This chapter discusses some of the basic elements of technical analysis which can help make hedging and forward pricing decisions.


A. Constructing Bar Charts

Bar charts give you a seismograph to measure the hidden forces going on in a market. Since price resolves all market pressures, no market moving information can go unhidden in a price chart.

Many traders buy and sell based totally on charts. By examining bar charts, traders hope to pick-out significant market trends, look for market turning points, and develop price forecasts.

This type of analysis is referred to as technical analysis. This is in contrast to fundamental analysis which utilizes supply and demand information to forecast price direction. Just as a good carpenter utilizes a wide variety of tools to master his craft, we too rely on a wide array of both technical and fundamental methods to develop our price projections and make marketing decisions.

For technical analysts, the bar chart is probably the most valued tool for commodity futures trading. The bar chart is both a time and price chart. The vertical axis or y-axis, shows the price scale and the horizontal or x-axis shows the time scale. Bar charts can run from as short a time period as 5-minute bars to as long as a monthly graph of prices. The choice of a time period for a bar chart depends on the length of time that a trend is trying to be identified. The most commonly used bar charts are daily and weekly where weekly bar charts are used to identify longer term trends than a daily bar chart.

For a daily bar chart, each bar represents the three most important prices for any given trading day:

1. The highest point on the bar chart shows the highest price traded on a given day.
   
2. The lowest point on the bar chart shows the lowest price traded on a given day.
   
3. The closing price (also called the settlement price) is represented by a horizontal dash on the high-low bar.
   

The example below illustrates three trading days. In day 2, the market closed lower than on day 1 but the day 3 close was higher than day 2. By examining the high-low lines, we see a somewhat different story about the trading activity on each day. Both day 2 and day 3 had consecutively lower highs and lower lows. This formation is part of a downward trend and even though the price on day 3 closed higher than on day 2, a chart analyst would conclude that because the bars were trending lower, the market must be on a downward trend.



Weekends are not shown on a bar chart and on weekdays when the exchange is closed, the day's space is left blank.

Technical analysis interprets the predictive meaning of zigs and zags on charts. Technical analysis does not worry about the fundamental reason that could cause a zig to become a zag. The technical analyst accepts that the market itself will be the first news of some major weather scare or new buying pressure.

Do charts and technical analysis really work? The common explanation is that charts work because traders make them work. If an uptrend breaks, chartist rush to sell. The resulting downtrend confirms the old rule to sell when an uptrend breaks.

If you had a choice of trading only on fundamentals or on charts, your trading would be more disciplined based on charts. Our philosophy, like the carpenter, is to use any and every tool that will help us get a better price.


B. Trend Lines

While charts make nice pictures, the real issue is whether they can be used to make profitable trading decisions. The most basic charting method is the trendline. In this section, we show how to use trendlines to spot markets that are trending higher and show how to identify markets that may be changing from upward to downward trending.

Identifying Markets Trending Higher

Most traders plot uptrends on daily charts by drawing an uptrend line beneath the range of daily trading. Your line touches significant lows, and projects a constantly rising floor under trading.

If you are a beginner, your first question will be ''How do I decide where to draw the line? Which daily lows set the boundaries of the uptrend?''

You draw an uptrend line using the most significant daily lows. Most significant means the lows that poke below the routine trading range. These lows represent the markets' attempts to go lower. When buying strength jerks prices back up into the uptrend that?s your sign there's still enough strength to maintain the uptrend.

The longer an uptrend line can be maintained without being broken, the more confident we are that the market will continue higher. Furthermore, the more times an uptrend line is tested and bounces higher from the line, the more significant is the uptrend.



Breaking an Uptrend

When an uptrend is broken, this is a good signal to sell because the market has lost its momentum to move higher. A broken uptrend line occurs when the market moves below the uptrend line. While this can occur by the low price penetrating the uptrend line, it is considered to be more significant when the closing price is below the trendline. After breaking an uptrend, a market may continue to move lower and eventually form a downtrend line. In many cases, however, the market simply stalls after penetrating the uptrend and may just move sideways for some time.

Identifying Markets Trending Lower

A down-trending market is signified by prices setting new lows with the daily high prices trending down. The downtrend line is drawn across the top of the most significant highs during the trend stage. As with the uptrend, the more times a market reaches the downtrend line, the more significant the trend.

The chart below shows an example of a downtrend in the July 1998 wheat futures price that started in October. Notice that we have illustrated a long-term downtrend and a short-term downtrend.

Downtrend in July 1998 Wheat Futures


When a downtrend line is penetrated to the upside, this signals a change in trend. Usually, the market will remain in a sideways trend for sometime before either moving higher on an uptrend or resuming a downtrend. When the downtrend line is penetrated, this is usually a good time to buy since the market has lost its momentum to move lower.

Trendlines can be useful ways of identifying the market trend and possibly signaling a change in market trend. However, it is important to recognize that trendline analysis, as with any technical analysis, is not 100% guaranteed. Therefore, if you see a situation where a market trend is changing based on trend line analysis, is important to support this conclusion with other indicators, whether fundamental or technical.

C. Head and Shoulders

Using bar charts to successfully pick market tops and market bottoms is more art than science. The key to successful technical analysis is spotting market reversals. A reversal is simply a change in trend from downtrend to uptrend or vice versa. Using trend lines is one way to look for reversals, but other chart patterns can also signal a market reversal.

Probably one of the most reliable chart patterns for signaling a change in trend is the head and shoulders reversal. Before we look at this pattern specifically, there are a few common points about market reversals that we should be familiar with:

1. A prerequisite for any reversal pattern is the existence of a prior trend. A market must have something to reverse.
   
2. Breaking an important trendline signals the possibility of a trend reversal but does not guarantee it.
   
3. The longer the current trend, the greater the potential for a market reversal.
   
4. Reaching a market top usually occurs much quicker and with more volatility than reaching a market bottom.
   
5. Trading volume is usually more important on the upside reversal. Once a bear market gets under way, prices have a tendency to drop but for a bull market to begin, it usually requires significant buying activity to start a bull trend.
   

The head and shoulders formation is based on a reversal sequence where a market makes a chart pattern outlining a left shoulder, a head and a right shoulder. Below you will find an example of a head and shoulders top pattern. Be prepared to use a little imagination when trying to pick out the shoulders and the head. Shoulders may be sloped in different directions and the neckline, tracing out the bottom of the head and shoulders, may be upward sloping or downward sloping. The head and shoulders pattern can also occur at a market bottom, with the head and shoulders pointing down.



As a market is making a head and shoulders top or bottom there are very few clues that such a pattern is developing until the right shoulder is formed and the neckline can be established. The price objective of the head and shoulders pattern is calculated by taking the distance between the top of the head and the neckline. In the example below, that difference is 30 cents (720-690). This difference is than subtracted from the neckline to get a downside objective of 660.

It is not unusual for prices to break the neckline after completing the right shoulder and then make an attempt to move above the neckline. You can see that this occurred on several occasions in the Mar soybean example, but prices eventually approached the 660 level.


D. Double Tops and Bottoms

When futures prices are in an uptrend, there is likely to be an upper price limit where all buying interest is met and begins to dry up. At the same time, sellers may begin to actively enter the market either from the short side or as buyers begin to take profits. That price level will become a major resistance point and will establish where supply is significantly greater than the demand.

After reaching this market top (labeled as the left hand market top), a corrective phase will usually push the market lower even though fundamental news may still remain bullish. A temporary bottom is reached and the market returns to its long-term trend of higher prices. As the market rallies back to major resistance, it will take new fundamental news to push it above the previous high. If this doesn't occur, the second top may continue to hold resistance and push the market lower. If the market eventually breaks below the lows established between the two peaks, this signals a change from an uptrend to a downtrend.

An Example of a Double Top


For double bottoms, the same principles apply. A market in a downtrend may be reversed by breaking out from a double bottom.


E. Reversal Formations

Trend reversals can be signaled by only one trading day. The three most common forms of one-day reversals are the key reversal, hook reversal, and island reversal.

A key reversal top has two stipulations. First, the high price for the trading day must be higher than the previous day's high price and the low price must be lower than the previous day's low. This is known as the outside-day because the trading range for the day was wider than the previous day's range. The second condition is that the close for the day be lower than the previous day's close.

Example of a Key Reversal Day Signifying the End of an Uptrend


The logic behind the key reversal is a new high signifies bullish enthusiasm but when the market falls below the previous day's low and closes lower, this indicates a change in market sentiment. Buying power usually dries up at this stage and the market will likely move lower.

A hook reversal is similar to a key reversal but the new high or new low prices do not occur on an outside day. Usually, the day's high price will be above the previous day's high but the daily low price may not be below the previous day's low. A close below the previous day's low is required, however. The hook reversal is considered to be less reliable because it does not have the outside day condition. However, they occur more frequently than key reversals so if the fundamentals match the technicals, this may be a good indication of a change in trend.

Example of a Hook Reversal Day Signifying the End of an Uptrend


An island reversal is distinguished from the other reversals by gaps appearing on the chart. A gap occurs when there are no trades over previous trading ranges. With the island reversal, you have trading gaps on both the upside and the downside.

Example of an Island Reversal Ending an Uptrend



F. Consolidation Patterns

Many times a trending market will pause from its major trend to form a consolidation pattern. Probably the most easily recognizable consolidation patterns are the bull flag and the bear flag. A bull flag is a consolidation period during an uptrend while a bear flag is a consolidation pattern during a downtrend. You can also think of flags as short-term market corrections.

In a downtrending market, a bear flag is recognized by a sharp period of selling (known as the flagpole) which can be one day or a series of consecutive days. The flagpole is immediately followed by a flag consolidation pattern, which has an ascending shape. The flag is formed from parallel lines across the daily highs and lows of the flag formation. This channel acts as market support and resistance. A close below the lower parallel line points to a continuation of the downtrend. The length of the flagpole is used as a price projection for the downtrending market. For example, the chart below shows the formation of a bear flag. The sell-off labeled as 'D' is the flagpole. This distance forms the basis for the price target once the bear flag is broken.

Example of a Bear Flag Pattern


A bull flag is similar in that it occurs during an uptrend and has a corrective downward pointing flag. Once the flag is broken to the upside, the bull trend will continue.

A second major consolidation pattern is a triangle or pennant which is formed by a period of lower high prices and higher low prices. The consolidation can occur during either a market uptrend or downtrend. Usually, after the triangle is formed, the market is expected to move out of a triangle formation in the same direction of the trend.

Triangle Consolidation in Uptrend Market.


Major price moves often evolve after price breaks out of a congestion pattern. In general, the longer the time period of the congestion pattern, the greater the price move is expected to be.


G. Chart Gaps

A gap appears when the market moves suddenly higher or lower and trades outside of previous trading ranges. The result is a gap in the price trading range. This usually occurs when the market is surprised by new information which leads the price to a higher or lower level in a short time. A key feature of chart gaps is that the market usually moves to fill the gap that was made. However, this could take anywhere from one day to several months to occur. The are several different types of gaps that can exist which have different levels of significance.

The breakaway gap usually begins as a trend is changing or as the market is gaining significant momentum in its current direction. This gap is usually not filled within a few days (5-10) after it is created and may set the stage for a further gap to appear. This second gap is known as a measuring gap. The distance between the breakaway gap and the measuring gap provides a price target for the continued trend.

Often, after the projected price is achieved and the market begins to show signs of topping or bottoming, it is possible to see an exhaustion gap. The exhaustion gap signals the end of the prevailing trend.

Example of Breakaway and Measuring Gaps



H. Concluding Thoughts on Technical Analysis

As was mentioned earlier, technical analysis can be more art than science. It is not unusual to find a particular chart pattern but that moves opposite in direction than what the pattern would predict. For this reason, people often become frustrated with technical analysis.

However, like any method that is less than 100% reliable, it is useful to support your price projections based on a number of sources including technical and fundamental analysis. If a chart pattern signals that the market should go higher but fundamental analysis suggests the market should move lower, it is probably not a good idea to make a trading decision at this stage. However, when several technical and fundamental indicators corroborate the same market direction, this is likely to be a more reliable indication of market direction. Therefore, to be a successful hedger, it is important to utilize both technical and fundamental analysis.