WHAT IS TECHNICAL ANALYSIS?

Technical analysts confine their prognostication of future price trends solely on the analysis of price activity. The price of a futures contract, they contend, reflects the impact of every single bit of fundamental information known by anyone who can even remotely affect the price of the commodity. Every fact that is known about supply, demand, and, most importantly, the psychology of the public ends up on the price charts. Therefore, price action is the composite opinion of everyone involved in the markets. That is why learning to analyze price action is so important to anyone trading stocks, futures, or options. The function of technical analysis is to determine through the analysis of price change the probable strength of demand compared with the pressure of supply on a futures contract at various price levels and then to predict the direction, length, and velocity of the next move.

HISTORY REPEATS ITSELF IN PATTERNS AND FORMATION
In the commodity markets, history does repeat itself. Past price action can provide clues about future price action. On commodity price charts and indexes, price movements tend to repeat themselves with remarkable consistency. You’ll learn that some patterns or formations indicate that demand is greater than supply. Others suggest the reverse is true. And some imply that supply and demand will remain indefinitely in balance. This occurs for two reasons. First, technical analysis can be a self-fulfilling prophecy. It is self-fulfilling because so many professionals use it. They all see the same patterns and often expect the same results. Therefore, if enough of them act the same way to the same chart signal, the signal fulfills its promise. This occurs regularly with the most common and widely known signals. Second, the market is anticipatory, and you can see price movement first in the charts. For example, major buyers, like the Chinese, have been known to go long the futures market before they announce a big grain deal. They enter the futures market to cover their cash sale. Therefore, the first alert that something is about to happen often occurs on the futures price charts. Entering the market causes a price movement before the fundamental facts are known. Technical analysts are alerted in advance, before the fundamental information is public. Supply and demand factors are still the prime movers, and yet technical analysis is the earliest indicator of movement. If you use technical analysis, you don’t have to understand or acquire all the fundamental information in the world in order to trade. The impact of all the activity affecting price comes to you in the form of price movement. If you don’t understand what is causing the price movement, you can exit the market until you do. IS IT FOOLPROOF? There is no infallible system—technical or fundamental—for trading the futures markets. Chart signals, just like fundamental news, can be misleading. You don’t always have to be right to enjoy trading futures and options, but you need to have structure in your approach to the markets. Technical analysis can give you that structure (see Figure 6.2.). Since technical analysis is probably the only forecasting technique an individual investor can utilize, it is important to know the most common tools and signals. Fundamental analysis, because of the enormous amount of information necessary and the enormous amount of time required to absorb all the fundamental factors, is usually too costly and time-consuming for individual investors. There are basically four general approaches to technically analyzing commodity markets: (1) price charts, (2) trend following, (3) structural, and (4) character of market. The first two are the most widely used and recognized. Price chart analysis involves finding chart formations or patterns that often repeat themselves, such as reversals, support-resistance areas, head and shoulders, continuing formations, and others. 10 Technical Analysis Trading Rules
1. When a trend is established, it is likely to continue.
2. The longer term the chart (15 minute, hourly, daily, weekly, monthly), the more reliable the trend line.
3. The greater the volume of trading when a trend in established, the greater its significance. 4. In uptrending markets, when prices move too far too fast, trading volume decreases and prices decline.
5. In downtrending markets, volume is higher when prices are declining than when they rally.
6. Markets tend to give warnings before major trend changes occur.
7. If a market is in an uptrend, volume usually drops just prior to it reversing its direction.
8. Volume usually increases in downtrending markets, just before a reversal of trend. 9. Before they plunge through their trend lines, markets tend to test them by making shallow penetrations. These dips are warnings of impending trend reversals.
10. The steeper the trend, the more unstable it is and the more likely a reversal of trend is imminent.

Trend-following types of analysis include trend lines and moving averages.
Structural analysis presumes the market itself moves in established, recognizable patterns—seasonal, cyclical, or wave patterns being the most common. Once the analyst can exactly locate the current position of the market, a prediction can be made on the next move or price objective. Character-of-market analysis is more sophisticated, because it attempts to measure the quality of a price movement and then take a position that may be opposite the current trend. The other types of analysis try to spot existing trends or certain formations that are reliable harbingers of future price activity.

TECHNICAL ANALYSIS SIGNALS AND CHART FORMATIONS
There are 18 basic technical analysis signals and chart formations that you should be aware of: trend lines, rounded bottoms, consolidations, tops, bottoms, support, resistance, retracements, reversals, head and shoulders, continuation formations, triangles, coils, boxes, flags, pennants, diamonds, and moving averages.

THE TREND LINE
The most common technical analysis tool is the trend line. Prices tend to follow straight lines. They almost cling to them. If they bounce off a line, they are drawn back to it. There are sound psychological reasons why prices trend.
A trend line is a line drawn between at least two points on a price chart. Uptrend lines (see Figure 6.3) should be drawn so they connect lows and are drawn below prices. Downtrend lines (see Figure 6.4) connect highs and are drawn above prices. Sideways trend lines (see Figure 6.5) are drawn below prices and connect lows.

Why Do Prices Cling to Straight Lines?
It is simply human nature. A trader will resist paying more for a commodity than others are willing to pay unless there is some reason to believe it will continue to increase in price. The converse is equally true.
Therefore, if a price is going up, traders will watch the trend. As long as it moves higher, buyers will continue to buy. If it increases a little too fast, buyers hold back and the price returns to the trend line. The more buying (volume) taking place, the more confidence traders have that prices will continue to rise.
Everyone is more comfortable when others are behaving the same. This is referred to as herd psychology. Sometimes the herd psy- chology can be quantified through the measurement of volume and open interest. Volume is the total number of contracts traded in a day. Open interest is the number of contracts outstanding at the end of a trading day.
Other human psychological tendencies also come into play. The inventory manager, who is responsible for buying a commodity for a company or a country, increases purchases as prices go up, out of fear that prices will be even higher in the future. This increases consumption.
The person who owns the commodity holds out for higher prices when prices are seen to be increasing. This reduces the supply. And the uptrend continues.
The Law of Price-Trend Inertia
Human resistance to change has a strong impact on trends. Nobody wants to be the first one to go against the crowd. This brings us to rule 1. When a commodity is found to be following a trend, it is likely to continue along on that trend. Spotting trends is simply a matter of drawing trend lines on price charts. The key to technical analysis is recognizing which trends are significant and reliable. Technical analysis is more of an art than a science.
Rule 2 says the longer the term of the chart, the more reliable the trend line. Atrend line on a monthly price chart is more reliable and significant than one on a weekly chart. One on a weekly is better than one on a daily, and a daily means more than an hourly. The reason is that the longer something lasts, the more comfortable it seems, and the less likely we are to want to change it. How Do You Confirm a Trend Is a Trend?
One of the answers is volume. The more trades behind a price move, the stronger the conviction there is in the marketplace of the trend. This is rule 3. The greater the volume, the greater the significance of a price trend.
Volume also tells you when traders think prices are moving too far or too fast. In these two situations, volume decreases and prices reverse. For example, in the normal uptrending market, when prices move too far above the trend line, volume will decrease until prices return to the trend line. Conversely, in a downtrend, the volume is usually greater when prices are falling than when they are rallying. These are rules 4 and 5. Markets are like rattlesnakes. They make a noise before they bite. Each time an established trend line is penetrated, it’s a warning that the market may reverse. This is rule 6. Substantial changes in volume are another rattle from a market that it is about to reverse. Rule 7 notes that if the market is in an uptrend, volume usually decreases before a reversal. If it is a downtrending market, rule 8 notes that volume usually increases before it reverses. The reason is that prices can fall from their own weight, but they need constantly increasing buying activity to trend higher. The first sign to look for when a market is changing direction is a violation of the trend line. A small dip below an uptrend doesn’t necessarily mean the trend has changed, but it is a warning (rule 9).

Other Formations
There are several different types of trend lines besides the basic up, down, and sideways. There is the fan formation, for example (see Figure 6.6). It is a series of trend lines extending from the same point, but drawn at different angles.
The fan trend-line formation develops when an established trend line is broken, but the price continues to move in the same direction, forming a new trend line. This can happen two or three times, and rarely four or more times (rule 10). After the third, be very alert.
It also occurs when prices heat up. Each successive trend line becomes steeper and steeper as a market heads for a blow-off top. The internal trend line is an interesting formation. It develops out of a broken uptrend line. After the uptrend is broken, the market retraces, and eventually the highs are attracted to the bottom of the old trend line. This is also an example of the “pullback” effect. What Does All This Mean to a Trader?
Trend lines are your basic signals for whether you should be on the long or the short side of the markets. Additionally, they tell you how much conviction traders have in their positions. They warn you when investors are losing faith in their positions. They tell the contrary trader what the herd thinks about where prices are headed.
The trend can be your friend—if you learn how to read it. Always analyze it in light of volume and open interest. (There’s more on volume and open interest later in this chapter).