Chapter 12 - Technical Analysis of Futures Markets

Question 1

What is the commitments of traders (COT) report?

Answer 1

A report released by the Commodity
Futures Trading Commission that shows
the number of futures contracts held by
large commercial, large non-commercial,
and small traders.

Question 2

What is the CONSENSUS Index of Bullish Market Opinion?

Answer 2

A survey, published by CONSENSUS Inc.,
of major professional brokers and advisors,
showing the percentage that are bullish on
each futures market.

Question 3

What is the continuous contract chart?

Answer 3

A chart that links prices of only one
contract month from year to year; for
example,
Dec 2005 gold linked to Dec 2006 gold.

Question 4

What is the continuous (spread-adjusted) chart?

Answer 4

A chart that links futures contract months
by adjusting prices to discount the spread
between the contracts.

Question 5

What is the nearby chart?

Answer 5

A continuous chart that connects the
nearby, closest-delivery futures contract; as
one contract month stops trading, the chart
begins plotting the next contract month.

Question 6

What is open interest?

Answer 6

The number of futures contracts at any
given time that have not been settled by
either an offsetting transaction or delivery.

Question 7

What is seasonality?

Answer 7

The tendency of certain markets to show
weakness and strength at certain times of
the year on a reliable basis.

Question 8

What are the unique characteristics of futures markets and what implications do these characteristics have for technical analysis?

Answer 8

• Futures markets have the following unique characteristics:
  – availability of leverage
  – contracts have limited lives
  – prices include a cost of carry or are based on expectations of the future spot price
  – commodity futures can exhibit seasonality
  – statistics available on the open interest and the types of traders holding positions
• Technical analysis of futures markets must consider:
  – importance of market timing;
  – need for long-term charts that smooth out the transition from one contract month
  to the next;
  – significance of open interest and volume;
  – breakdown of open interest; and
  – seasonality of different commodities.

Question 9

Explain the importance of timing in the futures markets.

Answer 9

• Timing is very important when trading futures for a variety of reasons, including the
  availability of leverage and the short-term nature of futures contracts.
• The use of leverage can cause large losses in a very short period of time. Therefore,
  correctly timing market entry and exit points becomes even more important.
• Because futures have expiration dates, timing is crucial.

Question 10

What are the three kinds of longer-term charts you learned how to create in this chapter? What are the pros and cons of each method?

Answer 10

• The three longer-term types of futures charts are nearby charts, continuous contract
  charts and continuous (spread-adjusted) charts.
• Nearby charts simply plot the price of the nearest-term futures contract.
• Continuous contract charts plot the price of the same contract month from year-to-
  year.
• Continuous (spread-adjusted) charts link the prices of different contract months by
  applying a “premium” or “discount” to a new contract’s price.
• Nearby contracts have the advantage of displaying the true price of each contract; the
  disadvantage is that the chart will display price distortions from contract to contract
  that cannot be captured by a trader.
• Continuous contract charts have the advantage of dampening any seasonal distortions
  in price; the disadvantage is that any differences in price due to non-seasonal factors will
  still cause price distortions, which can be large.
• Continuous (spread-adjusted) charts have the advantage of displaying true price moves
  from contract month to contract month; the disadvantage is that the true price level will
  not be shown.

Question 11

Explain the implications of seasonality and cycles.

Answer 11

• Established seasonal and/or cyclical trends should be used in conjunction with other
  market analysis tools.
• If seasonal and/or cyclical tendencies do not confirm a signal from other forms of
  analysis, special caution should be taken.

Question 12

Explain how one can use the concepts of open interest, commitment of traders, and bullish consensus numbers.

Answer 12

• Changes in open interest signal changes in the flow of “money” into or out of a market.
• Increasing open interest means that new positions are being established, while
  decreasing open interest means that positions are being liquidated.
• To confirm a move in either direction, open interest should increase.
• The Commitment of Traders (COT) report breaks down the open interest in a futures
  contract by type of trader.
• Three types of traders are identified: reportable commercial (i.e., large hedgers),
  reportable non-commercial (i.e., large speculators), and non-reportable (i.e., small
  hedgers and speculators).
• The COT report can be used in a direct fashion or as a contrary indicator.
• When used in a direct fashion, market participants will follow the lead of the large
  traders and will do the opposite of the small traders.
• As a contrary indicator, market participants will watch for large positions being built
  by large traders. The theory is that if the large traders are significantly invested in one
  direction, there probably isn’t much room for the market to move further, and prices
  must eventually move in the opposite direction.
• The CONSENSUS Index is a survey of market participants’ bullishness on each futures
  contract.
• It is mainly used as a contrary indicator; a reading of 75% or more is bearish, while a
  reading of 25% or less is bullish.

Question 13

What does it mean to “roll over” a futures contract?

Answer 13

Rollover is when a trader moves his position from the front month contract to a another contract further in the future. Traders will determine when they need to move to the new contract by watching volume of both the expiring contract and next month contract.

Question 14

What is the front month?

Answer 14

The term “front month” refers to the nearest expiration date in futures trading. It is commonly used when describing futures or options contracts with earlier expiration dates.

Question 15

What is the main purpose of the futures contract?

Answer 15

A futures contract allows an investor to speculate on the direction of a security, commodity, or financial instrument, either long or short, using leverage. Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.

Question 16

What is an offset?

Answer 16

An offset is a financial market strategy that requires a trader to take an opening position and then take a directly opposite position. For example, if you are long 100 shares of XYZ, selling 100 shares of XYZ would be the offsetting position. Offsetting transactions can occur in any market, but typically offsetting transactions refer to the options, futures, and exotic instrument markets. An offsetting transaction can mean closing a transaction or taking another position in the opposite direction to cancel the effects of the first.

Question 17

What are notice days?

Answer 17

A first notice day (FND) is the deadline date after which an investor who has purchased a futures contract may be required to take physical delivery of the contract’s underlying commodity. The first notice day can vary by contract and will also depend on exchange rules.

Question 18

Describe the unique characteristics of futures contracts.

Answer 18

1. Traders have the opportunity to use very heavy leverage.
2. Futures contracts have limited lives.
3. Futures prices differ from spot prices in that they reflect either the spot price plus cost of
   carry or expectations of where the underlying spot price will be by expiry.
4. Contracts that have commodities as their underlying asset exhibit a fair degree of seasonality.
5. Statistics are kept on the number of contracts outstanding (open interest) and are
   categorized by type of trader.
   As a result of these characteristics, the analysis of futures markets must consider the following:
   * importance of market timing (due to leverage and the contract’s limited life)
   * need for long term-charts that smooth out the transition from one contract month to the
   next
   * signifi cance of open interest and volume as they relate to price action
   * composition of open interest (the breakdown between large and small trader positions)
   * seasonality of different commodities

Question 19

How does leverage magnify both percentage gains and losses?

Answer 19

Traders are attracted to the futures market by the extreme leverage that can be used. Based on
current margin requirements set by the exchanges where the futures contract trades, the margin
required for gold futures, for example, is US$4,400 (subject to change by the exchange) or about
5% of the size of the contract.
Leverage magnifies both percentage gains and losses. A trader who buys gold futures at $880
(all figures in U.S. dollars) by depositing the minimum margin requirement of $4.400, and
eventually sells at $850 has lost $30 per ounce or $3,000 per contract (each contract is for
100 ounces of gold). In percentage terms, the trader has lost 68% of their margin deposit
($3,000/$4,400). If the trader had deposited the full contact value of $88,000 ($880 × 100
ounces) rather than the minimum margin requirement of $4,400 (i.e., did not use leverage), the
percentage loss would only have been 3.41% ($3,000/$88,000).

Question 20

What is cost of carry?

Answer 20

Cost of carry is the amount of additional money you might have to spend in order to maintain a position. This can come in the form of overnight funding charges, interest payments on margin accounts and forex transactions, or the costs of storing any commodities on the delivery of a futures contract.

Question 21

Summarize volume and open interest interpretations.

Answer 21

• If prices are rising and open interest is rising, the market is considered bullish (new money is
  coming into the market and pushing prices higher).
• If prices are rising and open interest is falling, it is bearish (this pattern suggests no new
  money is coming into the market, but rather short sellers are merely buying back their sales
  and once completed, there may not be any buyers left).
• If prices are falling and open interest is rising, the market is bearish (new money is coming
  into the market and driving prices lower).
• If prices are falling and open interest is falling, it is bullish (this pattern implies no new
  sellers are coming into the market, but rather prices are falling as traders liquidate their long
  positions).