From the August 01, 2010 issue of Futures Magazine • Subscribe!

How to use charts to trade today's markets

Traders have relied on charts to forecast various markets since there have been markets to trade. While many different forms of charts were available, from standard bar charts to candlesticks to line chart and everything in between, there always seemed to be some hidden ancient charting method that held the secret to success. However, through all this one thing remained constant: the markets. They opened in the morning and closed in the afternoon...period. That was, until the internet opened the door to globalized trading.

Electronic trading was introduced on Globex in 1992 and allowed traders to participate in virtually any market in the world that was open, whether from a booth on the floor of an exchange or the comfort of their own home or office, regardless of the difference in distance or local time.

As the sun rises on one continent and sets on another, the same thing occurs in the markets; one country’s markets begin trading as another country’s ends. While there are overlapping periods of active trading as well as dead zones where there is a dearth of liquid markets, it’s close enough to have market access for nearly 24 hours per day starting on Sunday evening through Friday evening in the United States.

As access to the various world markets evolved, so did the trading industry, giving traders the ability to participate in any market with just the push of a button. The internet and online trading provided virtually unlimited access through computerized matching, which eliminated the need for a floor broker to execute the trade, eventually leading to a virtual explosion in overnight volume. This ease of access incentivized exchanges to add additional trading sessions to almost every market through an electronic session after the floor closed.

As the overnight/off hours sessions grew in popularity, a dilemma in charting appeared. Traders had long used the open/high/low/close based on the open outcry session in their daily analysis and were reluctant to change. When questioned why they were ignoring the after hours sessions, they would quickly point out the huge swings that sometimes occurred at night which would trigger orders based upon whatever technical ingredients they were using.

Many traders and brokers discredited the night sessions, saying that they were subject to stop running and randomness. However, over the last few years the off hours sessions have gained credibility with growth in both volume and liquidity.

By 2004, analysis on both traditional open outcry hours as well as a combined session chart of the same market showed that the same trading techniques used in an open outcry environment worked just as well after hours.

The transition occurred in stages. Even as trading moved to an electronic platform, many technical trades continued to use the traditional floor hours as their technical inputs. That is changing as many now use the 4 p.m. CST close for forex markets.

In 2010, the floor volume is drying up in many markets and has been eliminated in the softs traded at the Intercontinental Exchange (ICE). Looking at an open outcry session chart in July corn vs. a combined chart shows that a majority of the trading volume has migrated to the electronic side because of faster execution times, transparency and lack of slippage (see “One market, two sessions,” below).

chart

Comparing the two charts, chart development can be seen on the combined chart as well as what appears to be a more liquid market, which is evident by the lack of gaps between trading sessions. In the old days, traders would zero in on gaps whenever they occurred due to the market’s tendency to backtrack and fill the gaps shortly after they occurred. Now the gaps that occur on the open outcry charts really show no evidence that the market is even aware that they exist.

Traditional floor hours are still the most liquid time to trade. The highs and lows between traditional hours and the expanded hours will be different, of course, but if you are using a combined chart to do your analysis, you would take that into consideration and place your orders based upon the same methodology that you would if 24-hour trading didn’t exist.

In the case of using mechanical trading analysis, only minor changes were necessary in a 21-year old trading method to adjust to the expanded hours. Instead of executing a new trade on the open, we use a support or resistance filter to trade an individual market. While we still place and trail our stops as we always have, taking into account the Globex highs or lows in our analysis, the use of stop loss or contingent orders may not protect profits or limit losses to the amounts intended. Certain market conditions make it difficult or impossible to execute such orders.

Most of the markets’ trading ranges have increased because they are trading at levels rarely seen before 2008, but they are still maintaining a proportion of progression better in an electronic market than what we see during the traditional hours, even though volume drops during off hours.

Everything else has remained pretty much the same in our analysis; we use the same moving averages we used for the last two decades, only now they are based on the close of the electronic market. The expanded hours have not made any real difference in our results.

The amount of hours that a market is open doesn’t really change the way we analyze a market. We still look at the open/high/low/close, support and resistance in the same manner, only the hours have changed.

Another problem involves the continuous charts traders use to monitor long-term price movement to define trends for trading systems. They are attempting to back test a trading system’s parameters on a futures market like they would on an individual stock. The problem is that futures markets trade contracts that expire every month or every quarter and traders usually will want to trade the most liquid contract. Further out contracts trade at either a premium (contango) or a discount (backwardation) to the current lead month contract. The difference in price can be significant and is based on carry costs such as storage, transportation and interest rates.

When a commodity contract goes off the board, a continuous chart picks up the next contract in its data accumulation and smooths the difference to avoid showing a gap. Unfortunately, the next contract’s price doesn’t start where the previous contract left off, so the chart will look like the market either rallied or sold off , creating a disparity in the reality of the pricing because the market never actually traded at the prices shown. When a trader runs out of time, he will roll the expiring contract by simultaneously selling (if long) the contract he owns at the market while buying the next contract out. It’s a very rare thing that these two prices are the same.

The problem comes when using a long-term continuous chart to detect technical signals. The smoothing function can create false prices that appear to breach support and resistance levels and send false signals. Technical traders must adjust for these anomalies to properly use the data. Every approach needs to be constantly monitored and possibly tuned up to adjust for a market’s ever changing nature in both price and volatility.

Paul Brittain is the branch manager of Whitehall Investment Management Las Vegas and has been a broker for 27 years.

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