Futures For You
INSIDE THE FUTURES WORLD

Want to learn how the futures markets really work? Dan O'Neil, a principal at online futures and forex broker Xpresstrade (www.xpresstrade.com), responds to your questions about today's futures markets.

To submit a question, post your question to our website at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Dan O'Neil

TECHNICALITIES

It doesn't seem like you can trade commodities without at least some knowledge of technical analysis. What are some of the more popular technical indicators to incorporate into my research?

There's no question charting and technical analysis play significant roles in the futures markets. Even traders who focus on the fundamentals tend to incorporate some technical analysis into their decision-making. Trading based at least in part on the established statistical movement of some markets can spare a trader not only from the emotional swings of trading, but the confusion of weeding through a conflicting picture as well.

When you're beginning to look at technical analysis, remember: each futures market has its own trading personality, and a combination of charting strategies is often needed to identify and confirm trading opportunities. While every trader has his or her own preferred studies and methods, four common indicators generally constitute the basic building blocks of most technical analysis. Here's a look at several of the most popular technical studies among individual futures traders.

Moving average convergence/divergence (MACD): The MACD is used to measure short-term momentum. The MACD tends to be one of the earliest generators of buy & sell signals, providing a tipoff of flagging momentum in a given market trend. The MACD is calculated by taking the difference between two exponential moving averages, typically the 26-day and 12-day averages.

One of the most common ways to use the MACD is to buy or sell a futures contract when it crosses the signal line, or zero (sell when the MACD falls below the signal line, or buy when it climbs above the signal line). The MACD can also be used to identify an overbought or oversold market. When the shorter moving average moves away from the longer moving average (the MACD rises), it suggests that current movement in a particular direction may begin to wane and soon return to more realistic levels. The MACD divergences from the trend of the futures price may also signal a trend reversal.

Relative strength index (RSI): The RSI is used to measure the velocity of directional movement, but it does not, as its name might suggest, compare the relative strength of different futures markets. Instead, this indicator measures the internal strength of a single futures contract, plotting a value from zero to 100. The RSI above 70 is generally considered overbought and indicates a sell signal, while below 30 is considered oversold and implies a buy. Some traders use the RSI to identify the long-term trend and use extreme readings for entry/exit points. If the long-term trend is bearish, overbought readings could represent potential points at which to establish or add to shorts.

Another method of analyzing the RSI is to look for divergences between the underlying futures market and its RSI. For example, if the futures contract is rallying to a new high but the RSI fails to surpass its previous high, the possibility of a false breakout and an impending price reversal must be considered.

Stochastics: The stochastic indicator can help identify whether bulls or bears are in control of a market. Stochastics can point out short-term price fluctuations to determine whether the current price level is sustainable or on the verge of the reversing course. Oscillators like stochastics can help pinpoint entry or exit points by signaling potential turning points as well as indicate a broader, more significant upturn or downturn in the trend.

Using a scale of zero to 100, the most common way to analyze stochastics is to sell when the reading is above 80, suggesting overbought conditions, and to buy when the reading is below 20, which may imply an oversold market. The direction of the stochastics should confirm price movement (rising stochastics confirm a rising futures price). Divergence occurs when the stochastic values are moving in one direction and the futures price is moving in the other, which could imply a turning point in the market, such as where prices are making a series of new highs and the stochastic indicator is failing to surpass its previous highs. A false breakout may be afoot if a new high in price is reached without a new high in stochastics.

Bollinger Bands: Bollinger Bands behave like moving averages and are plotted at two standard deviations above or below the moving average, typically using either the simple moving average or an exponential moving average to increase the sensitivity of the indicator. Bollinger Bands not only help identify relative price levels and volatility, they can also be combined with price action and other indicators to generate signals and act as a precursor to significant moves.

Traders typically use Bollinger Bands to detect unsustainable price moves, capture changes in trend, target support & resistance levels, and spot contractions or expansions in volatility. Some traders believe that when prices break above or below an upper or lower band, it is an indication a breakout is occurring and will then take a position in the direction of the breakout. Others use Bollinger Bands as an indicator of overbought and oversold conditions. When a price touches the top of the band, traders assume the futures contract is overbought and will sell futures, believing it will ultimately revert back to the mean. Conversely, if the price touches the bottom, traders figure the market is oversold and will rally back toward the top of the band and thus buy futures. The spacing or width of the band is dependent on the volatility of the prices; higher volatility is typically characterized by a wider band, while lower volatility results in a narrower band.

Originally published in the August 2007 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.

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