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4. Commodity Futures Trading Chart Patterns

There are two approaches to analyze the markets. One uses technical analysis, and the other uses fundamental analysis.

Technical analysis is the art of forecasting future price direction by analyzing commodity futures trading chart patterns. All the information you need to know about the commodity regarding supply and demand is "baked" into the price. These commodity futures trading chart patterns use price to reflect supply and demand forces in the market. Price only goes in one of three constantly changing directions: Up, Down, and Sideways. Big profits can be obtained by the technical trader who approaches the market scientifically. Technical Analysis gives you an edge when you can consistently identify trends and time your entry and exit to profit from them.

Fundamental analysis looks at all factors which affect production and consumption of the commodity in order to determine if price will rise or decline. I believe that doing a fundamental analysis on any commodity is a waste of time because not all factors can be known by one individual – rendering the analysis incomplete. In addition, certain forces deliberately release deceptive information for publication in order to influence and manipulate you into making the wrong trading decisions. Most news is propaganda for special interests. Don't risk your money on the obvious.

Monitoring raw price data is very cumbersome and not very useful. However, when price data is presented in a graphical or chart form it is more useful because:

You can see the direction of price movement
Price patterns which suggest market buying and selling pressures are more visible
You can easily identify the current price trend and when changes in trend occur

Price is charted on commodity futures trading chart patterns (either daily, weekly, or monthly – each providing a different historic perspective) with a vertical line and two attaching horizontal nubs at each side of the vertical line. This is illustrated in Figure 4-1. The nub extending to the left of the vertical line identifies the opening price and the nub extending to the right identifies the closing price. The top of the vertical line identifies the highest price of the day and the bottom of the vertical line identifies the lowest price of the day. Price which is charted on the weekly or monthly charts represent the average for the week or month. The daily price is like a battlefield. It identifies if the buyers or sellers are in control of the day's trading.

Open. The first price traded that day.

High. The highest price traded that day.

Low. The lowest price traded that day.

Close. The last, or closing price, traded that day. Also called the settle.

Change. The difference between the previous day's closing price and today's closing price. It's not unusual to see a disparity between one day's close (settle) and the next day's opening price.

A. Support and Resistance

Price trend is analyzed with trend lines drawn on the price chart by you. These trend lines are used to monitor the price changes in trend behavior. Because trends persist for long periods, a position taken with the trend will more likely be successful that one taken randomly or against the trend. The most reliable trends proceed at a 45 degree angle. In uptrending markets, the close price is higher than the open price.

Support and resistance levels identify highs and lows, trends, changes in trend, and also identify trading objectives and where to place protective Stop-Loss orders. The idea is that past support and resistance points suggest where there was sufficient force to oppose further price change in that direction. They also make ideal points to enter the market.

An uptrending movement in price has a line drawn by you underneath price bars of the price chart – identifying support. You would buy the dips (i.e., when price pulls back temporarily) to get a favorable entry price.

A downtrending movement in price has a line drawn by you on top of the price bars of the price chart – establishing resistance. You will sell the rallies (i.e., when price rises temporarily) to get a favorable entry price.

A trading range is a sideways price movement. It has two lines drawn by you, both on top and bottom, to define the support and resistance of the channel.

If the price has broken the trend line, considerable force (i.e., major market influence) was required to do so. A change in trend will most likely continue for some time. However, unexpected occurrences can change price trends abruptly, and without warning. For example, Orange Juice may be trending downward but a freeze warning can quickly cause price to trend upward and perhaps in a volatile manner.

B. Price Chart Patterns

There are several commodity futures trading chart patterns that occur frequently enough that they repeat with a high degree of probability and provide good indication of a likely change in trend. Although no pattern is ever 100% correct, it gives you some idea of how to analyze and interpret price behavior to benefit from an impending price move. Some patterns are hard to visualize so you need a good imagination.

Your job as a commodity futures speculator is to track and monitor commodity futures trading chart patterns and identify those commodities that are likely to be your best trades. Study the charts as though you were a general in the field of battle watching for a strategic move, and watch for those patterns to unfold that have proven themselves in the past.

C. Common Price Patterns

Commodity futures trading chart patterns display fluctuating prices over periods of time. Prices can only move up, down, or sideways. Prices also tend to move in identifiable patterns. You get a different perspective between a daily chart, a weekly chart, and a monthly chart.

Study these different perspectives because they will help you to spot an opportunity, create a sound plan, establish your position in the market, and provide for contingencies. You only have to spot specific opportunities, and know what to do when you see them. You need to trade the market that is set up now. Wait for the right time and conditions.

A "–" (dash) on a price chart means a limit move in price occurred on that day. It tells you that price either rose or dropped the maximum amount allowed by the Exchange. Limit moves beget more limit moves. A reversal of this pattern points to a market opportunity. This topic is covered more In Chapter 6.

Major price moves are punctuated by retracements of a portion of the current trend. The market "catches its breath" by giving up some of the gains and tends to correct about 40-60% of the move in many cases. When a market's trend is very strong, retracements tend to be brief and shallow, and are about 40% rather than 60%.

D. 1-2-3 Top / 1-2-3 Bottom

Every commodity has only one high point and only one low point during each year. The 1-2-3 Top and 1-2-3 Bottom technique is used to spot major market tops and bottoms. When a market makes a new 12-month high or 12-month low, it's a signal to start monitoring that market's price trend for a change, looking for a trend reversal.

1-2-3 Top

To spot the potential market top of any futures price, watch for a new highest price during the past 12 months (point #1).

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Watch for price to drop below that point #1, and then rise again (leaving behind point #2). As price rises from point #2 it approaches (but never reaches) point #1. Price then starts to drop, forming point #3.

However, if price exceeds the #1 point, you need to start over. This can happen when a head-and-shoulders pattern (described shortly) develops. If the price can't break the #1 point, the trend will very likely change.

When price drops towards point #2, place your open order to go short (sell) a futures contract at a price somewhere below point #2. At the same time, also place your stop-loss order slightly above either point #1 or point #3. When price drops below point #2, this is a bear signal that suggests a change in trend is likely to occur. If price declines, your open order is activated and you are in the market.

When trading on the short side, call your broker and tell them to move your stop-loss down as price moves down in your favor and profit accumulates. Keep lowering that stop-loss point to either further limit your losses, or to help lock in any profit you've already earned.

Placing your stop-loss too close to the current price will cost you potential profit. The more profit you accumulate, the farther behind you can afford to place your stops. Ideal places to put your stop-loss order are at a previous resistance point on the chart.

The ideal time span for the 1-2-3 Top or Bottom price pattern to develop should be at least two weeks or more, otherwise it's too far, too fast!

1-2-3 Bottom

To spot the potential market bottom of any futures price, watch for a new lowest price during the past 12 months (point #1).

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Watch for price to rise above point #1, and then drop again (leaving behind point #2). As price drops from point #2 it approaches (but never reaches) point #1. Price then starts to rise, forming point #3.

When price rises towards point #2, place your open order to go long (buy) a futures contract at a price somewhere above point #2. At the same time, also place your stop-loss order slightly below either point #1 or point #3. When price rises above point #2, this is a bull signal that suggests a change in trend is likely to occur. If price advances, your open order is activated and you are in the market.

When trading on the long side, call your broker and tell them to move your stop-loss up as price moves up in your favor and profit accumulates. Keep raising that stop-loss point to either further limit your losses, or to help lock in any profit you've already earned.

Placing your stop-loss too close will cost you potential profit. The more profit you accumulate, the farther behind you can afford to place your stops. Ideal places to put your stop-loss order are at a previous support point on the chart.

A 1-2-3 Top or Bottom can actually be a double-top or double-bottom. This is where point #2 equals but doesn't exceed point #1.

E. How to Calculate a 50% Retracement Objective

Ok, you're in the market – now what? Without a previously established and specific trading goal, it is foolish to be in the market.

Knowing where the markets may tend to be heading, and where they tend to turn around, helps you to trade more successfully. Using these market tendencies, you can identify and establish a trading objective.

The 50% Retracement Rule means price tends to retrace (or reverse its direction) by 50% of its current major move. To determine the 50% level, add the High Price and the Low Price of the last major move and divide by 2.

High + Low ÷ 2 = 50% target

The result is the likely target objective. The 50% level is a good indicator of how far prices may go. It is wise to close out your position once the 50% objective is reached. Don't be greedy!

F. How to Calculate (and quantify) Risk vs. Reward

Commodity futures trading is also a thinking person's game. You need to go beyond the 50% calculation and ask still another question. Is the potential profit of trade worth the risk? The greater the ratio of profit to risk, the better the trade.

Look at the distance between the #1 point (stop loss) and the #2 point (entry price) to consider how much you are risking vs. the first target objective (50% retracement).

To help quantify risk vs. reward, use the following procedure:

Add the High + Low of the recent price move and divide the sum by 2 to identify the 50% retracement target objective.
Take the 1-2-3 pattern's Point #1 and subtract Point #2. Multiply the result by the commodity's point value. The result is the risk amount.
If you intend to go long, subtract Point #2 from the 50% target. Multiply the result by the commodity's point value. The result is profit.

If you intend to go short, subtract the 50% target from Point #2.

Multiply the result by the commodity's point value. The result is profit.
Divide profit by risk amount. The result is the ratio.

Use the following ratios as a guide:
```
ratio             evaluation
-----------       -----------------
2.0 or less       use an option
2.0 - 2.9         Poor opportunity
3.0 - 4.9         Good opportunity
5.0 - up          Great opportunity
```
Anticipating a 50% retracement of prices, the distance from Point #2 (your entry price) to the 50% level would be the initial profit expectation. The closer the entry price is to the 50% target, the less the profit potential. (In other words, some 1-2-3s are better than others).

G. Trading Range

When a market's price is in a trading range (also called a narrow sideways channel), this is a signal that there isn't much interest in that market right then. This is a trading opportunity you shouldn't ignore. Because traders need time to be convinced that they should put their money into the market, channels are more likely to occur near the bottom of a price move.

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When price breaks out of the channel, the price movement will tend to continue in that direction. Set your stop-loss order just beyond the middle of the channel, away from the direction of the breakout. Gaps (described shortly) also help to identify when price is breaking out of a channel, and in which direction the breakout is occurring.

A base is a long trading range that is formed during a period of accumulation, and typically occurs at the bottom portion of the price chart. The longer the consolidation period, the greater the rally after the breakout.

Trading range rule of thumb: The upside or downside breakout of the channel will carry prices in a one-to-one (1:1) ratio. That is, if the trading range is 20 squares wide on the price chart, when price breaks out of the channel it will frequently rise or fall 20 squares. This gives you an idea of a likely price objective for the move.

H. Gaps

When a market becomes more volatile, the market price will open higher or lower than the previous day's close leaving a gap on the price chart. Gaps often occur at the onset of a major price move. Price tends to retrace and fill the gap sometime in the future before continuing. Gaps that remain unfilled become future chart objectives.

Gaps can serve several purposes. They are used to:

Spot the beginning of a move
Measure a move (suggest how far price is likely to go)
Signal the end of the move
Signal market strength and weakness
Indicate likely buy or sell points

With gaps, if you're long, you place a stop-loss below the gap. If short, place the stop-loss above the gap. Exactly where? This depends on each commodity and its personality. You need to paper trade (covered in a later chapter) to learn the characteristics of each commodity.

There are 4 types of gaps:

Common gap:

The most frequently occurring gap. Whenever a gap occurs within a trading range, it is of no significance.

Breakaway gap:

Occurs outside of a trading range and it marks the beginning of a significant move. It's a signal that price is heading further in that direction. This type of gap remains unfilled for a long time. Heavy Volume breakaway gaps are usually important levels of support and resistance over the long-term as well.

Measuring gap:

The measuring gap gives you a way to determine the next market objective. It typically occurs in the middle of a price move and can predict how much farther price may go. Measure the distance from the breakaway gap to the measuring gap. This distance extends from the measuring gap in the trend direction to project how much farther price will likely go.

Exhaustion gap:

This gap often signals the end of the move. Although prices may continue further in the trend direction, the rally will not last long. An extreme exhaustion gap may form an island reversal (described shortly)

Note: Information about the following price chart patterns and how they are used is only available in the complete Commodity FUTURES Trading Home Study Course^TM.