hot to spot profitable timing signals

8/10/2019 Hot to Spot Profitable Timing Signals

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How to Spot

Profitable Timing Signal

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How to Spot Protable Timing Signals

Copyright 2011 Commodity Research Bureau www.crbtrader.com

The psychology of commodity price movement

The price of a futures contract is the result of a decision on the part of both a buyer and a seller. The buyer believes prices will gohigher; the seller feels prices will decline. These decisions are represented by a trade at an exact price.

Once the buyer and seller make their trade, their inuence in the market is spentexcept for the opposite reaction they willultimately have when they close the trade. Thus, there are two aspects to every trade:

1) each trade must ultimately have an opposite reaction on themarket, and

2) the trade will inuence other traders.

Each traders reaction to price movements can be generalized into the reactions of three basic groups of traders who are alwayspresent in the market:

1) traders who have long positions;2) those who hold short positions; and3) those who have not taken a position but soon will.

Traders in the third group have mixed views on the markets probable direction. Some are bullish while others are bearish, but a lackof positive conviction has kept them out of the market. Therefore, they also have no vested interest in the markets direction.

It is this group which wields the greatest power, since their market impact is still in reserve. They neither fret nor rejoice as themarket moves. But as it moves, their particular market bias is either strengthened or diminished. The most important aspect of thepsychology of this group is they want to go with the market, whichever the direction. They are awaiting a conrmation of their marketviews.

The impact of human nature on futures prices can perhaps best be seen by examining changing market psychology as a typicalmarket moves through a complete cycle from price low to price low.

Classic price patternAssume prices trade within a relatively narrow trading range (between points A and B on the chart). Recognizing the sideways

price movement, the longs might buy additional contracts if the price advances above the recent trading range. They may even enterstop orders to buy at B, to add to their position if they should get some conrmation the trend is higher. But by the same token, recog-nizing prices might decline below the recent trading range and move lower, they might also enter stop loss orders below the market at A

to limit their loss.

The shorts have exactly the opposite reaction to the market. If the price advances above the recent trading range, many of themmight enter stop loss orders to buy above point B to limit losses. But they, too, may add to their position if the price should decline belowpoint A with orders to sell additional contracts on a stop below point A.

The third group is not in the market, but they are watching it for a signal either to go long or short. This group may have stop ordersto buy above point B, because presumably the price trend would begin to indicate an upward bias if point B were penetrated. They mayalso have standing orders to sell below point A for converse reasons.

Assume the market advances to point C. If the trading range between points A and B has been relatively narrow and the time periodof the lateral movement relatively long, the accumulated buy stops above the market could be quite numerous. Also, as the marketbreaks above point B, brokers contact their clients with the news, and this results in a stream of market orders. As this urry of buyersbecomes satised and prot-taking from previous long positions causes the market to dip from the high point of C to point D, another

distinct attitude begins working in the market.

Part of the rst group that went long between points A and B did not buy additional contracts as the market rallied to point C. Nowthey may be willing to add to their position on a dip. Consequently, buy orders trickle in from these traders as the market drifts down.

The second group of traders with short positions established in the original trading range have now seen prices advance to pointC, then decline to move back closer to the price at which they originally sold. If they did not cover their short positions on a buy stopabove point B, they may be more than willing to cover on any further dip to minimize the loss.

Those not yet in the market will place price orders just below the market with the idea of getting in on a dip.
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So, with each dip the market should nd the support of 1) traders with long positions who are adding to their positions; 2) traderswho are short the market and want to buy back their shorts if the market will only back down some; and 3) new traders without aposition in the market who want to get aboard what they consider a full-edged bull market.

This rationale results in price action that features one prominent high after another and each prominent reactionary low is higherthan the previous low. In a broad sense, it should appear as an upward series of waves of successively higher highs and higher lows.

But at some point the psychology again subtly shifts. The rst group with long positions and fat prots is no longer willing to add toits positions. In fact they are looking for a place to take prots. The second group of battered traders with short positions has nallybeen worn down to a nub of die-hard shorts who absolutely refuse to cover their short positions. They are no longer a supportingelement, eagerly waiting to buy the market on dips.

The third group of those who never quite got aboard the up-move become unwilling to buy because they feel the greatest partof the upside move has been missed. They consider the risk on the downside too great when compared to the now-limited upsidepotential. In fact, they may be looking for a place to short the market and ride it back down.

The net effect of the rally from A to C is a psychological change in all three groups. The result is a different tone to the market, wheresome support could be expected from all three groups on dips. (Support on a chart is dened as the place where the buying of a futurescontract is sufcient demand to halt a decline in prices.) As this support is strengthened by an increase in market orders and a raising ofbuy orders, the market once again advances toward point C. Then, as the market gathers momentum and rallies above point C towardpoint E, the psychology again changes subtly.

The rst group of long traders may now have enough prot to pyramid additional contracts with their prots. In any case, as themarket advances, their enthusiasm grows and they set their sights on higher price objectives. Psychologically, they have the market

advantage.

The original group who sold short between A and B and who have not yet covered are all carrying increasing losses. Their generalattitude is negative because they are losing money and condence. Their hopes fade as their losses mount. Some of this group beginliquidating their short positions either with stops or market orders. Some reverse their position and go long.

The group which has still not entered the marketeither because their orders to buy the market were never reached or becausethey had hesitated to see whether the market was actually moving higherbegins to buy at the market.

Remember that even if a number of traders have not entered the market because of hesitation, their attitude is still bullish. Andperhaps they are even kicking themselves for not getting in earlier. As for those who sold out previously-established long positions at aprot only to see the market move still higher, their attitude still favors the long side. They may also be among those who are looking tobuy on any further dip.


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Finding a friend in trend

The trend is your friend is an important trading guideline.

Because trends persist for long periods, a position taken with the trend will more likely be successful than one taken randomly oragainst the trend. Trading with the trend in a bull market means buying on dips; in a bear market, selling on rallies.

On a bar chart, each vertical line connects the days, weeks, or months high and low. The horizontal tick to the right of the lineindicates that time periods closing price.

A trend is easily spotted on a bar chart. An uptrend is a series of higher lows and higher highs. Uptrend lines are drawn under thelows of the market and give support. A downtrend is a series of lower lows and lower highs. Downtrend lines are drawn across the highsand give resistance to the market. The soybean chart shown below has both uptrend lines and a downtrend line.

Lows and highs vs. closesA trendline can be drawn when two points are available. The more times a trendline is touched, the more technically signicant this

support or resistance line becomes.

While some chartists draw trendlines through lows and highs, others may prefer drawing lines through closes in hopes of detecting achange in trend more quickly.

Trendlines may change angles, requiring another line drawn through new high or low points. For example, the sideways tradingaction in March and April broke the steeper uptrend line connecting the February 13 and March 20 lows. But when the uptrend resumedin early May, a more shallow uptrend line can be drawn connecting the February and late-April lows.

The most reliable trendlines are those near a 45 angle. If about four weeks have elapsed between the two connecting points, thisincreases the trendlines validity. However, steep trendlines that dont t these guidelines, like the uptrend line in the early portion of thesoybean chart, may be just as useful.

Often, minor uptrends or downtrends will confuse the beginner. It may seem the market has turned around. However, sharp chartistswill see these minor trends as small ripples within a major wave. Remember, if the trendline isnt broken, that trend remains intact.

Two closes outside the trendline are the criteria for detecting a change in trend. However, very seldom do markets go directlyfrom uptrend to downtrend. At the end of a move, traders become less aggressive and prices may swing in a sideways pattern orconsolidation period.


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Many times, markets break into an uptrend or downtrend out of a sideways trading pattern or consolidation period. In the soybeanchart, prices traded in a 50 cent range for nine weeks before breaking the resistance level and beginning a short move up. As a generalrule, the longer the consolidation period, the greater the rally after the breakout.

Because traders need time to be convinced that they should put their money into the market, sideways patterns are more likelyto occur near the bottom of a move. The beginning of a downtrend often will be sharp and sudden as investors pull money out of themarket.

False breakoutsAnother way beginners might be fooled is seeing false breakouts of tops and bottoms. As prices begin to make their move in

switching from a downtrend to an uptrend, traders with short positions will cover. This buying many times will cause the market torally above the downtrend line. This short-covering rally seldom holds, and prices may drop back to the breakout point. The uptrend isconrmed when prices close above the high of the short rally.

On a topping formation, long liquidation takes prices through the uptrend line on a short break. Before the downtrend begins, themarket sometimes rallies back to test the uptrend line as shown on the soybean chart in September. As the downtrend unfolds, thesecond reaction rally could not top the highs of the rst rally.

Channel lines are an extension of the trendline theory. The October through January downtrend on the soybean chart shows pricesstaying in a channel between the downtrend line and a line drawn parallel to it, connecting the lows. A channel line in a down trendingmarket helps identify where support may be found.

Speedlines are another line which show where prices may nd support or resistance. Frequently, speedlines and trendlines willoverlap, emphasizing that lines importance to the market.

The speedline on the soybean chart (page 8) starts from the June 29 low. To nd the points to connect with the low, divide the rangebetween the low ($6.40) and the high ($9.94) into thirds and subtract from the high.

Plot the point obtained by subtracting one-third of the range from the high on the day the high was made. A line drawn between thispoint ($8.76) and the low established the 1/3 speedline. The 2/3 speedline is drawn through the point that is two-thirds of the rangesubtracted from the high ($7.58) plotted on the day the high was made.


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Technical specics show price objectives, turns

Traders who believe in price charts make them work.

Chartists try to nd repetitive price patterns which have a high degree of accuracy and usually are self-fullling. Gaps and specicformations frequently meet these criteria.

Gaps are one of the most easily recognizable technical indicators. A gap is simply an empty spot formed on a chart when price linesdont overlap the previous days price action. Sometimes market psychology changes overnight or over a weekend. That change inpsychology forces prices to open and stay above or below the previous days range.

Time-tested ruleGaps are lled is another time-tested rule of the market. That is why gaps become future price objectives. Quite often, prices

retreat to ll a gap in a bull market before continuing the move. Likewise, prices often rally in a bear market to ll gaps.

Gaps may serve one of three purposes. They are used to spot the beginning of a move, to measure a move and to signal the end.There are four different kinds of gaps: common or temporary, breakaway, measuring or runaway, and exhaustion.

The most frequently occurring gap is the common gap. When this gap occurs because of a slight change in psychology, tradersexpect it to be lled soon. Once a gap is lled, it no longer has signicance.

The early portion of the soybean chart on page 12 shows common gaps during the December and January period which were laterlled.

The breakaway gap on this chart occurred on May 7 and begins a major bull move.

Breakaway gaps often occur after a stretch of sideways trading and in the leading days of an uptrend or downtrend. This type of gapremains unlled for a long time.

It sometimes is difcult to tell right away that its a breakaway gap and not a common gap. When the market fails to ll this gap aftera couple of weeks, this conrms the breakaway gap.


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Additional gapsA measuring gap typically occurs in the middle of a price move and predicts how much farther the move will go. It is also called a

midpoint gap and a runaway gap.

On the soybean chart (page 11), the measuring gap, which occurred on June 8, left an empty spot from $6.16 to $6.26. The April5 low at $4.90 marked the beginning of this move. The distance from the low at $4.90 to the measuring gap is $1.26 to $1.36. Addingthis distance to the measuring gap projects a move to at least $7. 50. Whether you add the distance to the top, bottom or middle of the

measuring gap depends on your preference.

An exhaustion gap shows frustrated bears giving up and aggressive bulls trying to make the market go their way. It is the rst signof sputtering before the end.

Though prices may go higher after an exhaustion gap at the top, the rally will not last long before the market dies. An extremeexhaustion gap may form an island reversal.

What about gaps that remain unlled? They become future chart objectives. If gaps are unlled when a futures contract expires,there are usually corresponding gaps on the charts of subsequent contract months.

Gaps also appear on longer-term charts such as weekly commodity charts, but gaps on monthly charts are rare because theygenerally are constructed to avoid gaps caused by contract changeover. Like those on the daily charts, gaps on weekly charts are alsomade to be lled.

A downtrend may slide to a slow, gradual halt in the saucer bottom formation. Open interest and volume follow the same patternas prices in this formation, reecting speculator disinterest in a market with little action and little prot potential. Our example on themonthly cocoa chart took three years to form. Saucer bottoms on daily charts may take at least four weeks to become visible.

Although this bottom formation doesnt meet the requirements of other bottom formations, its just as signicant in signaling a trendchange. Usually, the longer it takes to form a saucer bottom, the more violently prices will rise out of their lows.

Key reversalsOne of the most easily recognizable technical signals in trend change is the key reversal. A key reversal often has an unusually wide

trading range. Its requirements are a days range outside the previous days range with a close higher than the previous close for anupward turnaround and a lower close for a downward turn.

Here again, this chart formation reects market psychology. A key reversal is the climax of a period of buying or selling fever. Inextremely volatile markets, two or more key reversals may occur. The key reversal on the silver chart dened the top of its rally andsignaled a fall in prices.


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To be a valid key reversal top, trading volume must be heavy and thedaily trading range should be wide. Prices rst surge to new highs, but fallback and close lower for the day.

For a key reversal bottom, the characteristics are the same. The sellingclimax has to have heavy volume with a wide trading range which rstbreaks to new lows, rebounds above the previous days high and closes

higher. Frequently, the highest trading volume and the highest or lowestprice of the year will be set on a key reversal day.

An island reversal takes gaps to the extreme. It receives its name forobvious reasons. An island reversal can be only one day or a few days oftrading above (or below) the previous and following days trading activity.The action is isolated by gaps on both sides. Thus, it leaves a day or a fewdays of price action surrounded by empty space.

The Japanese yen chart shows two island reversals. The I-day islandtop of April 11 marked the climax of a bull move and the beginning offalling prices. The 3-day island reversal bottom in mid-May signaled a haltto the decline and the beginning of a bear market rally.

Island reversals occur less frequently than key reversals. Theexhaustion gap which marks the beginning of the island reversal willremain unlled for a lengthy period because the island reversal is usuallythe climax to an existing trend.

Technical analysis is not an absolute tool. Because it is more an artthan a science, individuals will interpret formations and trends differently.

Thin marketsthose with very low open interest and tradingvolumewill create false technical signals. These markets, as well asdeferred contracts which also have low open interest, should be avoidedby inexperienced traders.

Despite these cautions, technical analysis is a powerful tool and if used

with common sense, can enhance a traders perspective and prots.


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Picturing technical objectives

When prices form pictures on charts, you can obtain realistic objectives for later moves. One of the most reliable chart formationsis the head-and-shoulders top or bottom. This easily recognizable chart pattern is seen in the accompanying weekly gold chart andsignals a major turn in trend.

The main advantage of the head-and-shoulders pattern is it gives you a clear-cut objective of the price move after breaking out of

the formation. Measure the price distance between the head and the neckline, which is $75 in this case, and add it to the price wherethe neckline is broken. This projects the minimum objective. Although the head-and-shoulders gives no time projection, it predicts goldeventually will move to $445.

In most cases, a head-and-shoulders formation will be symmetrical, with the left and right shoulders equally developed. Althoughthe neckline doesnt have to be horizontal, the most reliable formations stray only a little.

Flags and pennants are consolidation patterns which give objectives for further moves. As the formation develops, price action inan uptrending market will look like a ag ying from a agpole as prices tend to form a parallelogram after a quick, steep upmove.Flags y at half-mast. The more vertical the agpole, the better.

A price objective is obtained by measuring the agpole and adding it to the breakout point of the formation, as shown on cornsweekly chart. The agpole should begin at the point from which it broke away from a previous congestion area, or from importantsupport or resistance lines. Flags in a down trending market look like they are defying gravity and slant upward.

Continuation patternsA pennant also starts with a nearly vertical price rise or fall. But, instead of having equal-move reactions in the consolidation phase

like a ag, pennant reactions gradually decrease to form short uptrend and downtrend lines from the agpole.

The same measuring tools used in ags are used in pennants. Add the length of the agpole to the breakout point to get theminimum objective. Remember, ags and pennants are usually continuation patterns in an overall trend which resumes after thebreakout of the consolidation area.

Also, the coil formation, or symmetrical triangle, appears while prices trade in continually narrower ranges, forming uptrend anddowntrend lines. This pattern doesnt tell you much about the direction of the next move. After breaking one of the trendlines, theobjective is found by adding the width of the coils base to the breakout point.

Springing from coilsThe formation gets its name from the way prices contract

and suddenly spring out of this pattern like a tight coil spring.One caution about this formation: Its best if prices break out ofthe formation while halfway to three-quarters of the way to thetriangles apex. If prices reach the apex, a strong move in eitherdirection is less likely.

Ascending and descending triangles are similar to coils butare much better at predicting the direction prices will take. Pricesshould break to the at side of the triangle.

Price objectives from ascending and descending triangles canbe obtained two ways. The easiest is to add the length of the leftside of the triangle to the triangles at side.

Another method of projecting price is to draw a line parallel tothe sloping line from the beginning of the triangle. Expect pricesto rise or fall out of the triangle formation until they reach thisparallel line.


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More objectivesIn the chapter on trends, we mentioned double and triple tops and bottoms. These formations also provide us objectives. Once a

double bottom is completed, prices should rise at least as far as the distance from the bottom of the to the breakout point.

For example, on the T-Bill chart shown on page 9, the double bottom was conrmed when prices closed above the center of theW formation. This is referred to as the breakout. The difference from the bottom of the formation, 87.15, to the top at 87.95 is 80points. Adding 80 points to 87. 95 gives a price objective of at least 88.75. Targets for price declines from double tops are gured thesame way.

Often, prices will retest the breakout point after completing the formation. After a double top is completed, prices may brieyrebound to test the resistance, which is the same point where the original double top was completed.


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If you decided to use the faster 4-day/9-day signal that came on July 23, you would have gotten out of your long position the next daywhen prices ranged between $8.30 and $7.80. The slower signal on July 30 would have gotten you out July 31 between $8.25 and$8.10. In this particular case, both the faster and slower averages got you out of your long position at nearly the same price. But thiswasnt the case in later trading activity.

Bad in congestionNeither method worked well in the congestion phase that lasted until late August. However, a faster signal would have gotten you

into the next upmove 40 cents to 50 cents better than the slower signal. It also would have gotten you out of the position about 50 centsbetter.

After the climb into late September, once again, both methods placed you badly during the reaction. But, from late October, themoving average chart shows you how you can watch the faster averages when prots might reach the windfall stage.

Although the faster signal didnt do well on its rst two signals, it did give a sell signal ve days and about 80 cents earlier than theslower signal before the December crash.

A linearly-weighted moving average also could help eliminate false signals. A 4-day linearly weighted moving average multiplies theoldest price by four, the next oldest price by three, etc., and divides the total by 10.

This weighted average is more sensitive to recent prices than a standard average. The term, linearly-weighted, comes from the factthat each days contribution diminishes by one digit.

The rules for trading a weighted moving average are the same as using a combination of three moving averages. The weightedaverage must be above or below the other moving averages, or the signal is ignored.

A more sophisticated average is the exponential moving average, which is weighted nonlinearly by using a specic smoothingconstant derived for each commodity to allocate the weight exponentially back over prior trading days.

However, it requires high mathematics to determine each optimum smoothing constant.


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Figuring out point-and-gure charts

You know what point-and-gure charts look like: an elongated version of tic-tac-toe. Yet, they provide another means of determininga trend. In fact, their advantage over a bar chart is the specic buy and sell signalsno personal interpretation is needed.

The pork belly chart is shown for the same time period in both bar chart and point-and-gure form. The differences in appearanceare striking. This is due mainly to the lack of a time scale on the point-and-gure chart. Time is irrelevant; price movements are chartedonly when they occur. On days when no new high or low is made, no additional entries are made on the chart.

Also, on a point-and-gure chart, the price scale marks the space between the lines rather than on the lines as bar charts aremarked.

Upward price action in a point-and-gure chart is indicated by Xs; downward movement by Os.

The point-and-gure chart gives a simple buy signal when an X in the latest column has lled a box that is one box higher thanthe preceding column of Xs. A simple sell signal appears when the latest column is in Os, and the Os ll the box below the previouscolumn of Os. These simple signals are marked on the pork belly point-and-gure chart on this page.

Each point-and-gure chart you see will have a box size and reversal number. In this case, it is 40x 6, which means each box isworth 40 points, and it takes a price change of six full boxes in the opposite direction to start a new column. When beginning a newcolumn, the box adjacent to the last entry is always left empty.

Rules for plotting

When plotting Xs, wait for the price to rise to ll the entire box before adding another X to the current column. Likewise, whenworking with a down trending column of Os, wait for prices to drop to ll the whole box before adding another 0 to the column.

Based on a single days price action, you dont add to the current column and then plot a reversal. If you continued the currentcolumn of Xs or Os, dont start a new column based on one days price action.

For example, if the most recent column is Xs, look at the daily high rst. If the high is high enough to require drawing one or moreadditional Xs in the current column, the daily low is ignored, regardless of how low it might be. If the trend has truly reversed, it willbe revealed the following day. Only if you cant add an X do you check the low to see if you can ll the required number of boxes for areversal.


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A similar procedure is used when the current column is Os. Look at the daily low rst and ignore the high if you can add to the 0column. As before, only if you cant add an 0 do you check the high to determine if you can add enough Xs for a reversal. A ow chartfor plotting a 3-box reversal chart is below.

Each vertical column will always have at least the number of Xs or Os needed for a reversal. For example, the pork bellyillustration of a 40 by 6 box size and reversal will always have at lease six Xs or Os in each column.

There are many formations on point-and-gure charts, but breakouts of double or triple tops or bottoms are probably the mostreliable ones. The last rally (the June rally) on the pork belly point-and-gure chart to just over the 70 cents level was a breakout of atriple top.

Trendlines can also be used on point-and-gure charts. Most traders agree that the 45-degree trendline, which cuts each boxdiagonally, is more useful than connecting highs or lows as you do on a bar chart.

An uptrend line is started at the lower right hand corner of the box with an 0 and drawn up to the right at a 45-degree angle. Adowntrend line begins at the upper right hand corner of a box with an X and is drawn down at a 45-degree angle to the right.


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Selective useBreakouts of point-and-gure formations must completely clear the 45- degree line, and, if applicable, move one box higher or

lower than the previous column of like letters.

The disadvantage of point-and-gure charts is that they may be slow to signal trend changes. Since point-and-gure traders arebuying and selling breakouts, follow-through is needed for a protable trade. Similar to moving averages, they dont work well insideways markets.

One way to use the point-and-gure selectively is to ignore minor trend reversals when a new column is started. Some whipsawsmay be reduced by ignoring minor signals unless they are in tune with the major trendline on the point-and-gure chart.


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How you can use the Relative Strength Index

One of the most useful tools employed by many technical commodity traders is a momentum oscillator which measures thevelocity of directional price movement.

When prices move up very rapidly, at some point the commodity is considered overbought; when they move down very rapidly,the commodity is considered oversold at some point. In either case, a reaction or reversal is imminent. The slope of the momentumoscillator is directly proportional to the velocity of the move, and the distance traveled up or down by this oscillator is proportional tothe magnitude of the move.

The momentum oscillator is usually characterized by a line on a chart drawn in two dimensions. The vertical axis representsmagnitude or distance the indicator moves; the horizontal axis represents time. Such a momentum oscillator moves very rapidly atmarket turning points and then tends to slow down as the market continues the directional move.

Suppose we are using closing prices to calculate the oscillator and the price is moving up daily by exactly the same increment fromclose to close. At some point, the oscillator begins to atten out and eventually becomes a horizontal line. If the price begins to levelout, the oscillator will begin to descend.

Plotting the oscillatorLets look at this concept using a simple oscillator expressed in terms of the price today minus the price x number of days

agolets say 10 days ago, for example.

The easiest way to illustrate the interaction between price movement and oscillator movement is to take a straight line pricerelationship and plot the oscillator points used on this relationship, as shown on this pages chart.

In our illustration, we begin on Day 10 when the closing price is 48.50. The price 10 days ago on Day 1 is 50.75. So with a 10-dayoscillator, todays price of 48.50 subtracted from the price 10 days ago of 50.75 results in an oscillator value of -2.25, which is plottedbelow the zero line. By following this procedure each day, we develop an oscillator curve.

The oscillator curve developed by using this hypothetical situation is very interesting. As the price moves down by the sameincrement each day between Days 10 and 14, the oscillator curve is a horizontal line. On Day 15, the price turns up by 25 points, yetthe oscillator turns up by 50 points. The oscillator is going up twice as fast as the price. The oscillator continues this rate of movementuntil Day 23 when its value becomes constant, although the price continues to move up at the same rate.

On Day 29, another very interesting thing happens. The price levels out at 51.00, yet the oscillator begins to go down. If the price

continues to move horizontally, the oscillator will continue to descend until the 10th day, at which time both the oscillator and the pricewill be moving horizontally.

Note the interaction of the oscillator curve and the price curve. The oscillator appears to be one step ahead of the price. Thatsbecause the oscillator, in effect, is measuring the rate of change of price movement.


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Between Days 14 and 23, the oscillator shows the rate of price change is very fast because the direction of the price is changingfrom down to up. Once the price has bottomed out and started up, then the rate of change slows down because the increments ofchange are measured in on direction only.

Three problemsThe oscillator can be an excellent technical tool for the trader who understands its inherent characteristics. However, there are

three problems encountered in developing a meaningful oscillator:

1. Erratic movement within the general oscillator conguration. Suppose that 10 days ago the price moved limit down from theprevious day. Now, suppose that today the price closed the same as yesterday. When you subtract the price 10 days ago from todaysprice, you get an erroneously high value for the oscillator today. To overcome this, there must be some way to dampen or smooth outthe extreme points used to calculate the oscillator.

2. The second problem with oscillators is the scale to use on the horizontal axis. How high is high, and how low is low? The scalewill change with each commodity. To overcome this problem, there must be some common denominator to apply to all commoditiesso the amplitude of the oscillator is relative and meaningful.

3. Calculating enormous amounts of data. This is the least of the three problems. A solution to these three problems is incorporatedin the indicator which we call the Relative Strength Index (RSI):

RSI = 100 100 RS = Average of 14 days closes UP 1 + RS Average of 14 days closes DOWN

For the rst calculation of the Relative Strength Index (RSI), we need closing prices for the previous 14 days. From then on, weneed only the previous days data. The initial RSI is calculated as follows:

1. Obtain the sum of the UP closes for the previous 14 days and divide this sum by 14. This is the average UP close.

2. Obtain the sum of the DOWN closes for the previous 14 days and divide this sum by 14. This is the average DOWN close.

3. Divide the average UP close by the average DOWN close. This is the Relative Strength (RS).

4. Add 1.00 to the RS.

5. Divide the result obtained in Step 4 into 100.

6. Subtract the result obtained in Step 5 from 100. This is the rst RSI.

Smoothing effectFrom this point on, it is necessary to use only the previous average UP close and the previous average DOWN close in calculating

the next RSI. This procedure incorporates the dampening or smoothing factor into the equation:

1. To obtain the next average UP close, multiply the previous average UP close by 13, add to this amount todays UP close (if any)and divide the total by 14.

Steps 3 to 6 are the same as for the initial RSI.

The RSI approach surmounts the three basic problems of oscillators:

2. Erroneous erratic movement is eliminated by the averaging technique. However, the RSI is amply responsive to price movementbecause an increase of the average UP close is automatically coordinated with a decrease in the average DOWN close and viceversa.

3. The question, How high is high and how low is low? is answered because the RSI value must always fall between 0 and 100.Therefore, the daily momentum of any number of commodities can be measured on the same scale for comparison to each other andto previous highs and lows within the same commodity.


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4. The problem of having to keep up with mountains of previous data is also solved. After calculating the initial RSI, only the previousdays data is required for the next calculation.

Just one toolThe Relative Strength Index, used in conjunction with a bar chart, can provide a new dimension of interpretation for the chart reader.

No single tool, method, or system is going to produce the right answers 100% of the time. However, the RSI can be a valuable inputinto this decision-making process.

PriceCharts.com (30 Day Trial) plots the 14-day RSI, updating the chart through Thursday of each week. Contrary to popularopinion, the choice of the number of market days used in calculating the RSI doesnt really matter because the smoothing nature of theexponential averages reduces the effect of the early days as more data is included.

To help you update the RSI values until the next issue of the charts arrives, we list the up average and down average as ofThursday on each RSI chart.

Simplied formulaThe procedure outlined earlier for beginning and updating RSIs is from J. Welles Wilders book, which made the RSI a popular

technical tool. The following is a simpler and faster method of computing the RSI. The results are the same as Wilders morecomplicated method.

To begin a new RSI, just list the changes for 14 consecutive trading days and total the changes. Divide these totals by 14, and you

will have the new up and down average. Then proceed with this formula:

RSI = 100 xU

U + D

U = up average; D = down averageThe example below is for T-Bills.

Date Up Down1/28 +411/29 - 22/1 -60

2/2 - 72/3 + 22/4 + 12/5 + 62/8 -262/9 +112/10 +142/11 0 02/12 -112/16 +282/17 -18Total 103 124

103 / 14 = .074 = Up ave.1.24 + 14 = .089 = Down ave.

RSI = 100 x .074 = 45.39 163

To calculate the next days RSI, multiply the up average (.074) by 13. Add the change for the day, if it is up. Divide the total by 14. Dothe same for the new down average. Multiply the new down average (.089) by 13. Add the change for the day, if it is down. Divide totalby 14.
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Then, proceed with the formula:

RSI = 100 x U

U + D

For example, if T-Bills closed up 25 points the next day, calculate the new RSI as follows:

New Up ave. =.074(13) + .25 = .087

14

New Down ave. = .089(13) + 0 = .083

14

New RSI = 100 x .087

.087 + .083

RSI = 51.2

Learning to use this index is a lot like learning to read a chart. The more you study the interaction between chart movement and theRelative Strength Index, the more revealing the RSI will become. If used properly, the RSI can be a very valuable tool in interpretingchart movement.

Some of its usesRSI points are plotted daily on a bar chart and, when connected, form the RSI line. Here are some things the index indicates as

shown by examples from the silver chart.

Tops and bottomsThese are often indicated when the index goes above 70 or below 30. The index will usually top out or bottomout before the actual market top or bottom, giving an indication a reversal or at least a signicant reaction is imminent.

The major bottom of Aug. 15 was accompanied by an RSI value below 30. The major top of Nov. 9 was preceded by an RSI valueabove 70. The top made on Jan. 24 was preceded by an RSI value of less than 70. This would indicate this top is less signicant thanthe previous one and either a higher top is in the making or the long-term uptrend is running out of steam.

Chart formationsThe index will display graphic chart formations which may not be obvious on a corresponding bar chart. Forinstance, head-and-shoulders tops or bottoms, pennants or triangles often show up on the index to indicate breakouts and buy and sellpoints.

A descending triangle was formed on the RSI chart during October and early November that is not evident on the bar chart. A

breakout of this triangle indicates an intermediate move in the direction of the breakout. Note also the long-term coil on the RSI chartwith the large number of support points.

Failure swingsFailure swings above 70 or below 30 (illustrated in Fig. 3 and 4) are very strong indications of a market reversal.

After the RSI exceeded 70 during October, the immediate downswing carried to 65. When this low point of 65 was penetrated thefollowing week, the failure swing was completed.

After the low of Aug. 15, the RSI shot up to 41. After two downswings, this point was penetrated on the upside on Aug. 26,completing the failure swing.


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Support and resistanceAreas of support and resistance often show up clearly on the index before becoming apparent on the barchart. Trendlines on the bar chart often show up as support lines on the RSI. The mid-November break penetrated the uptrend line onthe bar chart at the same time as the support level on the RSI chart.

DivergenceDivergence between price action and the RSI is a very strong indicator of a market turning point and is the single mostindicative characteristic of the Relative Strength Index. Divergence occurs when the RSI is increasing and price movement is either ator decreasing. Conversely, divergence occurs when the RSI is decreasing and price movement is either at or increasing. Divergencedoes not occur at every turning point.

On the silver chart, there was divergence between the bar chart and RSI at every major turning point. The top made in Novemberwas warned by the RSI exceeding 70, a failure swing and divergence with the RSI turning sideways while prices continued to climbhigher.


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Stochastics

Like the Relative Strength Index (RSI), stochastics is another popular oscillator to gauge price momentum and judge the age of aprice move. Stochastics is not a new oscillator. Stochastics was perfected by Dr. George Land and is one of the oldest studies usedtoday.

But unlike the RSI, which measures momentum based on the changes in daily settlement prices, stochastics has two lines and the

calculations are based on the rate of change in the daily high, low, and close. The concept for stochastics is based on the tendencythat as prices move higher, the daily closes will be closer to the high of the daily range. The reverse is true in down trends. As pricesdecrease, the daily closes tend to accumulate closer to the lows of the daily trading range. This concept also holds true on daily, weeklyand monthly charts.

Stochastics can be calculated for any time period. Choosing the right time period for the stochastics is similar to choosing the rightnumber of days for a moving average. In effect, stochastics is a trend-following method since its lines will cross after tops and bottomshave been made. Choosing too short a time period will make the stochastics so sensitive that it becomes virtually worthless. If the timeperiod is too long, it is too slow to turn and too insensitive to be useful.

Since an RSI and stochastics for the same length of time would give similar signals, we chart a 14-day RSI and 20-day stochasticsin PriceCharts.com (30 Day Trial) . The longer period for the stochastics reduces the number of false signals generated by a short-termoscillator. Also, this 20-day period will correlate more closely with a cycle that is present in many futures markets.

To construct a stochastics chart, we need to calculate three valuesthe raw value, %K, and %D. These values are plotted on a scalefrom 0 to 100. When the raw value and the %K are plotted on the same chart, the result is fast stochastics, which shows many up anddown swings in a very short period of time. When the % K are plotted on the same chart, the result is fast stochastics, which showsmany up and down swings in a very short period of time. When the %K and the %D are used, as in PriceCharts.com ( 30 Day Trial), youhave slow stochastics, which smoothes the data.

In the chart service, we publish the numbers for the raw value, %K and %D as of Thursday and the formula for guring the dailyupdates. The formula for the stochastics raw value is:

100 x last close - 20-day low

20-day high - 20-day low

%K is a 3-day smoothed moving average of the raw value, and the %D is a 3-day smoothed moving average of the %K. Use thefollowing formula to nd the new %K.

2/3 previous %K + 1/3 new raw value

The formula for the new %D line is:

2/3 previous %D + 1/3 new %K
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Note that we must have 20 days of information before we can begin guring the raw value. For clarity, the 20-day high is the highestprice for the commodity during the last 20 days, and the 20-day low is the lowest price for the last 20 days, not the high or low 20 daysago.

When beginning a new stochastics chart, you will not have a previous %K and previous %D. Therefore, on the rst day ofcalculations, %K and %D are initially assigned the same number as the rst raw value. This will help you quickly approach the truevalues for the %K and %D. Within 11 days, you will have %K and %D values which are within 1% of the actual number. If the data isfavorable, you will be within 1% in a week.

In the table on this page, we have listed the daily high, low and settlement prices for the September S&P 500 index. The last threecolumns are for the raw value, %K and %D. For this example, lets begin by working through the formula as though we were starting anew stochastics chart.

Well begin our calculations on Feb. 25. The highest price for the 20-day period was 191.80 on Feb. 13, and the lowest price was183.70 on Jan. 28. The close on Feb. 25 was 188.00. Put these numbers in the formula for the raw stochastics.

Raw Value = 100 x188.00 - 183.70

191.80 - 183.70

Raw Value = 100 x4.30

8.10

Raw Value = 53.09

After nding the raw value of 53.09 on Feb. 25, you also give this 53.09 value to the %K and %D for this rst day of calculations.Notice on the next day, the 20-day high is the same, but the 20-day low is a new number, because you go back only 20 days to nd thehigh and low. The raw value for Feb. 26 is 75.00. New %K and %D calculations are as follows:

New %K = 2/3 x 53.09 + 1/3 X 75.00New %K = 35.39 + 25.00

New %K = 60.39

While most people use a computer to calculate stochastics, it can be easily gured with just a calculator. In guring these by hand,weve noticed it saves time if you rst go through your data and gure the raw values for several days, and then go back and calculatethe %K and %D.

Comparing the data in the table with data from our computer, it took only until March 1 to be within 1% of actual values for %K and%D.

Stochastics signalsIn PriceCharts.com (30-Day Trial), we plot the %K with a solid line and the %D with a dashed line. Traders use the action on the

stochastics charts in several ways, including the following:

Divergence. Like the RSI, the %D line may diverge with the price action to warn of a potential top or bottom. If prices make a newhigh, but %D does not, a top may be near. The opposite is true at bottoms.

Both bearish and bullish divergence are shown on the accompanying S&P chart. Theres bearish divergence in late February whenS&P prices make a new high but the %D line stays far below its winter high. This divergence accurately warned that a top was forming.An equally good signal of a bottom was the bullish divergence during the spring. The S&P was making new lows into early May, but the%D line held above the lows made during March.
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Overbought/oversold zonesMarkets seldom go straight in one direction without a pause or correction. When prices move upand appear to be ready to correct, the market is called overbought. When prices have been moving down and appear to be ready torebound, the market is oversold. As a mathematical representation of a markets overbought or oversold condition, stochastics tells youwhen prices have gone too far in one direction.

Values above 75 (in the shaded area) indicate the overbought zone. Values below 25 (also shaded) indicate the oversold zone.(Some traders prefer using 80 and 20 as the parameters for overbought and oversold markets.) In sustained moves, stochastics valuesmay remain in these shaded areas for extended lengths of time.

Buy/Sell signalsThere are at least two popular ways traders use stochastics for buy and sell signals. A conservative approach isto wait for both the %K and %D to come out of the shaded area to issue the signal. For sell signals, a conservative trader waits for bothlines to rise into the overbought zone and then fall below 75 again. An opposite pattern is followed for a buy signal. After both lines dropbelow 25, the buy signal is given when the stochastics lines climb above 25 again. This is a more conservative approach because youwill be slower in taking a position, but it may eliminate some false signals.

For more aggressive traders, the buy and sell signals on the stochastics charts are generated when the two lines cross. For mosttraders the buy and sell signals are ashed when %K crosses %D, as long as both lines have rst gone into the overbought or oversoldzones. This is similar to the buy and sell signals of two moving averages.

Waiting for the stochastics lines to come out of the shaded area will sometimes prevent false signals. For example, you werewatching for a buy signal on the stochastics chart for the NYSE composite index during the August-September period, %K crossed the%D line in early August and at least ve more buy signals were given before the trend nally turned up in early October. An aggressivetrader who went with the rst crossing of the lines would have been stopped out at least a couple times before nally getting on boardfor a good move up. But the more conservative trader would have been waiting for both lines to climb out of the oversold area beforebuying, thus avoiding the whipsaw signals in August and September.


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Oscillators are notoriously unreliable in signaling trades against the trend. For good stochastics signals, youll need to trade with thelonger-term trend. Follow only the buy signals in uptrends and only the sell signals in bear markets. However, in a trading range market,stochastics will give good buy and sell signals.

Buy and sell signals are shown on S&P 500 chart. With stock indexes in an overall uptrending pattern, the stochastics buy signalwould have helped traders establish long positions on the buy signals in November, December and March. The sell signals in February,June and July could have been used to take prots on long positions.

Some traders prefer to see the %K line cross the %D line on the rightside. This is called a right-hand crossing. In other words, %K is crossing%D after %D has bottomed or topped. When the %K crosses the %Dline before the %D has bottomed or topped, it is referred to as left-handcrossing. Of course, this can only be seen in hindsight because, atthe time the two lines intersect, you dont know if the %D has reachedits ultimate top or bottom. Left-hand crossings are not as common asright-hand crossings. You can see a left-hand crossing on the S&P chartin early February. The %K dipped below the %D before the %D hadreached its ultimate peak.

Stochastics is a very useful technical indicator which helps you with

your timing, especially when it is used in conjunction with the othertrading tools described in this booklet.


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Average Directional Movement Index

Although the average directional movement index (ADX) isnt used as frequently as some of the popular technical indicators, theADX line has denite advantages because it lters out a lot of the false oscillator signals which are frequently given early in a move.

A longer-term trader can stay with trending positions longer by following the simple guidelines for the ADX line. A climb by the ADXline above 40 followed by a downturn signals an imminent end to the current trend (whether up or down). When this signal is given,

traders should take prots on existing positions. More aggressive traders can use this signal to consider taking positions for a possiblemove in the opposite direction.

The charts on this page show how the ADX works. The ADX line on the feeder cattle chart gave two signals during the year. The rstdownturn accurately marked the top in February, and the second downturn above the 40 level signaled a bottom in late summer. Notethat the signal in late July was actually more than a month ahead of the actual bottom in September. The ADX warns you of an end tothe trend. In this case, it gave you more than a months warning.


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Like the feeder cattle signals, crude oils ADX gave two signals during the year, one at the summer low and the second at thewinter high. Both signals were given by climbing above 40 and turning down.

The ADX signals by feeder cattle and crude oil signaled the end of one trend and the beginning of a new trend. But the ADX is notdesigned to signal a trend reversal. It only signals the end of the existing trend. A good example of not signaling a trend reversal isT-Bonds. The end of the strong spring rally was accurately marked by the ADX signal in June. Then T-bonds consolidated in a coiluntil the upside breakout in the fall. An ADX climb above 40 and downturn in November signaled another consolidation.

Usually, a commodity gives no more than a couple ADX signals during a year, unless the market has particularly volatile priceaction.

The ADX is less helpful during sideways markets, During extended consolidation periods, the ADX line will slip toward 10, WhenADX approaches 10, a major move is usually about to take place. But the ADX line doesnt tell you which direction it will go. You haveto rely on other indicators for the probable direction of the next move.

The ADX is part of the direction movement system introduced by J. Welles Wilder in his book, New Concepts in Technical TradingSystems. Wilder introduced a 14-day ADX, and Babcock has not found any good reason to vary this time period. We are plotting a14-day ADX line in PriceCharts.com (30-Day Trial).

In summary, if the market is trending (whether up or down), the ADX line should be rising. During an extended consolidationperiod, the ADX line will slip toward a low number.
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Cycles

Everything in nature moves in cycles ... the cycles of the seasons ... night and day ... tides ... phases of the moon. Each year animalshibernate ... geese migrate ... salmon swim upstream to spawn ... and every seven years lemmings run into the ocean.

While natures cycles are very visible, there are many cycles in the futures markets that are not quite as obvious. Often the reasonsome cycles are not easily seen is because the interaction of many large and small cycles makes individual cycles harder to see.

Cycles are the tendency for events to repeat themselves at more or less uniform intervals. One of the easiest cycles to see andunderstand is the seasonal cycle. Agricultural commodities have a repetitive annual price pattern called the seasonal price cycle. Morethan 70% of the time, the lowest cash prices of the year for corn, cotton and soybeans occur during the fall harvest period. Due toincreased marketings, cattle and hogs also have price weakness during the fall. Wheat and oats tend to make seasonal lows duringtheir summer harvest. Seasonal price trends are a reection of regular annual changes in supply and demand factors caused byweather, production and demand.

After a seasonal cycle has bottomed, a trader knows prices should not drop below the seasonal low until after the seasonal high hasbeen made, normally several months later. After the seasonal cycle has topped, the uptrend is over and prices should move lower untilthe seasonal cycle bottoms. Traders who know the direction of the seasonal cycle are able to follow the protable maxim of trading withthe trend.

Keep in mind there are sometimes some surprising differences in the seasonal pattern of cash and futures prices for agriculturalmarkets. Futures markets try to anticipate the cash market due to expected production and expected demand. Therefore, futures

market may bottom as much as two months ahead of the cash market. For example, the hog futures market may bottom in August,anticipating the fall low for the cash market, but the cash hog market may not bottom until October.

While the causes of seasonal cycles are known, the causes of other cyclical patterns are not always known. The Foundation for theStudy of Cycles (124 South Highland Ave., Pittsburgh, PA 15206), a nonprot organization, has catalogued thousands of cycles usingdetrending processes. Some of the longer-term cycles they have identied include the 9- year wheat cycle, the 5-year com cycle, the5-year cycle for precious metals, the 25-month and 38-month soybean cycles, the 11-year cattle cycle, and the 4-year business cycle.


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The theory of cyclical analysis is that events will occur within a cycle to move prices in the expected direction of the cycle. The basicdrawback of fundamental analysis is that the events causing changes in supply and demand are not known until after the factwellafter tops and bottoms have occurred. All fundamental information relative to supply and demand is in the market each trading day. Butthe market usually moves before the fundamental reasons are known. Cycles help traders pick the direction of price moves before thenews comes out.

To analyze a futures market based on cycles, it is necessary to isolate the dominant cycles affecting price activity. Once these

dominant cycles have been identied, future price expectations can be established by combining the effects of these dominant cycles.Long-term cycles, such as the yearly cycles identied by the Foundation for the Study of Cycles, tell you the direction of the overallprice trend. Shorter cycles, weekly and daily, can then be used to determine when long-term cycles have topped or bottomed and whento enter and exit a market.

Most markets have a dominant short-term daily cycle which may be as short as 14 calendar days or as long as 35 days. Most of themeats and grains, for example, have a short-term cycle averaging 28 calendar days.

Combing two or more of these short-term daily cycles forms a dominant intermediate-term weekly cycle which runs 6 to some 20weeks from low to low, depending on the futures market. When the short-term cycles are combined with a larger cycle, the smallercycles will look like the drawing at the bottom of this page.

Cycles are seldom symmetrical, and their patterns differ in bull and bear markets. In a bull market, the crest of the cycle tends tolean to the right because the highs are to the right of the midpoint of the cycle. This is called right translation. In strong bull markets, thelength of the cycles tend to contract (shorten) slightly.


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Just the opposite is true in a bear market. In bear markets, thecycles tend to be slightly longer than they were during bull markets.Cycles in bear markets tend to peak early in the cycle to the left ofthe midpointcalled left translation. Note the 13-week cycle fromAugust to November on the K.C. May wheat had right translation upto the seasonal high and left translation coming down from the winterseasonal high. Right translation quickly followed by left translation isoften the way a longer-term cycle high is made. Seasonal lows areoften made the way Dec. hogs bottomed in September with extremeleft translation followed by extreme right translation.

Trendlines are also an important tool to conrm cyclical tops andbottoms. Penetration of a trendline drawn from the crest of two cyclesof similar length conrms that the next longer cycle has bottomed.In bull markets, breaking an uptrend line connecting the lows of twosimilar length cycles will conrm that the next longer-term cycle hascrested.

The wheat charts on these pages are a good example of repetitivepatterns which are helpful in protably trading a market. For the long-term perspective, these charts show wheat when it was decliningtoward the 9-year cycle low, which is expected the next summer. Thecurrent seasonal cycle began in August, topped in December and isexpected to bottom with the 9-year cycle the following summer.

Near the 13-week cycle low in February, intermediate-termtraders would be taking prots with plans to sell again as the next13- week cycle crests. The next cycle high is likely to come early (lefttranslation) because the dominant 9-year and seasonal cycles arepointing down. The crest of the 13-week cycle may be made with thecrest of the rst 28-day cycle out of the February low. This 13-weekcycle should bottom again about 13 weeks from the February low,which would put the expected low in May (plus or minus 15%). Thenext 13-week cycle low would be due in another 13 weeks in August,which would be the most likely time for the seasonal cycle lows.


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On the Chicago July wheat chart, three 28-calendar-day cycles make up the 13-week wheat cycle. Breaking the uptrend lineconnecting 28-day cycle lows conrmed the 13-week cycle high in November. The winter seasonal high was conrmed during theJanuary collapse when prices dropped below the previous 13-week low (Nov. 25 low). The 13-week cycle low in February wasconrmed by breaking the downtrend line connecting 28-day cycle highs. Shorter-term traders would be trading the 28-day cycle highsand lows in the direction of the intermediate-term cycle.

In PriceCharts.com (30 Day Trial), we have space to show only one of the cycles that is affecting the price activity for the contractscharted on the large format pages. Where we have two large charts for the same type of market, we are able to show a couple ofdifferent dominant cycles. For stock index futures, we show the short-term 21-calendar-day (16 trading day) cycle on the S&P 500chart. On the NYSE composite index chart, we are showing a dominant weekly cycle, which has been running from 6 weeks to 10weeks in length. For the wheat market, the Chicago wheat chart has the 28-calendar-day cycle; the lead K.C. wheat chart has the 13-week cycle. In the pork complex, the nearby pork belly chart has the 28-day cycle; the hog chart shows the 9- to 13-week cycle.

The cycles shown in PriceCharts.com (30-Day Trial) are usually easy to see at a glance without having to use detrending to identify.

Cycles are most accurately measured from low to low. It is not unusual for a cycle to have a variation of plus or minus 15% of thelength of the cycle, and expectations should be established accordingly. While the most probable times for cycles to top and bottom canbe established, cycles do sometimes stretch, shrink and, on occasion, disappear. It is a common feature of cycles to correct themselvesas time passes. A cycle that runs too short, for example, might then make an adjustment by running longer on its next repetition.Chicago July wheat had two short cycles in September and October, which was followed by a cycle that ran more than ve weeks frommid-October to late November.
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Other Commodity Research Bureau Publications:

50 Rules of Futures Trading

Charting Tools for Professional Traders

Guide to Technical Indicators - Volume 1

Guide to Technical Indicators - Volume 2

Guide to Trading


How to Use Charts to Forecast Futures Prices

To order, please contact us at 1.800.621.5271 or 1.312.554.8456Fax: 312.939.4135 Email: [email protected]
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hot to spot profitable timing signals

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