst estimates, the environment is much better suited for new long positions. In commodities, more basic elements of supply and demand are in control. So, for example, if we were to see reduced production output from oil refiners, long positions become more appropriate. This is because the reduction in supply is likely to lead to higher prices down the road.
For short positions, many of the same elements are in place — only in reverse. For example, those looking to sell short the market in currency futures might wait for evidence of declining inflation. This would be a possible indication that the central bank in that country might be forced to cut interest rates in order to stabilize markets. Lower interest rates are almost always a negative for any currency, so it would not be surprising in that type of scenario to see a majority of futures traders to start selling that currency short.
For stock markets, changes in interest rates tend to work in the opposite direction. Higher interest rates mean that it will be more expensive for consumers to buy items on credit and this generally leads to weaker sales figures overall. For these reasons, futures traders will often use higher interest rates as a basis for selling short a stock index (such as the NASDAQ or S&P 500). Commodities markets tend to work in the same way, as higher interest rate costs tend to limit demand. A scenario like this could also be used as a basis for defining a negative outlook in a commodity like oil, and then to sell that market short.
Overall, it is a good idea to have some sense of which factors are viewed as positive or negative for the asset you are trading. Then, once visible, you can make the decision to either buy the asset, or to sell it.
Futures Intermediate — Using Leverage To Maximize Positions
Many traders that enter the futures market with a small account size find it difficult to make significant gains. One way of overcoming this is to use leverage, which is an effective way of maximizing your positions and increasing the potential gains that can be captured in a trade. When using leverage, futures traders need to put up a margin payment which is essentially a deposit of “good faith” that will allow you to buy or sell a larger futures contract than you would have been able to purchase otherwise. You are then responsible for all profits and losses that are incurred for the larger trading size.
Entering Trades On Margin
The initial margin deposit is used to protect against any losses that might be incurred during the life of the position. Once the contract is liquidated, that initial margin money is refunded back to your balance along with and gains or losses that accumulated while the position was open. In most cases, futures exchanges will require the initial margin deposit is at least 5-10% of the total position size. So, if you want to buy a $100,000 position in oil futures, your initial margin will need to be at least $5,000-$10,000. In some cases, these margin percentage requirements will be increased during times of heightened market volatility.
But while using leverage can help increase gains, it must be remembered that it can also increase losses. If the leveraged trade goes in the wrong direction, your maintenance margin level will show you the minimum amount of money that will need to be in your account to keep your position open. If the losses continue, and your account falls below this level, you will receive a margin call and you will need to add funds until your margin is brought back to the appropriate level. If you are unable to do this, your trade will be closed at a loss.
Margin Call Trading Example
Let’s look at a hypothetical trading example. Assume we deposit $500 on a futures contract in the S&P 500, and our broker requires a maintenance margin level of $250. The trade turns against us and the total amount in our account is $200. The broker would then initiate a margin call requiring an additional deposit of $300, which would bring us back to the initial margin ($500). This additional deposit will generally need to be done immediately or the contract will be liquidated at a loss.
For these reasons, trading in the futures markets using leverage should be viewed as a risky endeavor. So these types of positions should not be entered without sufficient planning. It is also generally not the best idea to use high leverage levels during times of heightened market volatility (such as when a central bank changes interest rates or right after a major economic release).
Trading Protected With Leverage
These scenarios are not meant to scare futures traders from using leverage. Not all turns will turn negatively against you, but it is essential for you to know what is going to occur if this is the case. Here, the old maxim “prepare for the worst, but hope for the best” does bear some merit. A positive trade should be based on a little more than simple “hope,” but if you want to keep your account balance positive (and stay in the futures game) it is much more important to protect your account from excessive downside.
One method to take as a futures trader is to never use the minimum allowable margin deposit that is required by your broker. If you are only putting up an initial deposit of 5%, it is much more likely that your trade will end in a margin call if things turn south. If you put up more in your initial deposit, your trade will have added protection and give you the breathing room you might need to “wait out” the dark period and give you more time for things to turn positive again.
Futures Intermediate — Technical Indicators: RSI and MACD
One of the greatest advantages of technical analysis is that it will allow you to view an asset in objective terms. Since we are only viewing the asset in terms of its price activity, we have added information that will allow us to see things from a less biased perspective. Technical chart indicators are some of the best tools to be found in these areas. Some traders feel intimidated when trying to understand these tools at first.
But once we understand that technical indicators are really just meant to show instances where an asset’s value has risen too far above or below its historical averages, the application becomes much easier to grasp. Here, we will look at the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD) to get a better understanding of how these technical indicators can send trading signals in the futures market.
Technical indicators might seem intimidating if we try to understand the mathematical formulas used when constructing them. Of course, there is nothing wrong with understanding the math behind these calculations. But when just starting out, it is generally a better idea watch how these indicators behave visually, as this is the best way of spotting the trading signals themselves. Each of these indicators is meant to show when an asset’s price has become overbought (too expensive) or oversold (too cheap). This information is highly useful in constructing futures positions.
Relative Strength Index
The Relative Strength Index is usually referred to as the RSI, and is plotted below prices on your chart. The RSI ranges in value from 0 to 100. Higher numbers suggest that asset prices are becoming more expensive relative to their historical values. Numbers above 70 suggest that the asset has become overbought and is increasingly at risk for future declines. Numbers below 30 suggest that the asset has become oversold and markets are likely to start rallying.
In the chart above, we can see the RSI plotted against price activity in gold futures. Here, two RSI lines are used, but many trading stations will only show one line. We have a slow RSI (plotted over 14 days) and a faster RSI (6 days) to show some of the differences. Essentially, the faster RSI sends more trading signals, so if you are looking to enter into a larger number of trades, it is usually very easy to adjust your setting and accommodate this need. But no matter which settings you use, the rules for when to buy and sell remain the same.
The upper line on the indicator is the “overbought” at 70. This is generally viewed as a signal to sell the asset because it means that prices have risen too high, too fast. This makes it difficult for the asset to sustain its lofty levels without at least some downside correction. When the RSI crosses above 70 and then crosses back below that threshold, a sell signal is in place and short positions can be taken.
The lower line on the indicator is the “oversold” at 30. This is viewed as a signal to buy the asset because it means that prices have fallen too far, too fast. But market declines cannot continue forever and futures traders will start to look for an upside correction. When the RSI crosses below 30 and then crosses back above that threshold, a buy signal is in place and long positions can be taken.
Moving Average Convergence Divergence
Visually, the MACD looks very different. But the signals sent to traders attempt to show the same types of events. The MACD is made up of two exponential moving averages (EMAs), a 12-day EMA and a 9-day EMA. The faster EMA is the “signal line” as it is going to react more quickly to price movements seen on your chart. All of this is plotted along with the MACD Histogram, which shows where momentum is positioned in the market (positive or negative).
In the NASDAQ 100 chart above, we can see all three elements in place. The red line is the slow EMA and the blue line is the faster EMA (the signal line). When the blue line crosses above the red line, a buy signal is generated. When the blue line crosses below the red line, a sell signal is generated.
Additionally, futures traders should remember to watch the histogram (the grey bars). When the histogram falls below the center of the indicator, bearish momentum is building and short positions should be considered. When the histogram rises above the center of the indicator, bullish momentum is building and long positions should be considered. You might notice here that the MACD generates two different types of signals, where the RSI really only sends one. If you are using the MACD, the highest probability positions are found when both signal types are seen at the same time (ie. bullish histogram momentum along with an upward EMA crossover, or bearish histogram momentum along with a downward EMA crossover).
Futures Intermediate — Small Caps Vs. Large Caps
When you turn on the financial news, most of the commentary you will find there is related to stock markets. But not all stocks are created equal. One of the most commonly used distinctions separate companies by their total market values. This is also referred to as market capitalization, or “market cap.” Companies with a lower market value are referred to as “small caps.” Companies with a higher market value are referred to as “large caps.” There are certain advantages and drawbacks that are generally associated with both types of stocks. So it is a good id to have some understanding of how these different stock types perform before choosing which assets to buy or sell in a futures contract.
Small Cap Stock Futures
Small cap companies are generally valued in the $300 million to $2 billion range. Exact definitions can change depending on the views of the trader — but these are the stocks that have the lowest valuations in the market. There are several key advantages that can be found when trading these stocks. Most important here is their potential for growth. Small cap stocks are generally “under the radar” of most market participants. This means that there is much more potential growth value because fewer people are ready to start buying shares in the company.
There are drawbacks to trading in small cap futures, as well. Small cap stocks are less commonly bought and sold, and these lower trading volumes tend to create higher price volatility. So while there is greater potential for growth, there is also greater potential for sharp declines. In other words, those trading in small cap stock futures are generally willing to sacrifice more potential risk for the chance to capture larger potential rewards.
One of the best ways of using futures contracts to gain exposure to small cap stocks is through the Russell 2000 Index, which tracks the performance of 2000 individual companies that fall into this category. This can be found using the futures symbol TF. Alternatively, futures traders can look to enter into positions in the tech-heavy NASDAQ 100, which also tracks the performance of many small caps. NASDAQ futures can be found using the symbol NQ. But it should be remembered that the NASDAQ 100 index also includes many commonly known large cap companies, as well. For this reason, the NASDAQ is often used by traders that want some exposure to small cap companies along with some of the added security that can be found in large cap stocks.
Large Cap Stock Futures
More commonly traded are the companies that fall into the large cap stock category. Large cap companies are generally valued $10 billion or greater. Some of the most well-known names in this category include names like Exxon Mobil, Microsoft, and General Electric. Since these stocks are more commonly bought and sold, the higher trading volumes tend to produce lower volatility levels (stable trends).
Added advantages when trading in large cap stocks come with the fact that they have already had proven histories of strong market performance. For example, it is relatively rare to see a quick bankruptcy in a large cap company. This is not something that can be said for small caps. But the downside when trading large caps is the lack of potential growth that is available for investors. When trading large caps, futures traders tend to sacrifice significant growth for the added protection from downside surprises.
Two of the best ways to futures contracts in gaining exposure to large cap stocks are through the S&P 500 and the Dow Jones Industrials Index, which track the performance of some of the most valuable companies in the world. When trading futures, the symbol in the S&P 500 is SP. For the Dow Jones Industrials, the futures symbol is DJ. Alternatively, futures traders are able to gain access to these indices using mini futures contracts. The S&P 500 e-mini symbol is ES, the symbol for the Dow Jones e-mini is YM.
Futures Intermediate — Range Trading and Sideways Markets
Those looking to establish “buy and hold” positions over the long term will often want to see a solid trend in place before committing to a position in a futures contract. But the unfortunate reality is that there will be many situations where there is simply no trend in place. Does this mean that you should avoid that market altogether? Perhaps. But there are many traders that are able to successfully navigate these types of scenarios, and capitalize on price movements even when there is no significant trend in place.
Those that are able to analyze the market and establish positions even when no trend is in place will have many more tools in their arsenal and much greater flexibility to attack the market no matter what is happening. Here we look at trendless, or “sideways,” scenarios and discuss the main trading strategy employed as price ranges form.
Sideways Markets: Periods of Trader Indecision
In another article, we explained that an uptrend requires a series of higher highs and higher lows, while a downtrend involves a series of lower higher and lower lows. When none of these elements are apparent, the lack of direction signals a period of indecision. There are many reasons why these sideways markets might occur. If you are trading commodities futures, you might see a slowdown in the supply/demand dynamics needed to cause heightened volatility. In stocks, this might occur if quarterly earning performances start to flatten out. In currencies, a country might see little or no change in monthly inflation numbers and this could create a scenario where a country’s central bank might leave interest rates steady.
Any of these scenarios could make it difficult for the market to take a definitive stance, and drive prices significantly higher or lower. Scenarios like this will keep many traders on the sidelines, or at least keep them from establishing large positions. This makes it nearly impossible for the market itself to generate positive or negative momentum. In the chart above, we can see a period of indecision in gold markets after a strong uptrend.
Trading Ranges: Buying At Support, Selling At Resistance
When we say “a period of indecision,” we are looking at things from a fundamental perspective. Statements likes these essentially means that there is no real fundamental driver to cause the majority of the market to side one way or another. The exact reason for why something like this might occur will generally depend on the type of asset being traded. As we said above, for stocks it might be stalling earnings that causes a scenario like this. The chart above shows gold, which is one of the most commonly traded commodities. But with no real trend in place, how could futures traders have positioned within this market?
Instead of staying on the sidelines (and sacrificing potential profits), it would have made a good deal of sense to start playing the range. When this is done, futures traders do not have to worry as much about constructing a specific directional bias (because there is no clear market direction). In the example above, trading signals should have been blaring once the uptrend’s series of higher high and higher lows came to an end. This becomes clear in Q2 2011.
Futures traders would then be looking for evidence of a total bearish reversal, or for evidence that a trading range is starting to develop. In this case, the latter scenario becomes true as support and resistance zones signal that a sideways market is in place. Instead of avoiding the trendless markets, futures traders could have bought gold as prices fell to support and then taken profits on those positions once prices rose back to resistance. These areas are marked by the green and red arrows in the chart above. This could have continued until that range broke to the downside, as this would have signalled an end to the sideways market.
Range Trading Advantages
There are some clear advantages to range trading. One is that it allows futures traders to be active when there is no real trend in place. Another is that it is very easy to identify trade entries, stop losses, and profit targets. Stop losses are generally placed just outside the trading range, while profit targets are placed just inside the range. Overall, this approach should be taken once market momentum starts to slow, and fundamental indecision is what characterizes the stance for most futures traders.
Futures Intermediate — News Trading
(note: For this article, I recommend that the site has its own economic calendar. I used DailyFX in the article but this could be changed if there is a current calendar on the site)
If you haven’t figured it out already, there are many different approaches to trading the futures market. Technical and fundamental analysis tend to be the broadest ways of defining the strategies that futures traders generally take, but there are many individual subsets within those two categories that will need to be considered at some stage. For those more focused on the fundamental side of things, news trading is definitely a strategy that has proven itself over time and has been successfully implemented for as long as futures markets have been around.
As a term, news trading refers to a strategies that involve waiting for a significant economic report or news stories before establishing new positions. This might seem like a difficult practice. But the fact is that most market-moving news events are scheduled in advance, and are widely anticipated by the market. This is why they end up changing asset valuations most significantly: once important economic news is made publicly available, a much larger percentage of the market is going to use that information and start entering into active positions.
For a news trader in futures markets, the best tool in your arsenal is the economic calendar. These calendars are widely available — but some are certainly better than others. Any good economic calendar will have the market consensus expectation, and the previous results in addition to the date and time of the release. Economic events that are closely watched by the majority will lead to the greatest price volatility (in either direction) once released. This is because that majority doesn’t have the opportunity to react to the new information until after it is publicly available. Once released, markets start to see a surge in new buy or sell orders.
Expectation Vs. Reality
As data releases are made public, futures traders are looking to assess those results versus what market analysts were originally expecting. For example, if the market is expecting a quarterly earnings figure to come in better than what was seen previously, that expectation will need to be met or surpassed. If not, the stock is almost certainly going to be heavily sold-off so that the market can account for the new outlook in the company. When dealing with stocks, most earnings releases are made public outside of the normal trading hours seen on the main exchanges. In these cases, futures traders actually have an edge on the rest of the market because there are no limitations placed on the time availability for trading.
Different Assets Are Impacted By Different News Events
Of course, different events are going to affect different markets. For example, a corporate earnings release will probably not have much impact on the value of the Euro or US Dollar. This is because a stock event is really not a good indicator for tor the perceived strength or weakness for an entire nation’s economy. When dealing with currencies, different types of economic information will be viewed as relevant by futures traders. Relevant factors include things like inflation numbers, jobs data, and manufacturing activity.
When we look at the current economic calendar, if it not difficult to figure out when these types of events will occur. So, if you are looking to enter into a short term futures position, it might be a better to wait on the sidelines until after the important economic report is made publicly available. There is nothing worse than opening a position only to find out later that your stance conflicts with that day’s important economic headline. But there is one economic even that often has the potential to move all major asset classes, and this can be seen in central bank meetings where an increase or decrease in interest rates is expected. Those trading stock, commodity, or currency futures will likely see additional volatility in their positions when these events are scheduled.
All of these are factors that should be considered by futures traders that are looking to establish positions based on information contained in economic reports and news releases.
Futures Intermediate — How To Value Stocks
In order to take an active position on a stock market futures contract, you will need some way of determining whether the current price is undervalued or overvalued. Those using technical analysis might use common chart indicators like the Relative Strength Index (RSI) or Stochastics to make these assessments. But which tools are available for those that look to trade futures from the fundamental side of things?
To be sure, this takes a bit more work because there are a lot of individual factors at play. But there are some commonly used valuation metrics that can help to remove some of the guesswork. Here, we will look at the price-to-earnings ratio and the price to book value and then explain how this information can be utilized when making trades.
The price-to-earnings ratio, or P/E ratio, compares a stock’s current market value to its per-share earnings (the amount of earnings generated per share of tradable stock). So the simple formula to calculate the P/E ratio would be as follows:
Generally, this calculation will not need to be done manually, as there is usually plenty of publicly available information that will give you the P/E for your chosen asset. But what does this P/E number really tell us? Broadly speaking, a rising P/E shows that the market is valuing the asset at a higher rate per unit of earnings. Higher P/E numbers suggest a more expensive asset. Once the P/E ratio reaches extreme levels relative to the historical averages, it becomes much more likely that the price of that asset will start to fall.
Let’s take a look at the historical P/E in the S&P 500:
Here, we can see the market’s P/E valuation in the S&P 500 stretching back all the way to the mid-1800s. Over this period, the average P/E number is 15.5, but the most recent figure shows that the market is trading at a multiple of 19.42. This tells us that the S&P 500 is overvalued when compared to its historical average. Training on this information alone, a futures trader might be reluctant to take long positions in an S&P 500 futures contract until it trades back toward its historical averages. Of course, there are always other factors to consider when taking active positions in a stock index. But the historical P/E ratio is generally viewed as a good indicator of whether or not the current market valuation is appropriate.
Price to Book Value
Another commonly used valuation metric is the Price to Book Value, which compares the market’s current price to its net asset value. This is the value that would, in theory, be paid out to shareholders if the asset was liquidated. For some fundamental traders, the price to book value is often viewed as a more comprehensive valuation metric because more factors than simple earnings are taken into consideration.
In the chart below, we can see the historical price to book value in the S&P 500 dating back to the year 2000:
How could this information be used in constructing a trade? The chart shows that the S&P is currently trading at a price to book multiple of 2.73. During this period, the average seen in the ratio is only one tick higher at 2.74. This tells us that the S&P is currently trading roughly in line with its historical averages and that the current market valuation is appropriate.
For those looking to establish positions in a futures contract, it might be better to wait on the sidelines until better opportunities arise. Futures traders that are looking to establish short positions might want to wait until the S&P 500 has become overvalued. We can see an example of this type of scenario earlier in the year 2000, when the price to book ratio held at a lofty 5.06. Those looking to establish long positions might choose to wait for instances where the S&P is trading at cheaper levels. An example of this could be found in the year 2009, when the index was trading at a price to book multiple of 1.78.
Futures Intermediate — Breakouts And Momentum Trading
In prior articles, we outlined some of the technical analysis strategies that might be employed when markets are moving sideways and trading ranges dominate the landscape. But anyone with any trading experience knows that no market scenario can last forever. So how should traders position themselves once trading ranges start to break down?
In order to understand breakout trading, you must first have an identifiable trading range. This simply means that markets are trading with no clear directional bias and that prices are bouncing back and forth between definable support and resistance levels. This would look something like the activity seen in the graphic below:
But once one of these support or resistance levels is broken, that range is no longer valid and should not be traded. Instead, it makes sense to consider placing trades in the direction of the range breakout. This is because these events signal that market momentum is changing and a new trend is potentially developing.
To get a sense of the basic structure, lets consider what a bullish breakout might look like on a price chart:
Note that the initial trading range has been broken to the topside, as more buyers than sellers have entered into the market. The sideways environment that preceded no longer applies, and this shift in the dynamic is likely to continue, given the momentum forces that are needed create such a breakout event. Since this is a bullish breakout, it means that the critical resistance level has been broken. Since this area has already been defined by the market as an important price level, it is likely that prices will rise above the resistance point, and then fall back to retest that level. If this area then holds as new support, buy positions can be taken in the asset.
Breakouts can also happen to the downside. The same rules apply — only in reverse. So the range price level that is broken is the support line. When this occurs, sell entries can be taken in anticipation of lower prices going forward.
Breakout trading has many advantages because it is a signal to futures traders that market momentum is starting to build in a new direction. The logic here is that there must be something significant happening in the market in order to force prices through the trading range that had dominated previously. Additionally, this momentum has the opportunity to be propelled further, given the fact that every trader selling the asset at the top of the previous range will now be forced to close those positions at a loss. When a trader closes a short position, it effectively becomes another active long position that will help drive prices higher.
This added momentum is essentially what turns the odds in your favor when establishing breakout positions. Those that are already watching the price activity in the initial range will be able to capitalize on the new price movements earlier than many in the market. If you are able to establish your trades early enough, significant profits can be captured if a new trend develops. In these cases, you would be able to buy in at relatively low prices (or sell at relatively high prices).
For these reasons, breakout trades tend to be characterized by very strong risk-to-reward ratios. This is because breakout traders do not wait for a formalized trends to establish itself before committing to active positions in a futures contract. There are certainly many merits to trend trading, and we cover those in another article in this section. But the main disadvantage in the trend following approach is that traders must wait until a good portion of the trend is already over before positions are opened. Breakout traders do not have to worry about this, as they are generally able to spot new trends in their earliest stages.
Futures Intermediate — Are You A Technical Or Fundamental Trader?
Once you understand the basics elements of a futures trade, the next step is to start defining your strategy. A lot of old cliches can be applied here, and most of them suggest that even the most expert trader is “still learning” and revising strategy. But it is still useful to get some sense of where your strengths and weaknesses are — as this is the best way to structure repeatable positioning that will allow you to profit over time.
There are generally two different approaches that futures traders take when defining their outlook: technical analysis and fundamental analysis. Fundamental analysis has a much longer history and looks to make sense of the underlying economic factors that support a bullish or bearish position. Technical analysis, on the other hand focuses solely on chart activity as a means for defining a generalized market stance. Trying to figure out which is “best” is an exercise in futility. What is useful is to determine which type of approach works best for you. Here, we look at some of the main factors involved when practicing each type of discipline.
Fundamental Analysis: Assessing Economic Trends
For those using fundamental analysis, the underlying asset (and its associated economic trends) are the most important factor. In stocks, things like quarterly earnings, new product releases, relative valuations in competitor companies, and performance outlook are some of the factors that are most commonly watched. But for those looking at other asset classes, these factors are largely irrelevant.
In commodities, for example, supply and demand issues are much more important. If you are trading assets like gold or oil, you will likely be paying close attention to the companies that are producing those assets. Are oil companies refining more oil? Are gold miners able to pull less product out of the ground? Any scenario that leads to supply reductions in a commodity should push prices higher. Any scenario that leads to demand reductions should push prices lower.
In currencies, macro economic factors tend to control where prices are headed. Those trading currency futures generally watch factors like inflation, jobs numbers, manufacturing reports, and the central bank outlook in order to get an indication of where prices are headed next.
Technical Analysis: Assessing Price Chart Trends
In contrast, technical analysis relies on trends and price patterns found in charts as a means for constructing a position outlook. Here, the underlying asset type has no meaning and is not taken into consideration. It might seem difficult to believe that an approach like this could ever work but it is important to remember that technical analysis is really just a study of supply and demand in the market.
Where are the price levels where buyers have historically stepped in and pushed valuations higher? Where are the price levels where sellers have stepped in and pushed valuations lower? These are some of the central issues that technical analysts deal with on a daily basis. Those that swear by this approach will often argue that technical analysis is useful in determining exact exit and entry levels for a specific trade. Additional tools like indicators and oscillators can help futures traders to determine when an asset is overbought or oversold. These are all terms that will be covered further in future articles.
Choosing An Approach: Either, or Both?
When choosing an approach, it is most important to play to your strengths. Are you willing to read news articles and economic reports that will give you a better idea of the relative strength or weakness likely to be seen in an asset? Or do you prefer to take an assessment of the current price levels in relation to the historical chart activity? Most futures traders tend to side with one approach or the other.
But it is also important to remember that these strategies are not mutually exclusive, and it is also impossible to draw from both sources. One option is to start with a fundamental perspective and gain a positive or negative outlook for an asset. Technical analysis can then be used to define specific price levels needed to enter and exit a trade. The possibilities are literally endless in defining your approach are literally limitless. So pay attention to your own strengths, interests, and trading goals when you chose the approach that is likely to work best for you.
Futures Intermediate: How Do We Define Trends?
When futures traders base positions on technical analysis, one of the most common phrases you will head it ‘“the trend is your friend.” But what exactly is a trend, and why should it be your friend? If we deconstruct market activity to its component parts, we start to realize that valuations can only move in three directions: up, down, and sideways. When buyers are in control the trend is bullish, when the sellers are in control the trend is bearish. When markets are in a period of indecision, markets trade sideways and no real trend is apparent.
If we are able to accurately discern which trend is in place, it becomes much easier to construct a profitable trading position. Market direction is all about what the majority is doing relative to any given asset. Is the majority outlook positive or negative? How will this outlook influence prices (and potential futures positions) going forward? Here we look at some of the elements involved when assessing the dominant trend for an asset.
Futures Market Uptrends
If the majority of the market has a positive outlook on any asset (stocks, commodities, currencies, etc.), there are going to be more people buying that asset than selling it. This decreases the available supply of that asset and increases demand. Basic economics tells us that this the is formula that leads to higher prices. When these prices increase with enough momentum and sustainability, an uptrend is in place.
In technical analysis, an uptrend is defined as a series of higher highs and higher lows. Generally, three or more price points are needed to create a “series.” In the price chart above, we can see market activity in gold during the historic rally posted after 2004. In this example, prices ran progressively higher without any substantive declines. This meets the requirements needed to label a trend as bullish, and this created a scenario that could be used for long positions in a gold futures contract. If you had spotted this trend in its early stages and bought a futures contract in gold futures before momentum started to build, substantial profits could have been made as the commodity soon rose to new record highs.
Futures Market Downtrends
When the market has a negative outlook on an asset, there are going to be more people selling that asset. This increases the available supply of that asset and decreases demand. Here, our Economics 101 lessons tell us that lower valuations are on the horizon. When prices decline with enough momentum and sustainability, an downtrend is in place.
A downtrend is defined as a series of lower highs and lower lows. Again, technical analysts will need at least three different price points in order to determine that a valid downtrend is in place. In the price chart above, we can see the S&P 500 during the historic decline posted after 2007. In this example, prices ran progressively lower without any substantive rallies, creating three lower highs and lower lows in the process. This meets the requirements needed to label a trend as bearish, and this created a scenario that could be used for short positions in an S&P 500 futures contract. The futures traders that saw this bearish series early on could have sold a futures contract in the S&P before momentum started to build, and substantial profits could have been captured in the period that followed.
Siding With Majority Momentum
When dealing with market trends, futures traders ultimately need to decide whether or not they are interested in siding with the majority of the market. The main benefit of this type of approach is that there is already a substantial amount of market momentum in place to support your position. There are certainly traders that look for reversal scenarios in order to establish new positions, and this will be covered in the Contrarian Swing Trading article on this site. But for those looking “ride the trend” these are the essential elements that must be considered.