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Technical Analysis Theory

 

Is there a pattern to commodity prices? Can you predict future prices based upon past performance? These questions are ones every commodity market participant wonders about. To answer these questions requires study of the factors that influence market prices. To accomplish this task there are two methods available to the market analyst, fundamental and technical.

Fundamental analysis is based upon the traditional study of supply and demand factors that cause prices to rise or fall. Such factors include drought, flood, war, politics, exchange rates, inflation and deflation. The previous section on supply & demand and stocks/use ratios are methods used by fundamentalists to arrive at an estimate of the equilibrium market price of a commodity over time in order to determine if the current market price is over or undervalued.

Technical or chart analysis, by contrast, is based upon the study of the market action itself. While fundamental analysis studies the reasons or causes for prices going up or down, technical analysis studies the effect of the price movement itself. Technical analysts claim that markets do trend and that by charting market prices you can control commodity price risk management. They further claim that by combining the use of price charts with appropriate marketing tools and pricing strategies can have a major positive impact on your profitability and, therefore, the long-term survival of your business. Charting can be used by itself with no fundamental input, or in conjunction with fundamental information. You will find that as you become more skilled in charting and technical analysis that the illusion of randomness in the commodity market will gradually disappear. This will lead to more confidence in making those very crucial marketing decisions.

In this section of the course you will learn what technical theory is, how to construct daily, weekly, and monthly bar charts. You will also explore the basic concepts of trend, trend-lines, price support, price resistance, volume and open interest. Finally you will learn how to use all of these tools to confirm price action or to warn of impending price trend changes as you do some price forecasting of your own.

 

The ability to make commodity price forecasts is only the first step in the price decision-making process. The second, and often more difficult step, is market timing. Since commodity futures markets are so highly leveraged (initial margin requirements are generally less than 10% of a contractís value), minor price moves can have a dramatic impact on trading performance. Therefore, the precise timing of entry and exit points is an indispensable aspect of any market commitment. Timing is everything when dealing in the commodities markets, and timing is almost purely technical in nature. This is where a practical application of charting principles becomes absolutely essential in the price forecasting and risk management process.

There are three basic assumptions on which technical analysis is based:

1. The futures market discounts everything.

The technician believes that the price posted on the board of a commodity exchange at any given time is the intrinsic value of the commodity based upon the fundamental factors affecting the supply and demand of the product. Therefore, if the fundamentals are already reflected in the price, market action (charts- price, volume, open interest) is all that is needed to forecast future price direction. Although not knowing the specifics of the fundamental news, the technician indirectly studies the fundamentals by studying the charts, which reflect the fundamentals of the marketplace.

2. Prices move in trends

Prices can move in one of three directions, up, down or sideways. Once a trend in any of these directions is in effect it usually will persist. The market trend is simply the direction of market prices, a concept that is absolutely essential to the success of technical analysis. Identifying trends is quite simple; a price chart will usually indicate the prevailing trend as characterized by a series of waves with obvious peaks and troughs. It is the direction of these peaks and troughs that constitutes the market trend.

3. History repeats itself

Technical analysis includes the psychology of the market place. Patterns of human behavior have been identified and categorized for several hundred years and are repetitive in nature. The repetitive nature of the marketplace is illustrated by specific chart patterns, which will indicate a continuation of or change in trend.

The bar chart is the type of chart most commonly used by technical analysts. The horizontal scale on the bottom of the chart indicates the passage of time. The time scale can be anywhere from minutes to years, with the most popular scale being the daily bar chart, the weekly bar chart and the monthly bar chart. The daily bar chart indicates the range of prices for one dayís trade, as measured on the vertical scale of the chart. The "bar" is the range of price for a particular time period; for a daily bar chart, the top of the bar represents the highest value for the day while the bottom of the bar represents the lowest value for the day. Attached to the bar are two tics, one extending to the left and one extending to the right. The left tic represents the opening price for the trading day and the right tic represents the closing or settlement price for the day

The daily bar chart is used for short term marketing decisions, and is extremely useful for timing entry and exit points when designing a marketing strategy. (For example when to trigger a hedge position when profitable prices are available or where to place a protective stop on a speculative position)

For a weekly chart the price range is for one week, Monday to Friday. If a holiday occurs during the week only the data available for the week is used. The top of the bar represents the highest value for the week and the bottom of the bar represents the lowest value for the week. The tic to the left is the opening price for the first trading day of the week, usually Monday, and the tic to the right is the settlement price usually the close of trade on Friday.

The monthly chart includes the range of trade for an entire month, from the first trading day of the month to the last trading day of the month, with the opening and closing prices being the values for the first and last day of the trading month respectively.

The weekly and monthly charts are used for a longer-term perspective of the markets, and are extremely useful for market planning purposes. For example, if market prices as indicated on the monthly chart are at historical lows, sales of commodities should be delayed while if prices were historically high, a more aggressive approach to marketing would be undertaken.

Two other important pieces of information are usually included on a bar chart - Volume & Open Interest. Volume represents the total amount of trading activity that took place in a commodity for a period of time, one day on a daily bar chart, one week on a weekly bar chart, and one month on a monthly bar chart. The volume is plotted as a vertical bar extending upward from the bottom of the chart, directly under the price bar for that day. The further the volume bar extends upward into the chart the more trading volume has taken place. Open interest represents the total number of outstanding or un-liquidated contracts in a commodity at the end of a trading day. A purchase and a sale are required to establish a contract position, thus the open interest is the total of either the outstanding purchases or sales, not both. Open interest is plotted as a solid line above the volume bars on the price chart, with a vertical scale indicating the total number of contracts outstanding.

 
 
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