1

Futures Markets By M. Metghalchi

Introduction

Agricultural futures contracts were introduced on the Chicago Board of Trade (CBOT) during

the 1860s. After the Collapse of the Bretton Woods Agreement in 1971, Chicago Mercantile

Exchange (CME), Another Chicago Futures Exchange, began trading currency futures contracts

in 1972. The CME introduced in 70’s the interest rate future and then in early 1980s the stock

index future. The following are major world's futures and options exchanges:

1. The International Monetary Market (IMM), a subsidiary of CME

2. The Philadelphia Board of Trade (PBOT)

3. The Bolsa Mercadorias & de Futuros in Brazil

4. The London International Financial Futures Exchanges (LIFFE)

5. The Marche a Term des Instruments Financiers (MATIF)

6. The Singapore International Monetary Exchange (SIMEX)

7. The Tokyo International Financial Futures Exchange (TIFFE)

In summer of 2007 the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange

(CME) merged to form CME Group Inc. (the world’s largest futures exchange).

Futures

Futures are all about future prices. People who trade futures essentially trade agreements

(obligations) about how much they will buy or sell something (Underlying Product) for a

specific price at a specific date in the future – most contracts have an expiration date in March,

June, September and December, although oil contracts have monthly expiration dates. These

agreements are contracts that also specify the quantity and other details of the commodity being

traded.

Underlying Product: initially were created for agricultural products, however, today almost

everything has a future contract.

Therefore futures contracts are worldwide meeting places of buyers and sellers of an ever-

expanding list of products that includes financial instruments such as U.S.Treasury notes, bonds,

stock indexes (S&P500, Dow, Nasdaq), and foreign currencies (Euro, Yen,) as well as traditional

agricultural commodities (Corn, Wheat, soybeans), metals(Gold, Silver, Copper), and petroleum

products (Crude, Rbob, Gasoline, Heating oil, Natural gas).There is also active trading in options

on futures contracts allowing option buyers to participate in futures markets with known risk.

Futures contracts can be traded either in a pit (open outcry) or electronically. Generally, only

one type of contract is traded in each pit. For example, there's a T-bond pit, a Nasdaq 100 pit, an

2

S&P 500 pit, and many others. Whether trades are executed in the pits or matched

electronically, the trading process in both cases consists of an "auction" in which all bids and

offers on each of the contracts are made known to the public and traders can see that the market's

best price prevails. Futures prices, whether arrived at either through open outcry or by electronic

matching of bids and offers, are immediately and continuously relayed around the world.

Electronic order placement is increasingly being used in many markets. Most futures traders now

can trade electronically from their home 24 hours a day.

We have two types of futures contracts:

1. Contracts that require physical delivery of a particular commodity. The commodity is

specifically defined, as is the month when delivery is to occur.

2. Contracts that call for an eventual cash settlement. This means that contracts are settled in

cash rather than by delivery at the time the contract expires. For example Stock index futures

contracts are settled in cash on the basis of the index number at the close of the final day of

trading. Delivery of the actual shares of stock that comprise the index is not required.

Most futures contract will be closed before expiration, in other words, futures markets are rarely

used to actually buy or sell the physical commodity or financial instrument being traded; they're

used for risk management, and for some people, investment and profit.

Raison d’etre of futures markets (Primary purpose):

The primary purpose of the futures markets is to provide an efficient and effective mechanism

for RISK MANAGEMENT. By going long or short a futures contract that establish a known

price now for a purchase or sale that will take place at a later time, individuals and businesses are

able to achieve protection against adverse price changes. This is called hedging. Simultaneously,

other futures market participants are speculators

Therefore, we have two major types of players: "hedgers" (those seeking to minimize and

manage price risk) and "speculators" (those willing to take on risk in the hope of making a

profit). If you trade for your own financial benefit, you are a speculator. If you have risk

associated with the underlying commodity and trade futures to manage this risk, then you are a

hedger. This interaction between hedgers and speculators, each pursuing their own goals, helps

to provide active, liquid, and competitive markets.

A speculator job is to buy low and sell high, or sell high and buy low in order to make profits.

Speculators include:

Small investors. A person like you, who would like to make a killing in the futures

markets. They trade part time in various market by buying and selling various futures

contracts.

Professional traders. Many individuals devote 100 % of their time in speculation of

various markets. The use heavily futures markets.

3

Hedge fund managers. Many hedge funds speculate on some specific market and use

heavily futures contracts.

Some speculators use the services of a professional trading advisor by establishing a fully

managed trading account or by participating in a commodity pool that is similar in

concept to a mutual fund.

Speculation in futures contracts is very risky and not appropriate for everyone. Although

it is possible to realize a very high return in a short period of time, it is also possible to

loose losses almost all of your capital in a short period of time. The reason for possibility

of high profits or losses in relation to the initial commitment of capital is the fact that

futures trading are highly leveraged form of speculation. Only a relatively small amount

of money is required to participate in the price movements of assets having a much

greater value. Anybody can open a future account by initial capital of $5,000 and start

trading.

On the other hand, hedgers trade futures to manage cash market risk. Therefore for hedger,

making a futures trading decision also involves cash market decision. For example if Continental

Airline buys jet fuel futures as a hedge, the Company has concluded that cash jet fuel prices will

be higher when the Company has to buy jet fuel later on. Or if a wheat producer sells wheat

future as a hedge, this producer has decided that cash wheat prices will be lower down the road.

Or hedgers may use futures to lock in an acceptable margin between their purchase cost and their

selling price.

Example of Hedge:

Houston jewelry manufactures Gold Bracelet and need to buy additional gold from his supplier

in nine months. During this coming 9 months, he fears the price of gold may increase and given

his published price, he could be hurt. Today’s cash price is $530 per ounce. He goes to future

market and buys Gold future, delivery 9-month, he buys one future contract at a price of, say,

$550 an ounce.

If, nine months later, the cash market price of gold has risen to $600, he will have to pay his

supplier that amount to acquire gold. However, the extra $70 an ounce cost will be offset by a

$50 an ounce profit when the futures contract bought at $550 is sold for $600. So the Jeweler

some hedged himself. Had the price of gold declined instead of risen, he would have incurred a

loss on his futures position but this would have been offset by the lower cost of acquiring gold in

the cash market.

Other example of hedging: A cattle feeder can hedge against a decline in livestock prices buy

buying future cattle feeder. Borrowers can hedge against higher interest rates, and lenders

against lower interest rates buy selling and buying bonds. Investors can hedge against an overall

decline in stock prices buy selling stock index future. And the list goes on.

Whatever the hedging strategy, the common denominator is that hedgers willingly give up the

opportunity to benefit from favorable price changes in order to achieve protection against

unfavorable price

What Futures Are Not:

4

Futures are not Stocks. Futures are agreements (not ownership) that will end at the expiration

date whereas stocks are assets that one can keep forever.

Futures are contracts, not shares. The supply of futures contracts is unlimited. Every time a buyer

and a seller make a trade, a contract has been created.

The word margin in stock trading means that you are borrowing money and paying interest,

however in futures accounts, the margin is the amount of money that you need to have in your

account to trade a future contract, it is really a GOOD-FAITH deposit.

Futures are different than options in that, options give the owner the RIGHT, not the

OBLIGATION, like futures contract.

OPENING AN ACCOUNT:

A lot of paperwork is involved to open a future account. You will open an account with a

brokerage firm, also known as a future commission merchant, FCM, (Or Introducing

Broker). In these paper works you will disclose:

Your financial position

Your level of knowledge and experience in future trading

Your broker will:

Disclose risk associated with futures trading.

Describe the right and responsibility of the client and the broker

Type of account:

You may open an individual account, joint account, corporate account, trust account, limited

partnership account, and requirement account.

Since September 11, 2001, the accounts are screened much more closely.

Once an account has been approved, the customer must fund the account from a bank account

with the same title as the futures trading account. FMCs usually don’t accept third party checks,

or funds originating from a source different than the account owner.

Although futures accounts with FCMs are not insured, FMCs must segregate customer

funds from the rest of the firm’s money. FMCs are limited in how they may invest those

extra funds (above margin requirement) to earn interest.

Unlike securities industry, FMCs cannot require customers to binding arbitration.

Customers may go to Commodity Futures Trading Commission, CFTC or National

Futures Association or bring a lawsuit.

5

The Future Contracts Versus Forward Contracts

Forward Contracts and forward rates:

It is possible for economic agents to agree today to exchange currencies at some specified

time in the future, (1 month, 3 months, 6 months, 9 months, 1 year the most common). The rate

of exchange at which such a purchase or sale can be made is known as forward exchange rate.

Nonstandardized maturities (such as 40day, 70 days) are available, but transaction costs

make them more expensive.

No cash change hand when a forward contract is arranged or at any time until the settlement

date. Corporate customers gain access to the forward market on the basis of credit standing;

typically, there are no margin or collateral requirements.

Futures contract and forward contract are very similar but there are differences. As with a

forward contract, a foreign currency futures contract is a commitment to exchange a specified

amount of one currency for a specified amount of another currency at a specified time in the

future. However, the followings are important differences between the two transactions:

Dispersed versus Central Trading-- Whereas forward contracts are traded in an interbank

market (commercial banks, investment banks, dealers) which is geographically dispersed and

open 24 hours a day, futures contracts are mostly traded on centralized exchanges in a pit. Pit

traders use a system called open outcry to communicate (hand signals) and execute trades with

one another. The exchanges have their own hours, for example, currency futures on the IMM

trades between 7:20 AM to 2.00 PM Chicago time.

Customized versus Standardized Transactions-- whereas forward contracts are customized to

fit the particular needs of each client, futures contracts are highly standardized. The exchange

designs the contract and the regulatory authority approves it and the trade begins. Each futures

contract specifies a contract size of the underlying assets. Contract expiration dates are also

standardized, generally currency futures and bond futures expiration months are March, June,

September, and December. Also the exchange standardize the daily price limit, minimum tick,

delivery terms and trading days and hours. Since all futures contracts are identical (in the sense

that March 2003 yen is the same for all traders, in contrast to forward contract), therefore, futures

are more liquid than forwards.

Variable Counterparty Risk versus the Clearinghouse:

In the forward market each counterparty assumes the credit risk of other counterparty. In

contrast, all futures contract traded on an organized exchange has the clearinghouse as one of

the two counterparties. The clearinghouse may be a separate chartered corporation or a

division of the futures exchange. So the clearinghouse is the legal entity on one side of every

future contract (short or long) and stand ready to meet the obligations of the futures contract vis a

vis every customer of the exchange. Clearinghouses are backed by substantial reserves and, in

the US a clearinghouse of a major Exchange has never defaulted on an obligation.

6

Cash settlement and delivery versus the Marking to Market convention

In the forward contract transactions no cash flows take place until the final maturity of the

contract. In contrast the futures contracts are marked to market daily at the closing price. An

Initial margin should be deposited into your account to establish a futures position

(approximately 4% of contract size). Your position is marked to market every day, if the market

is moving in your favor the value of your account goes up, on the other hand, if the market is

going against you, when your position is market to market every day, the value of your account

keeps going down, if the value of your account falls below 75% of the initial margin,

maintenance margin, most broker will issue you a margin call and demand that you restore

your margin account to the level of the initial margin.

You can get forward rates from: http://www.fxstreet.com/rates-charts/forward-rates

Participants in the Futures Markets

Speculators and hedgers:

Speculators are: Trader who accepts risk by going long or short to bet on the future direction of

prices. (Long = you are bullish, therefore you buy the future contract. Short = you are bearish,

you have shorted the future contract).

Hedgers: Trader who seeks to transfer risk by taking a futures position opposite to an existing

position in the underlying commodity or financial instrument.

Most trades are reversed before the maturity of contract

Futures market is a zero-sum game, (stock market in not a zero-sum game)

Round trip commission between $15 at the discount broker and up to $100 at a full brokerage

houses.

Futures Margin: Required funds in your futures trading account in order to cover potential

losses from your open futures position.

Initial Margin: each future contract has an initial margin requirement set by the exchanges.

Initial margin varies with the type and size of a contract, for volatile contracts like S&P500 the

initial margin is high, for gold it is much lower. The initial margin is the same for long and short

futures positions. Usually initial margin for future contracts are between 5-10 percent of the

value of the contract (Highly leveraged).

Initial margin is therefore the the amount of funds that must be deposited by a customer when the

positions are initially taken in the future contract (Open position). On any day that profits or

losses accrue to your open positions, the profits will be added to the balance, and the losses will

be subtracted to the balance in your margin account. This process whereby gains and losses on

your open futures positions are recognized on a daily basis is called Marking-to-Market.

7

Marking-to-Market: the process whereby gains and losses on your open futures positions are

recognized on a daily basis.

Maintenance Margin: The minimum margin level your broker requires in a futures trading

account at all times. It is different from broker to broker. For example a broker may requires

$20,000 initial margin for trading S&P500. Assume this broker’s maintenance margin is

$12,000. It means you can deposit $20,000 to trade S&P500. Assume you trade S&P500 and the

market goes against you and you loose, but if your loss is less that $8,000 then your account

value will not go under $12,000 maintenance margin and you will not get a margin call. But if

you loose more that $8,000, then the value of your account will go below $12,000 the

maintenance margin and you will get a margin call from your broker to deposit funds in your

account. If you don’t deposit additional funds in your account the broker will close your position.

Are the Margin Requirements for Futures Similar to Those for Stocks?

No, margin means something different in futures than it does in stocks. In stocks it means that

you're borrowing money for the purchase of stocks and paying interest. In futures it simply refers

to the amount of money that you need to have in your account in order to trade.

Margin Call: Notification to deposit funds in your account to increase the margin level in your

trading account.

Reverse Trade: A trade that closes out a previously established futures position by taking the

opposite position.

Cash Price or Spot price: Price of a commodity or financial instrument for current delivery.

Cash-Futures Arbitrage: Strategy for earning risk-free profits from a mismatch (large difference

that is not justified ) between cash and futures prices. Example, if cash gold price is $400 (per

once) in April and August gold future price is $500, many will buy cash gold and sell August

future contract. The cost of storage is much lower than the $100 difference.

Carrying-Charge Market: In most situation the futures price is greater than the cash price; we

say this is the carrying-charge market

Inverted Market: is the opposite of carrying-charge market, in an inverted market the futures

price is less than the cash price. Does not happen too often.

Open Interest: is a measure of how many futures contract for a commodity exist at a point in

time. Every time two opening transactions are matched, the open interest increases by one, every

time two closing trades are matched, then the open interest decreases by one. If a trade involves

an opening transaction and a closing transaction, the open interest stays the same.

Triple witching: Four times a year (On the third Friday of the following months: March, June,

September, December) when S&P 500 futures contracts, options on the S&P index, and various

stock options (individual stocks) all expire at the same time.

8

Counterparty: you can have confidence that the other side of your trade will be made good. In

fact, the clearing member firms, and ultimately the futures exchanges themselves, guarantee that

each trade will be honored. So as a trader, you need never give thought to the guy on the other

side of your trade.

Are your funds protected?

Funds in your futures account are required to be segregated (held separately) from any of the

brokerage firm's own funds. That should provide some level of safety; however, your account is

not insured.

Spot-Futures Parity

It is a relationship between cash or spot prices and futures prices that theoretically holds.

The futures price (assuming no dividend payments) is simply the future value of the spot price,

compounded at the risk-free rate.

F = S(1 + r)T

Fair future premium value = S(1 + r)T

- S

Example:

Assume spot gold price is $640 and risk free rate is 5 percent. What should be a future contract

on gold that expires in three months?

F = S(1 + r)T = 640 * ( 1 + .05)

3/12 = 640 * 1.012272 = $647.85

If we consider that the underlying asset pays dividend, then the Spot-Future Parity becomes:

F = S(1 + r - d)T

Where d is the dividend yield of the underlying asset.

Example:

Assume spot (cash) S&P500 price is 1320 and risk free rate is 5 percent. What should be a future

contract price for S&P500 that expires in three months? Assume the dividend yield for S&P

500 is 1.8 percent per year.

F = S(1 + r - d)T

F = 1320 * (1+ .05 - .018)3/12

= 1320* 1.007906 = 1330.44

Therefore 3-month future S&P500 should be 1330.44. If future price is quiet different than

1330.44, then program trading will bring the future and cash price in line with the Spot-Future

Parity.

9

Index Arbitrage: If the future price of a stock index (S&P500, CAC40, Nasdaq 100, …) is quiet

different than its spot price, one can make riskless profits by exploiting this unusual difference. It

is done mostly by computer (program trading).

Program Trading: If there is a temporary discrepancy between future and spot prices, some

institutions have developed a coordinated trading program that could buys and sell an entire

portfolio of stocks.

Triple witching: Four times a year (On the third Friday of the following months: March, June,

September, December) when S&P 500 futures contracts, options on the S&P index, and various

stock options (individual stocks) all expire at the same time.

Trading in the futures market:

We have two types of futures contract:

i. those that provide for physical delivery of a particular commodity (Example, Crude oil,

Corn, Currencies, Ext.).

ii. those that call for an eventual cash settlement.

The commodity is defined in contract specification, as is the month when delivery or settlement

is to occur. A June futures contract, for example, provides for delivery or settlement in June.

More detail can be find in the contract specification.

Please note that even in the case of delivery-type futures contracts, very few actually result in

delivery. Not many speculators want to take or make delivery of 5,000 bushels of wheat or

1,000 barrel of oil. Rather, the majority of both speculators and hedgers choose to realize their

gains or losses by buying or selling an offsetting futures contract prior to the delivery date.

Cash settlement futures contracts are settled in cash rather than by delivery at the time the

contract expires. For example, all stock index futures contracts are settled in cash on the basis of

the index number at the close of the final day of trading. There is no delivery of actual stock

shares comprising the index.

When you buy or sell (Short) a future contract you are making a bit on the direction of the

security that the future contract represent. You don’t pay any money nor do you pay a down

payment, rather than providing a down payment, you need to have a deposit with your broker as

your margin requirement, therefore, for the futures contract a deposit of good faith money is

needed to buy or sell the future contract. This deposit with your broker is adjusted everyday to

reflect the gain or loss of your future contract on the daily basis.

One of the most important features of futures market is that they are highly leveraged. If the

10

price moves in the direction that you have bit on the future contract your profits will be very

large, on the other hand if the price moves against you, then your loss will be very large.

How do you determine your profits and losses? As we said, you bit on a future at a specific

point of time, say, 1/8/2010 at 3.00 PM central time. Let’s take S&P 500 index, at that specific

point of time S&P 500 is 1141.60. So, let’s say you think the market will go up, so therefore

you buy (bit) the future S&P 500 at 1141.60. Your bit is done, you don’t pay any down payment

but in your account you have to have at least an amount to initial margin requirement for S&P

500. If the S&P 500 goes up then you make money on your bit, on the other hand if the S&P

500 goes down you lose money on your bit. How do we determine our profits? It is easy, we

need to look at CONTRACT SPECIFICATION (CS) for that future. Once we know the price

and contract specification, then we can easily determine our profits and losses.

Major categories of future contracts:

Agricultural

Metals

Foreign Currency

Interest rate futures

Energy

Equity Indexes

Examples of futures trading.

As we said above, to determine our profits and losses, we need to know about contract

specification. (You can get contract specification of any future from the Exchange site that has

created the future contract). A lot of futures contracts are traded at the Chicago Mercantile

Exchange (http://www.cmegroup.com) and you can go to their site and get contract specification.

Below I took the contract specification for S&P 500 from CME in 2006 as follow:

.

SP500 futures: contract specification

Ticker Symbol SP

Contract Size $250 times S&P 500 futures price

Price Limits 5%, 10%, 15% and 20%

For more details see Price Limits

Minimum Price

Fluctuation (Tick) .10 index points = $25 per contract

Contract Months Mar, Jun, Sep, Dec

Regular Trading Hours

(Central Time) 8:30 a.m. - 3:15 p.m.

11

GLOBEX Trading Hours 3:45 p.m. - 8:15 a.m.

Last Trading Day The Thursday prior to the third Friday of the contract month

Final Settlement Date The third Friday of the contract month

Position Limits 20,000 net long or short in all contract months combined

Examples of trading SP500 future:

Example 1:

Assume that on October 10, 2002 you bought one S&P500 future (December 02 contract, as you

can see from CS, the S&P 500 has for future contract, March, June, September, and December)

at 800.25. On October 11, 2002 the market opened very strongly, at 9:52 am the S&P 500 was

trading around 828.00, you decide to take your profit and run and call your future broker or if

you trade on a platform, you can go to your computer and close your long position on the

S&P500 (market order). Assume you are filled (sold the SP500) at 827.95.

Estimate your profit?

As you can see, the price quote is based on two decimal. Minimum price fluctuation, or last

decimal (Last decimal is also called a pip) is $25 according to contract specification. If the last

decimal on a two decimal quote is $25, then one point in S&P500 move is therefore worth $250.

Given this, we can estimate our profits and losses as follow:

Profits = (827.95 – 800.25) * $250 = $6,925

Another way is as follow:

Contract size * Net gain on the number you have bit, or:

Profits = 250 * ((827.95 – 800.25) = $6,925

Example 2:

Assume that on October 10 you were bearish and sell (short) the S&P500 (December contract) at

800.25. However, you want to limit your losses and at the same time put a stop-loss order at

810.05. On October 11, 2002, the SP500 opened at 803.10 and kept going up as the price

registered 810.10 you are filled for sure, and your broker will call you and tell you that your

stop-loss order is filled at the 810.05 level, estimate your losses?

Loss = (810.05 – 800.25) * $250 = $2,450

Note: S&P500 has a mini sized contract called mini S&P , for mini-S&P each point of index

change is $50 and not $250. Most individual traders trade the mini-SP. Calculate the above

profit and loss assuming that you used mini-S&P contracts?

Example 1:

12

Profits = (827.95 – 800.25) * $50 = $1,385.00

Example 2:

Loss = (810.05 – 800.25) * $50 = $490.00

Contract Specification on Mini Nasdaq, (From:www.cme.com) futures

Ticker Symbol NQ

AON: NV

Contract Size $20 times E-mini Nasdaq-100 futures price

Price Limits 5%, 10%, 15% and 20%

For more details see Price Limits

Minimum Price

Fluctuation (Tick) .50 index points = $10 per contract

Contract Months Mar, Jun, Sep, Dec

Regular Trading Hours

(Central Time) Virtually 24 hours per day (from 5:30 p.m. Sunday to 3:15 p.m. Friday)

Last Trading Day Trading can occur up to 8:30 a.m. (Chicago Time) on the third Friday of the

contract month

Final Settlement Date The third Friday of the contract month

Position Limits Position limits work in conjunction with existing Nasdaq-100 position limits

Examples of trading Mini-NASDAQ 100 future:

Assume on October 10

th, 2002 you buy one contact of mini Nasdaq future (December 02

contract) at a price of 840.35 and as the market opens very strongly on October 11, 2002, you

sell it at 881.40. Estimate your profits:

Profits = (881.40 – 840.35) * 20 = $821

NASDAQ 100 has a large contract where each point is worth $100. So if you had bought

the large NASDAQ100 (Symbol ND) at 840.35 and sold it at 881.40, then your profits

would be:

Profits = (881.40 – 840.35) * 100 = $4,105.00

Note: If you had shorted and then covered your shorts at the above prices, then your profits

become your losses.

You can use both the S&P500 and NASDAQ100 futures to hedge or insure your portfolio.

13

Contract Specification on Currency Futures

Again for a lots of futures, please go to: http://www.cmegroup.com/.

Euro FX futures and options on futures contracts traded at CME are designed to reflect changes

in the U.S. dollar value of the Euro. Futures contracts are quoted in U.S dollars per foreign

currency, and call for physical delivery at expiration.

Understanding Foreign currency quotes:

Reading a foreign exchange quote is simple if you remember two things:

1. The first currency listed is the base currency

2. The value of the base currency is always 1. (In case of yen, it is 100)

For most futures contracts, the foreign currency is the base currency. When the bas currency is a

foreign currency, think of the quote as telling you what the foreign currency is worth in US

dollar.

When the foreign currency is the base and the quote goes up, that means USD has weakened in

value and the other currency has strengthened in value. Rising quotes means the foreign currency

in question now buys more USD than before.

Examples: EUR/USD

The first currency is the base (Euro). The March 2010 EUR/USD closed on 1/17/10 at 1.4325

and it closed at 1.4415 on 1/8/2010.

As we said above, a rising quote means the foreign currency (Euro) is strengthening. Here the

Euro has become stronger; on 1/7/10 1.4325 dollars would buy one Euro but on 1/18/10 more

dollars, 1.4425 dollars buys one Euro. Therefore, Euro is stronger or USD is weaker.

Example: YEN/USD

The first currency is the base (Yen). The March 2010 Yen/USD closed on 1/17/10 at 1.0740 and

it closed at 1.0800 on 1/8/2010.

As we said above, a rising quote means the foreign currency (yen) is strengthening. Here the Yen

has become stronger; on 1/7/10 1.0740 dollars would buy 100 yen (Remember only Yen is based

on 100) but on 1/18/10 more dollars, 1.0800 dollars buys 100 yen. Therefore, Yen is stronger or

USD is weaker.

Major futures contracts that have a lot of liquidity (Easy to trade):

14

Euro/USD, Pound/USD, Australian $/USD, JY/USD, Canadian $/USD, Swiss Franc/UDS

For all of the above contracts, please go to http://www.cmegroup.com and get the specification

for each.

Futures prices are often so liquid that they're quoted in tiny increments called pips, or

"percentage in point". A pip refers to the last decimal point in the quotation.

Here is the contract specification for Euro (Taken in 2006, now the format is different)

Example of Euro Future:

Assume you buy 1 March 10 Euro on 1/17/10 at 1.4325 and sell your position at 1.4415 on

1/8/2010. Estimate your profits and losses?

Contract Specification on the Euro, (http://www.cmegroup.com)

EUR/USD Futures

Contract Size 125,000 euro

Contract Month Listings

Six months in the March quarterly cycle (Mar, Jun, Sep, Dec)

Settlement Procedure

Physical Delivery

Position Accountability

10,000 contracts

Ticker Symbol

CME Globex Electronic Markets: 6E Open Outcry (All-or-None only): EC AON Code: UG View product and vendor codes

Minimum Price Increment

$.0001 per euro increments ($12.50/contract). $.00005 per euro increments ($6.25/contract) for EUR/USD futures intra-currency spreads executed on the trading floor and electronically, and for AON transactions.

Trading Hours

OPEN OUTCRY (RTH) 7:20 a.m.-2:00 p.m. GLOBEX (ETH) Sundays: 5:00 p.m. – 4:00 p.m. Central Time (CT) next day. Monday – Friday: 5:00 p.m. – 4:00 p.m. CT the next day, except on Friday - closes at 4:00 p.m. and reopens Sunday at 5:00 p.m. CT.

Last Trade Date / Time View calendar

9:16 a.m. Central Time (CT) on the second business day immediately preceding the third Wednesday of the contract month (usually Monday).

Exchange Rule

These contracts are listed with, and subject to, the rules and regulations of CME.

15

One tick or minimum tick, the fourth decimal = $12.50

Profits = 90 Ticks * $12.50 = $1,125

90 ticks are number of ticks from 1.4325 to 1.4415.

Another way of estimation your profits:

Contract size * Net gain on the number you have bit, or:

125000 * (1.4415 – 1.4325) = $1,125

Example of Yen future

Assume on December 31th of 2009, you buy one contract March 2010 yen future. The price you

paid was 1.0740 for 100 Yen (Sometimes it is quoted as 10740), or 100 yen will buy 1.0740

dollar. This is the way it is quoted in the futures market, 100Yen/USD. If that quote goes up, it

means the USD is weakening. Assume you closed your position on 1/4/2010 at a price of

1.08040. Estimate your profits and loss.

Here is the contract specification for JY/USD taken from CME.com.

JPY/USD Futures

Contract Size 12,500,000 Japanese yen

Contract Month Listings

Six months in the March quarterly cycle (Mar, Jun, Sep, Dec)

Settlement Procedure

Physical delivery

Position Accountability

10,000 contracts

Ticker Symbol

CME Globex Electronic Markets: 6J Open Outcry: JY AON Code: LJ View product and vendor codes

Minimum Price Increment

$.000001 per Japanese yen increments ($12.50/contract). $.0000005 per Japanese yen increments ($6.25/contract) for JPY/USD futures intra-currency spreads executed on the trading floor and electronically, and for AON transactions.

Trading Hours

OPEN OUTCRY (RTH) 7:20 a.m.-2:00 p.m. GLOBEX (ETH) Sundays: 5:00 p.m. – 4:00 p.m. Central Time (CT) next day. Monday – Friday: 5:00 p.m. – 4:00 p.m. CT the next day, except on Friday - closes at 4:00 p.m. and reopens Sunday at 5:00 p.m. CT.

Last Trade Date / Time View calendar

9:16 a.m. Central Time (CT) on the second business day immediately preceding the third Wednesday of the contract month (usually Monday).

The way I estimate profits and loss is as follow:

16

Although as the contract says $.000001 per Japanese yen increments ($12.50/contract), since the quote is

100 Yen/USD, then $.000001 will be in reality $.0001, which means the fourth decimal is equal

to a pip = $12.50 and here is my profit estimation:

(1.08040 – 1.0740) = 64 pips

Profits = 64 * 12.5 = $800

Another way of estimating profits:

Contract size * Net gain on the number you have bit, or:

12,500,000 /100 * (1.08040 -1.0740) = $800

Note: I have divided the contract size by 100, since the quotation is USD per 100 Yen.

Eurodollar Interest Rate Futures Contract

Trading in interest rate futures (short term interest or long term interest) is wide spread across

major world futures exchanges (Chicago, London, Paris, Tokyo,....). In the following table we

list some of interest rate futures traded in various exchanges:

Selected Interest Rate Futures Contract

Exchange Underlying Assets: Contract Size Minimum tick Value of a

Interest Rate futures on or Price change tick

CME 3 month Euro $ $1,000,000 $.01 $25

CBOT US treasury bond $ 100,000 $1/64 $15.625

LIFFE UK government bond Pond 50,000 p 1/64 p7.8125

The 3 month Eurodollar interest rate future of the CME has become the most widely used futures

contract for hedging short-term US dollar interest risk.

17

The basics:

All CME interest rate futures contracts are traded using a price index, which

is derived by subtracting the futures' interest rate from 100.00. For instance,

an interest rate of 5.00 percent translates to an index price of 95.00 (100.00 -

5.00 = 95.00). Given this price index construction, if interest rates rise, the

price of the contract falls and vice versa. Therefore, to profit from declining

interest rates, you would buy the futures contract (go long); to profit from a

rise in interest rates, you would sell the contract (go short). In either case, if

your view turns out to be correct, you will be able to liquidate or offset your

original position and realize a gain. If you are wrong, however, your trade

will result in a loss.”

The design of most CME interest rate futures contracts features a baseline

price move, of 0.01. Gains or losses, therefore, are calculated simply by

determining the number of ticks moved, multiplied by the value of the tick.

For all Eurodollar and LIBOR contracts, the minimum tick is typically .005,

(for the nearest contract) or $12.50 (Other contracts). Thus a price move

of from 95.00 to 95.01 for example, would mean a $25 gain for the long

position, and a $25 loss for the short position. The above quote is taken from

cme.com.

Example of Treasury Bill Future:

The following is the contract specification for 13-week Treasury Bill Future taken from CME:

13-Week U.S. Treasury Bill Futures

Underlying Unit

One three-month (13-week) U.S. Treasury bill having a face value at maturity of $1,000,000.

Price Quote 100 minus the Treasury bill discount rate for the delivery month (e.g., a 5.25 percent rate equals 94.75).

Tick Size (minimum fluctuation)

One-half of one basis point (0.005), or $12.50 per contract.

Contract Months

Three serial expirations plus four quarterly expirations in the March, June, September, and December quarterly cycle.

Last Trading Day

The business day of the 91-day U.S. Treasury bill auction in the week of the third Wednesday of the delivery month. Trading in expiring contracts closes at 12:00 p.m. on the last trading day.

Final Settlement

Expiring contracts are cash settled against the highest discount rate accepted in the U.S. Treasury Department's 91-day U.S. Treasury bill auction in the week of the third Wednesday of the contract month.

Position Limits

Current Position Limits

Block Minimum

Block Trade Minimums

All or None Minimum

All or None Minimums

Getting

Started

Trading CME

Interest Rates

CME Interest

Rate Products

CME Interest

Rate Futures

Options on

Interest Rates

The Trading

Process

How To Get

Started

18

Rulebook Chapter

CBOT Chapter 451

Trading Hours (All times listed are Central Time)

OPEN OUTCRY MON - FRI: 7:20 a.m. - 2:00 p.m. CME GLOBEX SUN - FRI: 5:00 p.m. - 4:00 p.m.

Ticker Symbol

OPEN OUTCRY TB CME GLOBEX GTB

Exchange Rule

These contracts are listed with, and subject to, the rules and regulations of CME.

Below please find the 3-months Treasury bill future contract (December) prices:

Open High Low Close

10/10/02 98.600 98.600 98.580 98.580

10/11/02 98.570 98.570 98.530 98.580

Suppose you shorted the T-Bill December future at the open on 10/10/02 and covered your short

on the open on 10/11/02. Estimate your profits?

As we saw above, minimum tick=.005 = $12.5 or .01 point (1 basis) = $25

Profits = 98.600 – 98.570 = .03 or 3 basis * $25 = $75 per contract (Commission is not

included).

Interest future contracts are cash settlement, that is the delivery of underlying assets is not made

or received, instead, final settlement is made through realizing profits or loss.

The price quotation establishes an inverse relationship between the futures price and the

underlying interest rate.

Treasury Bond Future Contract: Trades on CBOT

Contract Specification:

30-Year U.S. Treasury Bond Futures

Underlying Unit

One U.S. Treasury bond having a face value at maturity of $100,000.

Deliverable Grades

U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a remaining term to maturity of at least 15 years from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent.

Price Quote Points ($1,000) and 1/32 of a point. For example, 134-16 represents 134 16/32. Par is on the basis of 100 points.

19

Tick Size (minimum fluctuation)

One thirty-second (1/32) of one point ($31.25), except for intermonth spreads, where the minimum price fluctuation shall be one-quarter of one thirty-second of one point ($7.8125 per contract).

Contract Months

The first three consecutive contracts in the March, June, September, and December quarterly cycle.

Last Trading Day

Seventh business day preceding the last business day of the delivery month. Trading in expiring contracts closes at 12:01 p.m. on the last trading day.

Last Delivery Day

Last business day of the delivery month.

Delivery Method

Federal Reserve book-entry wire-transfer system.

Settlement U.S. Treasury Futures Settlement Procedures

Position Limits

Current Position Limits

Block Minimum

Block Trade Minimums

All or None Minimum

All or None Minimums

Rulebook Chapter

CBOT Chapter 18

Trading Hours (All times listed are Central Time)

OPEN OUTCRY MON - FRI: 7:20 a.m. - 2:00 p.m. CME GLOBEX SUN - FRI: 5:30 p.m. - 4:00 p.m.

Ticker Symbol

OPEN OUTCRY US CME GLOBEX ZB

Exchange Rule

These contracts are listed with, and subject to, the rules and regulations of CBOT.

Size: $100,000 face value U.S. Treasury bonds

Price Quotation: In points ($1,000) and thirty-seconds of a point; for example 98.18

equals to: 98-18/32. Or 112.14 equals to: 112-14/32.

Minimum Price fluctuation = tick= One thirty-second of a point, or $31.25

Expiration: March, June, September and December.

Ticker Symbol = US= pit symbol, ZB = Globex symbol

Last Trading day: Seven business days prior to the last business day of the month.

Delivery: Cash settlement

Example of 30-year Treasury Bond Future:

On October 10 2002 the interest rate is so low and you think that it should not go lower, so you

short one December Treasury bond future contract at 113.18. On October 11, 2002 the stock

20

market opens strong and some people switch from bond to stock, bond prices fall (interest rate

goes up) and you cover (buy back) your short position at 112.10. Estimate your profits:

Profits = (113.18-112.10) =1 points + 8 basis = $1,000 + 8(31.25) = $1,250.00 (Commission

not included)

. 10 Year U.S. Treasury Notes Futures 10-Year U.S. Treasury Note Futures

Underlying Unit

One U.S. Treasury note having a face value at maturity of $100,000.

Deliverable Grades

U.S. Treasury notes with a remaining term to maturity of at least six and a half years, but not more than 10 years, from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.

Price Quote Points ($1,000) and halves of 1/32 of a point. For example, 126-16 represents 126 16/32 and 126-165 represents 126 16.5/32. Par is on the basis of 100 points.

Tick Size (minimum fluctuation)

One-half of one thirty-second (1/32) of one point ($15.625, rounded up to the nearest cent per contract), except for intermonth spreads, where the minimum price fluctuation shall be one-quarter of one thirty-second of one point ($7.8125 per contract).

Contract Months

The first five consecutive contracts in the March, June, September, and December quarterly cycle.

Last Trading Day

Seventh business day preceding the last business day of the delivery month. Trading in expiring contracts closes at 12:01 p.m. on the last trading day.

Last Delivery Day

Last business day of the delivery month.

Delivery Method

Federal Reserve book-entry wire-transfer system.

Settlement U.S. Treasury Futures Settlement Procedures

Position Limits

Current Position Limits

Block Minimum

Block Trade Minimums

All or None Minimum

All or None Minimums

Rulebook Chapter

CBOT Chapter 19

Trading Hours (All times listed are Central Time)

OPEN OUTCRY MON - FRI: 7:20 a.m. - 2:00 p.m. CME GLOBEX SUN - FRI: 5:30 p.m. - 4:00 p.m.

Ticker Symbol

OPEN OUTCRY TY CME GLOBEX ZN

21

Example of Treasury Notes Future.

On October 10 2006 the interest rate is so low and you think that it should not go lower, so you

short one December Treasury note future contract at 108-050. On October 16, 2006 the stock

market opens strong and some people switch from bond to stock, bond prices fall (interest rate

goes up) and you cover (buy back) your short position at 106-145. Estimate your profits or

losses.

Each point = $1,000

1/32 of a point = 1000/32 = $31.25

Minimum tick = .5 * (1/32) = $15.625

108-050 = 108 + 5/32 = 108.1563

106-145 = 106+14.5/32 = 106.4531

Loss = (108.1563 – 106.4531)*1000 = 1.703125 * 1000 = $1703.125

Another way of estimation:

Loss = 1 point plus 22.5 ticks = $1,000 + 22.5* 31.25 = $1,703.125

For Agricultural and Energy futures contracts example, please see contract specifications file.

Futures Order Types:

Market Order: You will be filled at the best possible price obtainable at the time the order

reaches the trading pit.

Limit Order

Buy Limit: An order to buy a futures contract (Or any security) at or below a specified price

(called the limit price). Or to sell it at or above a specified price (Sell limit). The limit order is an

order to buy or sell at a designated price. Since the market may never get high enough or low

enough to trigger a limit order, a customer may miss the market if he or she uses a limit order.

(Even though you may see the market touch a limit price several times, this does not guarantee a

fill at that price, it has to go above or below the limit for guaranteed fill).

Example:

o With the Dec. DOW trading at 13,100 on December 1st, Buy 1 Dec DJIA 13,005

on a Limit. Order can only be filled at the stated price 13,005 or lower (better).

o With the market trading at 13,100, Sell 1 Dec DJIA at 13,195 on a Limit (or

better…fill at 13,195 or higher). Can only be filled at the stated price of 13,195 or

higher (better).

Stop Order

22

Buy stop: Buy stop is placed above the market. When the stop price is touched, then the order is

treated like a market order and will be filled at the best possible price. (Note: buy limit is placed

below market).

Sell Stop: Sell stop is placed below the market. Buy stop order is placed above the market and a

sell stop order is placed below the market. When the stop price is touched, then the order is

treated like a market order and will be filled at the best possible price. (Note: sell limit is placed

above the market).

Example Buy Stop.

o with the market trading at 13,100, Buy 1 Dec DJIA 13,200 Stop. Can only be

filled at the Market, after the Market trades (or is "offered") at 13,200 or higher.

Example of Sell Stop.

o With the market trading at 13,100, Sell 1 Dec DJIA 13,000 Stop. Can only be

filled at the Market, after the Market trades (or is "bid") at 13,000 or lower.

Stop Limit Order

A stop limit order is the combination of stop and limit order. The first part is written like the

above stop order. The second part of the order specifies a limit price. This means that once your

stop is triggered, you do not want to be filled beyond the limit price. Stop limit orders should

usually not be used when trying to exit a position. If a customer does not mention a limit price,

then the stop price and the limit price are the same.

Stop Close Order (SCO)

The stop price on a stop close only will only be triggered if the market touches the stop during

the close of trading. This could protect the trader from getting filled during adverse price

fluctuations during the course of the day.

Market If Touched Order (MIT)

An order which becomes a market order if and when the specified price is touched. The order is

carried out at the first available price after the specified price has been reached, which is not

always equal to the specified price. An MIT order is similar to a limit order in that a specific

price is placed on the order. But, an MIT order becomes a market order once the limit price is

touched or passed through. An execution may be at, above, or below the originally specified

price.

Good Until Canceled Order (GTC)

Good Till Canceled (or Open Order). Used in conjunction with a Limit or Stop order. Order will

remain valid and worked until client cancels order, or it is filled, or contract expires.

One Cancels the Other Order (OCO)

One (order) Cancels (the) Other.

23

Enter a pair of orders and link them together. When one order has been executed, our system will

automatically attempt to cancel the other.

As an example, with the DOW trading at 13,100 with support at 13,000 and resistance at

13,200. You want to buy at 13,000 Limit (lower), or on an upside breakout at 13,210

Stop (higher), Buy 1 Dec DJIA 13,000 on a Limit, OCO Buy 1 Dec DJIA 13,210 Stop.

When one order is executed, the other is automatically canceled.

Market on Close (MOC)

Your order will be filled during the final seconds of trading at whatever price is available.

Market on Opening (MOO)

You will be filled at the opening range of trading at the best possible price obtainable within the

opening range.

Spread Order

A spread can be established between different months of the same commodity, between related

commodities or between the same or related commodities traded on two different exchanges. A

spread order can be entered at the market or you can designate that you wish to be filled when

the price difference between the commodities reaches a certain point (or premium)

Fill or Kill Order (FOK)

The fill or kill order is used by customers wishing an immediate fill, but at a specified price. The

floor broker will bid or offer the order three times and immediately return either a fill or an

unable.

One Triggers the other (OTO)

Place a primary order and up to two contingent orders at the same time. When the primary

order's executed, your contingents are automatically activated! OTOs are perfect when you'd like

to place a limit order at your profit objective, as well as a stop order for protection.

Please go to http://www.cmegroup.com for the list of more than 100s futures and commodities

that you can trade.

Copy right M. Metghalchi, 2010, all rights reserved.

1

Fin 6361 By M. Metghalchi

EQUITY OPTIONS: options on the common stock of individual company trades on many exchanges, they started on the CBOE (Chicago Board Options Exchange) in 1973. Options and futures are Derivative Security: derivative Securities’ values are derived from the value of another security. For example, the value of a call option on IBM is derived from the value of IBM stock price. Call option gives the buyer the right to purchase underlying asset at striking (or exercise) price on or before expiration date. Put option gives the buyer of the put the right to sell underlying asset at striking price on of before expiration date. Writer (seller) of call option has commitment to sell underlying asset at striking price on or before expiration date. Writer of put option has the commitment to buy underlying asset at striking price on or before expiration date. Writing a covered call refers to owning the underlying stock; writing a naked call refers to not owning the underlying stock but selling the call on the stock. Buyer has right to exercise; writer has commitment to deliver. Buyer and seller have opposite price expectations. Premium is the price of the contract. Options may be: Exercised Traded in the open market Allowed to expire worthless. Profit and Loss on Call Option on IBM If you buy a call option on IBM: Exercise Price = $90; Premium = $7; If Market Price of IBM = $100 at expiration Proceeds = Stock Price - Exercise Price;

2

Proceeds = $100 - $90 = $10. Profit = Proceeds - Premium; Profit = $10 -- $7 = $3. If Market Price of IBM = $89.25; You would not exercise. Loss = $7. Now if you buy a put Options on IBM: Exercise Price = $90; Premium = $7.50; If Market Price = $90.25 at expiration, contract not exercised. If Market Price is $86 at expiration: Proceeds equal: Exercise Price - Stock Price; Proceeds = $90 -- $86 = $4. Profit = Proceeds - Premium; Profit = $4 -- $7.50 = -$2.50; (loss) Option would be exercised to offset partially the Premium Cost. For Option prices, see: www.yahoo.com American versus European Options 1. An American Option contract allows the owner to exercise the right to buy or sell the underlying asset on or before the expiration date. A European Option contract allows the owner to exercise the right to buy or sell the underlying asset on the expiration date only. In general, American Options are more valuable, due to increased flexibility. Virtually all option contracts traded in the U.S. are American option contracts.

3

Payoff and Profit to Call Options at Expiration for Equity Options: Value of the Call Option @ Expiration: Payoff to Call Owner = St - X; If St > X. Payoff to Call Owner = 0 ; If St < X. St = Value of the stock @ expiration. X = Striking Price. Example: Call Option on IBM; X = $90 Or striking price =90 Premium = $14. The buyer of the option will pay $14 for the right. Value of option at different stock prices at expiration: Stock Price at expiration $80 $90 $100 $110 $120 Option Value $0 $0 $10 $20 $30 Profit to option holder 0 0 (-$4) $6 $16 Bullish, Bearish Strategies of Puts & Calls Buyer of Call Option expects price of underlying stock to increase, therefore, if you buy a call on a stock, you expect the price of that stock to go up, you are bullish on the stock. Writer of Call Option expects price of underlying stock to decrease or to remain stable. Therefore, if you sell a call on a stock, you expect that the price of the stock to go down or stay the same. You are bearish on the stock. Buyer of Put Option expects price of underlying stock to decrease, therefore, if you buy a put option on a stock, you expect the stock price to go down, you are bearish on that stock. Writer of put option expects price of underlying stock to increase or to remain stable. If you sell a put option, you expect the stock price to go up or stay the same, you are bullish on that stock. Important variables that affect the value of a call option are:

1. the market stock price. (with the exercise price and everything else constant) an increase (decrease) in the stock price will increase (decrease) the value of a call option.

2. The exercise price (everything else the same). The higher the exercise price,

4

the lower will be the value of a call option.

3. The longer the time remaining until expiration the higher the option value (all other things being equal).

4. The higher the level of interest rates, the higher is the call option's value (all

other things being equal).

5. The greater the volatility of the stock price, the higher is the call option value (all other things being equal).

The intrinsic value of a call option is: Call option intrinsic value = max [0, S - K] Where S= stock price and K= strike price. In English, the intrinsic value of a call option is the maximum of zero or the value of the stock price minus the strike price. Example, if S=60 and K=53, then the intrinsic value of a call option on this stock is: Call option intrinsic value = max [0, S - K] = max [0, 60-53] = $7 Put option intrinsic value = max [0, K - S] Example: if S= 50 and K = 55, then Intrinsic value of a put option = max [0, K - S] = max[0, 55-50] =$5 Put and call options are never less than their intrinsic values,or:

Call option price ≥ max [0, S - K] Put option price ≥ max [0, K - S]

Intrinsic and time value The premium or the option prices that you pay consist of the sum of two specific elements: intrinsic value and time value. Intrinsic value The intrinsic value = if you exercise now (immediately) how much you can realize. Intrinsic value is always positive or zero. Out-of-the-money options have zero intrinsic values. (See above) Time value The time value of an option = Option price – intrinsic value. The price on this time value depends on a number of factors: time to expiration, volatility of the underlying product price, risk free interest rates and expected dividends. Option sensitivities

5

Option Sensitivity or the ‘Greeks’: these are defined as follow: Delta: the change in the option price for a given change in the price of the underlying security. The delta is between 0 and +1 for calls and between 0 and -1 for puts. If IBM has a delta of .5, it means that if IBM stock goes up by $2, the particular option on the IBM stock will delta of .5 will go up by $1. Gamma: the change in delta for a given change in the underlying security. For example if a call option on IBM has a delta of 0.5 and a gamma of 0.05, this indicates that the new delta for IBM option will be 0.55 if the IBM price moves up by $1 and 0.45 if the IBM price moves down by $1. Theta: shows the effect of time decay on an option. As time passes, options will lose time value and the theta measures the extent of this decay. Both call and put options have a negative theta. The decay of options is nonlinear in that the rate of decay will accelerate as the option approaches the expiration date. Vega: defines the effect that a change in implied volatility has on an option’s price. Both calls and puts will have a positive vega. (for more details see: http://www.euronext.com/fic/000/010/729/107297.pdf) Option Strategies: 1. Protective put: You own a stock but in order to protect yourself from downside, you buy

the put on the same stock that you own. Example: suppose you own the stock of IBM. Assume the IBM stock price is $83 dollars today. You are not confident about the next 12 months, and for some reasons (tax, not knowing the exact timing of sale, ect)you decide not to sell the stock. In order to sleep easy at nights, you can buy one year put option on IBM with an exercise price of $80. The premium could be $8. So if you are wrong and the IBM price goes up, you loose the $8 premium but you gain on IBM stock price increase. If you are correct and IBM price goes down to $50 by next year, you loose $33 on the IBM price (83 – 50 = $33) but the value of your put option on IBM will be $30 (80-50), so your profits on the option will be $22 (30 – 8). On the whole, you have reduced your downside risk. The Protective put strategy can be applied to your portfolio. If your portfolio is very diversified, then you can by a put option on the S&P 500. If your portfolio is mostly high tech stocks, then you can buy a put option on Nasdaq 100. If your portfolio is mostly small stocks, then you can buy a put on Russel 2000 index. 2. Covered Call: You own the stock and you think there is not much upside and downside possibility for your stock, you sell the call option for your stock.

6

Example: suppose you own the stock of IBM. Assume the IBM stock price is $83 dollars today. You are not confident about the next 12 months, and for some reasons you don’t think the stock will go MUCH lower, as a result you decide to sell the call option on your IBM. you can sell one year call option on IBM with an exercise price of $85. The premium could be $9. So if you are wrong and the IBM price goes up by next year to $105, you loose $11 on your option call (-105+85+9) but you own a stock that is worth $105 dollars. Or you could deliver the stock at expiration and receive $85 cash and you have already pocked the $9 premium, a total of $94 (versus $105 if you did not sell the call). However, If you are right and by next year IBM price is $78 dollars, then the call option that you have sold will expire with a zero value and you end up with IBM share that is worth $78 plus you have pocketed the $9 premium on the option (78+9=87). 3. Long Stradel: Buying both a call and a put option on a stock with the same exercise price and the same expiration date. Why you would do this? Because you think that the stock will move violently either up or down, you don’t know the direction of the move. Example: suppose you own the stock of IBM. Assume the IBM stock price is $83 dollars today and for some reasons (court case, new product, ext) you believe that within the next 6 months IBM stock will have a very strong move on either direction. So, you buy a call option On IBM, exercise price $85, expiration 6 months for $5 and at the same time you buy a put option on IBM, exercise price $85, expiration 6 months for $6. Your total costs on these two options will be $11. For you to break even on this long stradel strategy, the IBM stock should be $11 either above or below $85, or $96 and $74. If IBM stock price is $96 or $74 you just break even. Any price above $94 or below $74 will be your profits. If the stock price in six months ends up between $74 and $96, your strategy will be a loosing strategy. Your maximum loss will be $11 if the stock price settles at $85 in six months. 4. Short Stradel: Selling both a call and a put option on a stock with the same exercise price and the same expiration date. Why you would do this? Because you think that the stock will not move violently in either direction. 5. Strips: similar to stradel, however, a strip is two puts and one call on a security with the same exercise price and maturity date. 6. Straps: similar to stradel, however, a strap is two calls and one put on a security with the same exercise price and maturity date. 7. Spreads: usually a combination of calls and puts. There are many ways of spread strategies as follow: a). Bull Spread with call (Vertical): Buying a call with strike price of $X and selling another call with Strike price of $Y (Y must be greater than X) for the same expiration month. Limited risk reward.

7

b) Bull Spread with put: Selling a put with strike price $U and buying a put with strik price of $V (V must be lower than U) for the same expiration month. Limited Risk reward. c). Bear Spread with call: It involves two call options; you would sell the call with lower exercise price and buy the call with higher exercise price. The same expiration dates. d). Bear Spread with put: it involves two put options; you would buy the put with higher exercise price and sell the put with lower exercise price. The same expiration dates. e) The Box Spread: it consist of a bull spread with call plus a bear spread with puts, with the two spreads having the same pair of exercise prices. Example: 1 long IBM call $95, 1 short IBM call $105 and 1 long put $105, 1 short put $95, all have same expiration. Example of bull call spread: Assume the IBM stock price is $83. And you are mildly bullish on IBM. What can you do? One option would be simply to buy a call option on IBM. For example you may buy call IBM with exercise price 85 and maturity 1 year at $8. But since you are not VERY bullish on IBM you don’t want to spend $8. So you buy a call spread on IBM: You buy call 85 and sell call 95 both expiring in one year. This way you reduce your cost but at the same time you limit your upside potential. Your net cost could be $5 per share (assuming call 85 is $8 and call 95 is $3, you buy $8 call 85 and sell $3 call 95 for a net of $5. Your maximum profit would be $5 if IBM stock closes at 95 or higher one year from today. Your break even is $90, and below 90 you would loose and your maximum loss is $5 the net cost of the spread. You loose this $5 net cost of the spread strategy if IBM stock closes at $90 or lower in one year. f) The Butterfly Spread with Calls: It involves 4 calls, buy one call with low exercise price, buy another with very high exercise price and sell 2 calls with an intermediate exercise price. Example, long one IBM $95 call, short 2 IBM $100 call, and long 1 IBM $105 call. g) The Butterfly Spread with Puts: It consists of 4 puts, buy one put with high exercise price, sell 2 put with intermediate exercise price, and buy one put with low exercise price. Example: Long put IBM $105, Short 2 puts IBM $100, Long one put IBM $95. h) Call Calendar: example - You sell call IBM $100 March and buy call IBM $100 June. i)Put Calendar: example – You sell Put IBM $100 March and buy Put IBM $100 June. J). Call Diagonal: example - You sell call IBM $100 March and buy call IBM $105 June. k) Put Diagonal: You sell Put IBM $100 March and buy Put IBM $90 June.

8

Options on Stock Index: Call options exist for individual common stocks, but call options also exist on future contracts such as stock Indices (SP500, NYSE, NASDAQ, DOW), Treasury bonds, foreign exchange, and many other instruments. Most of these options on future contracts are traded on organized exchanges such as the Chicago Board Options Exchange and the Chicago Mercantile Exchange. WWW.CME.com The buyer of a call option on a stock index has the right, but not the obligation, to purchase (go long) a particular stock index contract at a specified price at any time during the life of the option.

The buyer of a put option on a stock has the right to sell (go short) a particular stock index contract at a specified price. Put options can be purchased to profit from an anticipated price decrease. Settlement is cash; Payoff is difference between the Striking Price and the Value of Index at settlement. Example Of option on stock index: On Friday December 15, 2006 the March S&P 500, 2007 closed at 1438.20. Below please find the March-07 option call and put prices for a few strike prices on S&P500: Call 1440 = $31.50 Call 1450 = $26.50 Call 1460 = $20.80 Put 1440 = $32.50 Put 1435 = $30.40 Put 1425 = $26.80 Put 1415 = $23.70 Exercise 1: Assume you are bullish on the stock market and buy one March call 1440 on the March S&P500. Estimate your profits and losses if S&P500 at its March expiration (Third Friday of March) closes at the following levels:

a. 1495.40 b. 1452.80 c. 1438.50

SOLUTION FOR EXCERSIE 1: Option premium = cost of option = 31.50 * 250 (each point of S&P500 =$250) Option costs = 31.50* 250 = $7,875

a. if the index closes at 1495.40, then the value of option at expiration is:

9

(1495.40 – 1440)* 250 = $13,850 Profits = 13,850 – 7,875 = $5,975

b. if the index closes at 1452.80, then the value of option at expiration is: (1452.80 – 1440)*250 = $3,200 Profits = 3,200 – 7,875 = -$4,675 (There will be a loss)

c. if the index closes at 1438.50, then the value of option at expiration is zero and you would lose $7,875.

Exercise 2: Assume you are bearish on the stock market and buy one March Put 1425 on the March S&P500. Estimate your profits and losses if S&P500 at its March expiration (Third Friday of March) closes at the following levels:

a. 1398.40 b. 1418.50 c. 1428.20

SOLUTION OF EXERCISE 2: Option cost = 26.80 * 250 = $6,700

a. if the index closes at 1398.40, then the value of option at expiration is: (1425 – 1398.40) * 250 = $6,650

Profits = 6,650 – 6,700 = -$50 (you lose 50 dollars) b. if the index closes at 1418.50, then the value of option at expiration is:

(1425 – 1418.50) * 250 = $1,625 Profits = 1,625 – 6,700 = -$5,075 (This would be your loss).

c. if the index closes at 1428.50, then the value of option at expiration is zero and you would lose $6,700

Exercise 3: Assume you think the stock market will violently move one way (Up or down), but you don’t know which way. So you go long one Stradel (Strike price 1440). Estimate your profits and losses if S&P500 at its March expiration (Third Friday of March) closes at the following levels:

a. 1510.40 b. 1480.95 c. 1445.60 d. 1432.60 e. 1410.20 f. 1360.40

SOLUTION OF EXCERSIE 3:

10

Cost of the stradel = cost of call + cost of put Cost of call = $7,875 (See exercise 1) Cost of put = 32.50 * 250 = $8,125 Cost of the Stradel = 7,875 + 8,125 = $16,000

a. if the index closes at 1510.40, then the value of the call option at expiration is: (1510.40 – 1440)* 250 = $17,600 Value of put option at the expiration is zero

Profits = 17,600– 16,000 = $1,600

b. if the index closes at 1480.95, then the value of the call option at expiration is: (1480.95 – 1440)* 250 = $10,237.50 Value of put option at the expiration is zero

Profits = 10,237.50 – 16,000 = $-5,762.50 (You would lose)

c. if the index closes at 1445.60, then the value of the call option at expiration is: (1445.60 – 1440)* 250 = $1400 Value of put option at the expiration is zero

Profits = 1400 – 16,000 = $-14,600 (You would lose)

d. if the index closes at 1432.60, then the value of the call option at expiration is zero. Value of put option at the expiration is: (1440 – 1432.60) *250 = $1,850

Profits = 1,850 – 16,000 = $-14,150 (You would lose)

e. if the index closes at 1410.20, then the value of the call option at expiration is zero. Value of put option at the expiration is: (1440 – 1410.20) *250 = $7,450

Profits = 7,450 – 16,000 = $-8,550 (You would lose)

f. if the index closes at 1360.40, then the value of the call option at expiration is zero. Value of put option at the expiration is: (1440 – 1360.40) *250 = $19,900

Profits = 19,900 – 16,000 = $3,900 (You would lose) As you can see, the long Stradel strategy only works if the price has a very big move in one direction. Exercise 4: Assume you think the stock market will trade sideway over the next three months. So you go short one Stradel (Strike price 1440). Estimate your profits and losses if S&P500 at its March expiration (Third Friday of March) closes at the following levels:

g. 1510.40 h. 1480.95 i. 1445.60 j. 1432.60

11

k. 1410.20 l. 1360.40

SOLUTION OF EXCERSIE 4: You sell both call and put March S&P500 1440. Your account will be credited as follow: Cost of call = $7,875 (See exercise 1) Cost of put = 32.50 * 250 = $8,125 Cost of the Stradel = 7,875 + 8,125 = $16,000 So, your account will be credited by $16,000, since you are now the seller of the options.

a. if the index closes at 1510.40, then the value of the call option at expiration is: (1510.40 – 1440)* 250 = $17,600 Value of put option at the expiration is zero

Profits = 16,000 – 17,600 = - $1,600 (You would lose)

b. if the index closes at 1480.95, then the value of the call option at expiration is: (1480.95 – 1440)* 250 = $10,237.50 Value of put option at the expiration is zero

Profits = 16,000 - 10,237.50 = $5,762.50 (Your profits)

c. if the index closes at 1445.60, then the value of the call option at expiration is: (1445.60 – 1440)* 250 = $1400 Value of put option at the expiration is zero

Profits = 16,000 - 1400 = $14,600 (Your profits)

d. if the index closes at 1432.60, then the value of the call option at expiration is zero. Value of put option at the expiration is: (1440 – 1432.60) *250 = $1,850

Profits = 16,000 - 1,850 = $14,150 (Your profits)

e. if the index closes at 1410.20, then the value of the call option at expiration is zero. Value of put option at the expiration is: (1440 – 1410.20) *250 = $7,450

Profits = 16,000 -7,450 = $8,550 (Your profits)

f. if the index closes at 1360.40, then the value of the call option at expiration is zero. Value of put option at the expiration is: (1440 – 1360.40) *250 = $19,900

Profits = 16,000 - 19,900 = -$3,900 (You would lose) Options on Futures

12

The buyer of a call option has the right, but not the obligation, to purchase (go long) a particular futures contract at a specified price at any time during the life of the option.

Example : A March -2007 Treasury Note 107 call option would convey the right to buy one March U.S. Treasury Note futures contract at a price of $107,000 at any time during the life of the option. The buyer may not hold the option till expiration, a profit can be realized if, prior to expiration, the option rights can be sold for more than its cost.

The most that an option buyer can lose is the option premium plus transaction costs. The buyer of a put option has the right to sell (go short) a particular futures contract at a specified price. Put options can be purchased to profit from an anticipated price decrease. Example: you pay a premium of $750 (Cost of put option) to purchase an April 620 gold put option. The option gives you the right to sell a 100 ounce gold futures contract for $620 an ounce.

Assume that, at expiration, the April futures price has declined to $600 an ounce. The option giving you the right to sell at $620 can thus be sold or exercised at a gain of $20 an ounce. On 100 ounces (see contract specification file), that’s $2,000.After subtracting $750 cost of the option, your net profit comes to $1,250. Not including the transaction cost.

Exercise 5: On Friday December 15, 2006 the March Euro, 2007 closed at 131.36. Below please find the March-07 option call and put prices for a few strike prices on Euro currency: Call 131.00 = 0.0193 Call 132.00 = 0.0146 Put 131.00 = 0.0157 Put 130.00 = 0.0116 Assume you think the Euro will violently move one way (Up or down), but you don’t know which way. So you go long one Stradel (Strike price 131.00). Estimate your profits and losses if March Euro at its March expiration (Third Friday of March) closes at the following levels:

a. 136.80 b. 132.60 c. 131.00 d. 130.20 e. 126.76

Solution of Exercise 5: Long Stradel, Stike price 131.00: Cost of the stradel = cost of call + cost of put

13

As we have seen in the Future chapter, for Euro trading can occur in $.0001 per Euro increments ($12.50/contract). So each .0001 = $12.5. Therefore a price of .0193 implies a cost of (.0193/.0001) * 12.50 = $2,412.50. This could be also obtained by (125,000 * .0193 = $2,412.50) Cost of call = $2,412.5 Cost of put = 125,000 * .0157 = $1,962.50 Cost of the Stradel = 2,412.5 + 1,962.5 = $4,375

a. if the Euro closes at 138.80 at its expiration, then the call option value at the expiration is: (138.80 – 131.00)*1,250 = $7,250 Value of put will be zero. Profits = 7,250 – 4375 = $2,875 b. if the Euro closes at 132.60 at its expiration, then the call option value at the expiration is: (132.60 – 131.00)*1,250 = $2,000 Value of put will be zero. Profits = 2,000 – 4375 = -$2,375 (There will be a loss) c. if the Euro closes at 131.00 at its expiration, then the call option value at the expiration is: (131.00 – 131.00)*1,250 = $0 Value of put will also be zero. Loss = $4,375 d. if the Euro closes at 130.20 at its expiration, then the put option value at the expiration is: (131.00 – 130.20)*1,250 = $1,000 Value of call will also be zero. Loss = 4,375 – 1,000 = 3,375 e. if the Euro closes at 126.76 at its expiration, then the put option value at the expiration is: (131.00 – 126.76)*1,250 = $5,300 Value of call will also be zero. Profits = 5,300 - 4,375 = $925.

Exercise 6: On Friday December 15, 2006 the March Euro, 2007 closed at 131.36. Below please find the March-07 option call and put prices for a few strike prices on Euro currency: Call 131.00 = 0.0193 Call 132.00 = 0.0146 Put 131.00 = 0.0157 Put 130.00 = 0.0116 Assume you think the Euro will trade sideway over the next three months. So you go short one Stradel (Strike price 131.00). Estimate your profits and losses if March Euro at its March expiration (Third Friday of March) closes at the following levels:

14

a. 136.80 b. 132.60 c. 131.00 d. 130.20 e. 126.76

Solution of Exercise 6: Short Stradel, Stike price 131.00: Cost of the stradel = cost of call + cost of put As we have seen in the Future chapter, for Euro trading can occur in $.0001 per Euro increments ($12.50/contract). So each .0001 = $12.5. Therefore a price of .0193 implies a cost of (.0193/.0001) * 12.50 = $2,412.50. This could be also obtained by (125,000 * .0193 = $2,412.50) Cost of call = $2,412.5 Cost of put = 125,000 * .0157 = $1,962.50 Cost of the Stradel = 2,412.5 + 1,962.5 = $4,375 Since you are a seller of the Stradel (Seller of both call and put), your account will be credited $4,375.

a. if the Euro closes at 138.80 at its expiration, then the call option value at the expiration is: (138.80 – 131.00)*1,250 = $7,250 Value of put will be zero. Your Loss = 7,250 – 4375 = $2,875 b. if the Euro closes at 132.60 at its expiration, then the call option value at the expiration is: (132.60 – 131.00)*1,250 = $2,000 Value of put will be zero. Profits = 4375 -2,000 = $2,375 c. if the Euro closes at 131.00 at its expiration, then the call option value at the expiration is: (131.00 – 131.00)*1,250 = $0 Value of put will also be zero. Your profits = $4,375 d. if the Euro closes at 130.20 at its expiration, then the put option value at the expiration is: (131.00 – 130.20)*1,250 = $1,000 Value of call will also be zero. Your profits = 4,375 – 1,000 = $3,375 e. if the Euro closes at 126.76 at its expiration, then the put option value at the expiration is: (131.00 – 126.76)*1,250 = $5,300 Value of call will also be zero. Your Loss = 5,300 - 4,375 = $925.

15

Crude Oil Options Exercise 7: On Friday December 15, 2006 the February Crude Oil, 2007 closed at 64.11. Below please find the Feb-07 option call and put prices for a few strike prices on Crude oil: Call 64.00 = 1.89 Call 65.00 = 1.42 Put 64.00 = 1.73 Put 63.00 = 1.33 Assume you think the crude price will violently move one way (Up or down), but you don’t know which way. So you go long one Stradel (Strike price 64.00). Estimate your profits and losses if February crude at its February expiration closes at the following levels:

a. 64.50 b. 72.50 c. 63.50 d. 55.50

Solution of Exercise 7: Long Stradel, Stike price 64.00: Cost of the stradel = cost of call + cost of put As we have seen in the Contract Specification file, for crude trading, each cent is $10.t0 or a point is $1,000. Therefore a price of 1.89 implies a cost of 189*10 =$1,890 This could be also obtained by 1.89* 1000) Cost of call = $1,890.00 Cost of put = 1.73* 1000 = $1,730.00 Cost of the Stradel = 1,890 + 1,730 = $3,620

a. if Crude closes at 64.50 at its expiration, then the call option value at the expiration is: (64.50 – 64.00)*1,000 = $500.00 Value of put will be zero. Loss = 3,620 - 500 = $3,120 b. if Crude closes at 72.50 at its expiration, then the call option value at the expiration is: (72.50 – 64.00)*1,000 = $8,500 Value of put will be zero. Profits = 8,500 – 3,620 = $4,880 c. if Crude closes at 63.50 at its expiration, then the call option value at the expiration is zero

and put value at expiration is: (64.00 – 63.50) * 1,000 = $500 Loss = 3,620 -500 = $3,120 d. if Crude closes at 55.50 at its expiration, then the put option value at the expiration is:

16

(64.00 – 55.50)*1,000 = $8,500 Value of call will also be zero. Profits = 8,500 – 3,620 = $4880.00

Interest Rate Options: Exercise 8: On Friday December 15, 2006 the March 10-year note, 2007 closed at 108.105. Below please find the march-07 option call and put prices for a few strike prices on 10-year Treasury note: Call 108 = 0.58 Call 109 = 0.30 Put 108 = 0.38 Put 107 = 016 Assume you think the 10-year Treasury note will trade sideway over the next three months. So you go short one Stradel (Strike price 108). Estimate your profits and losses if March 10-year Treasury note at its March expiration (Third Friday of March) closes at the following levels:

a. 110.225 b. 108.145 c. 107.180 d. 106.160

Solution of Exercise 8: Short Stradel, Stike price 108: Cost of the stradel = cost of call + cost of put As we have seen in the Future chapter, for 10- year Treasury Note, trading can occur in Minimum tick of .5 * (1/32) = $15.625 and each point = $1,000 (108 to 109). Therefore the call option price of.58 implies a cost of .58 * 1000 = $588.00. Cost of call = $580.00 Cost of put = $.38 * 1000 = $380 Cost of the Stradel = 580 + 380 = $960 Since you are a seller of the Stradel (Seller of both call and put options), your account will be credited $960.00

a. if the 10-year TN closes at 110.225 at its expiration, then the call option value at the expiration is: 110.225 = 110 + 22.5/32 = 110.703125

Value of call option = (110.703125 – 108)*1000 = $2,703.125 Value of put option =0 Loss = 2,703.125 – 960 = $1,743.125 b. b. if the 10-year TN closes at 108.145 at its expiration, then the call option value at the

expiration is: 108.145 = 108 + 14.5/32 = 108.453125

17

Value of call option = (108.453125 – 108)*1000 = $453.125 Value of put option =0 Profits = 960 – 453.125 = $506.875 c. if the 10-year Note closes at 107.180 at its expiration, then the call option value at the

expiration is zero: Value of put will be: 107.180 = 107 + 18/32 = 107.5625 Value of put option = (108 – 107.5625)*1000 = $437.50 Profits = 960 -437.50 = $522.50 d. if the 10-year Note closes at 106.160 at its expiration, then the call option value at the

expiration is zero: Value of put will be: 106.160 = 106 + 16/32 = 106.50 Value of put option = (108 – 106.50)*1000 = $1,500 Loss = 1,500 - 960 = $540.00

Bullish, Bearish Strategies of Puts & Calls on Stocks or Future contracts Buyer of Call Option expects price of underlying stock or future contract to increase, therefore, if you buy a call on a stock or on a future, you expect the price of that stock or the future to go up, you are bullish on the stock or on the future contract. Writer of Call Option expects price of underlying stock or future to decrease or to remain stable. Therefore, if you sell a call on a stock or future, you expect that the price of the stock or future to go down or stay the same. You are bearish on the stock or future contract. Buyer of Put Option expects price of underlying stock of future contract to decrease, therefore, if you buy a put option on a stock or future, you expect the stock or future price to go down, you are bearish on that stock or future contract. Writer of put option expects price of underlying stock or future to increase or to remain stable. If you sell a put option, you expect the stock or future price to go up or stay the same, you are bullish on that stock or future contract. How Option Prices (Premiums) are determined:

1. The current spot price. (with the exercise price and everything else constant) an increase (decrease) in the spot price will increase (decrease) the value of a call option.

2. The option’s exercise price (everything else the same). The higher the

exercise price, the lower will be the value of a call option. Or the lower the exercise price, the lower will be the value of a put option.

18

3. The longer the time remaining until expiration the higher the option value

(all other things being equal).

4. The higher the level of interest rates, the higher is the call and put option value (all other things being equal).

5. The greater the volatility of the underlying asset price, the higher is the call

and put option value (all other things being equal). Employee Stock Option (ESO): An employee stock option is a call option that a firm gives or sells at a very deep discount to employees. These will supposedly bring the convergence of shareholders and management. (Reduce the agency problem). However, because of the abuse of this practice, many corporations are switching to Stock Grant practice to reduce the agency problem. Stock grants are stocks given to employees that will vest over time as the employee stays with the company. The following quote is taken from the instructor manual of your textbook: Beginning of the quote:

“The details of ESOs vary by firm. However, there are some specifications that are standard enough to discuss. First, the life of the ESO is generally 10 years, which is much long than an ordinary call option. Second, ESOs can only be exercised—that is, unlike ordinary call options, ESOs cannot be sold. ESOs have a “vesting” period of about 3 years. That is, for the first three years that the employee owns the ESO, they cannot exercise it. Once the employee has worked for the company for the vesting period, the employee can exercise their ESOs any time during the remaining life of the ESO. If an employee leaves the company before the ESOs are “vested,” the employee loses the ESOs. If an employee leaves the company and has ESOs that are vested, the employee has some time to exercise these ESOs. One major feature of ESOs that is different from ordinary call options is that occasionally, their strike price is reduced. ESOs are generally issued exactly “at the money,” i.e., with zero intrinsic value. However, because of its ten-year life, the ESO is still valuable to the employee. If the stock price falls after the ESO is granted, the ESO is said to be “underwater.” Occasionally, companies will lower the strike prices of ESOs that are “underwater.” This controversial practice is called “restriking” or “repricing” Why is this practice controversial? PRO: Once an ESO is “underwater,” it loses its ability to motivate employees. Employees realize that there is only a small chance for a payoff from their ESOs.

19

Employees may leave for other companies where they get “fresh” options. CON: Lowering a strike price is a reward for failing. After all, decisions by employees made the stock price fall. If employees know that ESOs will be repriced, the ESOs loose their ability to motivate employees. Today, most companies award ESO on a regular basis (quarterly or annually). Therefore, employees will always have some “at the money” options. In addition, regular grants of ESOs means that employees always have some “unvested” ESOs—giving them the added incentive

to remain with the company.” End of quote from instructor manual. Put-Call Parity According to Put-Call Parity, if a stock does not pay dividend, then the difference between the call price and the put price (European options) should be equal to the difference between the stock price and the discounted strike price. C – P = S - Ke-rT Where, C = the call option price today P is the put option price today S = the stock price today Ke-rT = the discounted strike price (Present value of strike price) (PV=FV*e-rT this is the formula for continuous discounting) r is the risk-free interest rate. T is the time remaining until option expiration. If a stock pays dividend (D), then Put-Call parity becomes: C – P = S - Ke-rT – D. The Option Clearing Corporation Here is a quote from the instructor manual of your textbook:

“Options Clearing Corporation (OCC): Private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised; issues and clears all option contracts trading on U.S. exchanges.The OCC is the clearing agency for all options exchanges in the U.S. and it is subject to regulation by the SEC. Since the OCC assumes the writer's obligation in all trades, all default risk is transferred to the OCC” End of quote.

Clearing House is the trading partner of each trader in the option market.

20

Hedging versus Speculating Speculator uses Futures Contracts to profit from movements in Futures Prices. Hedger uses Futures Contracts to protect against price movements. If speculator believes prices will increase, they take long positions. If Speculator believes prices will decrease, they take short positions. Managers of bond portfolio (Hedger) takes short position in Bond Futures, which guarantees that total value of bond + futures position @ maturity is the Futures Price. A long hedge would exist if a pension fund manager enters the long side of the contract, (a commitment to purchase @ the current Futures Price) thus locking in current prices & yields. For a basic summary go to: http://www.angelfire.com/vt2/corpfin/. For more detail on options, please go to: www.cboe.com and then go to learning center.

Optional for Students (Not required)

Black-Scholes Option Valuation Model

V = P[N(d1) - tkRFXe− [N(d2)].

d1 = t

t)]/2(k[)P/Xln( 2RF

σ

σ++ .

d2 = d1 - tσ .

V = CURRENT VALUE OF A CALL OPTION WITH TIME t UNTIL EXPIRATION. P = CURRENT PRICE OF THE UNDERLYING STOCK. N(di) = PROBABILITY THAT A DEVIATION LESS THAN di WILL OCCUR IN A STANDARD NORMAL DISTRIBUTION. THUS, N(d1) AND N(d2) REPRESENT AREAS UNDER A STANDARD NORMAL DISTRIBUTION FUNCTION. X = EXERCISE, OR STRIKE, PRICE OF THE OPTION.

21

e ≈ 2.7183. kRF = RISK-FREE INTEREST RATE. t = TIME UNTIL THE OPTION EXPIRES (THE OPTION PERIOD). ln(P/X) = NATURAL LOGARITHM OF P/X. σ2 = VARIANCE OF THE RATE OF RETURN ON THE STOCK.

See an example of this model in the Excel file called “Black-Schole”. I have copied the Excel file in this lecture as follow: Assume two stocks, VI (Victoria Inc.) and H (Houston Inc.), both with call & put options Victoria Stock Houston Stock Call Put Call Put Exercise price, X $80.00 $80.00 $65.00 $65.00 Cost of option $8.90 $8.90 $1.20 $1.20 Price of stock,P, at expiration $95.50 $95.50 $63.75 $63.75 We use Excel's IF function to estimate the profits and loss at expiration. Value of option at expiration $15.50 $0.00 $0.00 -$1.25 Profit and loss $6.60 -$8.90 -$1.20 -$2.45 Although it is easy to value option at expiration date, it is not so easy before expiration. The most important model of option value is the Black-Scholes Model.

Assume Texas Inc's market price is $20, risk free rate =12%, time to maturity for the option=3 or .25 years, exercise price= $20, the annual variace of return =.16, what is the value of this option? P $20 Krf 12% s2 0.16 X $20 t 0.25 We first find d1 d1 = {ln(P/X) +[Krf + s2/2]t}/st1/2 = 0.25 (LN(B56/B57)+(D56+(F56/2))*D57)/((F56^0.5)*(D57^0.5)) d2 = d1-s(t1/2) = 0.05 C62-(F56^.5)*(D57^0.5) We now need N(d1) and N(d2) area under the normal curve, we could use a normal table. however, Excel can also be used. Click Insert, Function, Statistical, NORMDIST to access the

V = P[N(d1) - tkRFXe− [N(d2)].

d1 =

t

t)]/2(k[)P/Xln( 2RF

σ

σ++ .

d2 = d1 - tσ .

V = CURRENT VALUE OF A CALL OPTION WITH TIME t UNTILEXPIRATION. P = CURRENT PRICE OF THE UNDERLYING STOCK. N(di) = PROBABILITY THAT A DEVIATION LESS THAN di WILL OCCUR IN A STANDARD NORMAL DISTRIBUTION. THUS, N(d1) AND N(d2) REPRESENT AREAS UNDER A STANDARD NORMALDISTRIBUTION FUNCTION. X = EXERCISE, OR STRIKE, PRICE OF THE OPTION. e ≈ 2.7183. kRF = RISK-FREE INTEREST RATE. t = TIME UNTIL THE OPTION EXPIRES (THE OPTION PERIOD). ln(P/X) = NATURAL LOGARITHM OF P/X. σ2 = VARIANCE OF THE RATE OF RETURN ON THE STOCK.

22

menue, then fill .25 for X, 0 for mean, 1 for ST-Dev. And true for cumulative. N(d1) = 0.598706 N(d2) = 0.519939 e = 2.7183 Krf * t = 0.03

V = P(N(d1)) - XeKrf*t [N(d2)]

V = 1.258656 This is the option value of our example Sensitivity analysis: I change both exercise and market prices from $20 to $30, then the above model results to a Value = $1.90 The higher, the market price, the higher option value. I change t from 3 months to 6 months or t=.5, then the above model results to a Value = $2.61 Longer options are more expensive than shorter options. I change the value of stock volatility, s2, from .16 to .30 and the above model results to a Value = $1.89 The more volatile the stock, the higher will be its option value. I change the risk free rate from 12 % to 5 %, the above model results to a value Value= $2.15 The lower the risk free rate, the higher will be the option value. Multiple choice from the test bank of your textbook: STANDARDIZED OPTION CONTRACTS

25. Standardized option contracts are for ____ share(s) of stock.

A. 1 B. 10 C. 50 D. 100 E. 1,000

OPTION PAYOFF C 26. Ignoring the premium, the maximum loss from writing a call option is: A. the strike price. B. the stock price. C. unlimited. D. the option price. E. Insufficient information.

23

OPTION PAYOFF B 27. Ignoring the premium, the maximum loss from writing a put option is: A. the strike price. B. the stock price. C. unlimited. D. the option price. E. Insufficient information. PUT-CALL PARITY A 30. According to put-call parity, a put option can be replicated by: A. buying a call, selling the underlying stock, and lending at the risk-free rate. B. selling a call, selling the underlying stock, and lending at the risk-free rate. C. buying a call, buying the underlying stock, and borrowing at the risk-free rate. D. selling a call, buying the underlying stock, and borrowing at the risk-free rate. E. buying a call, selling the underlying stock, and borrowing at the risk-free rate. PUT-CALL PARITY D 31. According to put-call parity, a call option can be replicated by: A. selling a put, buying the underlying stock, and borrowing at the risk-free rate. B. buying a put, selling the underlying stock, and lending at the risk-free rate. C. buying a put, buying the underlying stock, and lending at the risk-free rate. D. buying a put, buying the underlying stock, and borrowing at the risk-free rate. E. selling a put, selling the underlying stock, and lending at the risk-free rate. OCC

45. All options traded on an exchange in the United States are originally issued, guaranteed, and cleared by the:

A. SEC. B. FDIC. C. CBOE. D. OCC. E. NYSE.

CALL PROFIT D 53. An investor purchases 25 call option contracts at a price of $1.86 and a strike price of $50. At

expiration, the stock price is $47.62. What is the profit on this transaction? A. –$10,600 B. –$5,950 C. $1,300 D. –$4,650 E. $5,950 PUT PROFIT D 57. You purchase 10 put option contracts at a price of $1.12. The strike price of the option is $35,

and the stock price at expiration is $32.18. What is the profit on your investment?

24

A. $2,820 B. $1,974 C. $2,160 D. $1,700 E. $2,432 CALL WRITING C 61. An investor writes 20 call options at a strike price of $85 and an option premium of $4.12. If the

stock price at expiration is $83.27, what is the profit from this transaction? A. –$3,460 B. –$4,120 C. $8,240 D. $3,460 E. –$4,780 PUT WRITING

63. You write 5 put option contracts with a premium of $4.85 and a strike price of $80. What is your profit if the stock price at expiration is $78.13?

A. $1,490 B. $935 C. $3,860 D. –$935 E. –$1,620

SPX OPTIONS E 77. Suppose you buy one SPX put option at a strike price of 1150 and sell one SPX put option at a

strike price of 1200. What is your payoff if the index is at 1130 at expiration? A. –$10,000 B. –$2,000 C. –$7,000 D. $3,000 E. –$5,000

25

63. You purchased 7 put option contracts on Alto Industries. The strike price was $42.50 and the option premium was $1.30. On the expiration date, the stock was valued at $41.40 a share. What is the total payoff on the option contracts? A. -$140 B. $0 C. $110 D. $360 E. $770

Payoff = 7 x 100 x ($42.50 - $41.40) = $770

70. You purchased a call option with a $22.50 strike price and a call premium of $0.30. On the expiration date, the underlying stock was priced at $23.10 per share. What is the percentage return on your investment? A. -100 percent B. 0 percent C. 50 percent D. 100 percent E. 200 percent

Percentage return = ($23.10 - $22.50 - $0.30) / $0.30 = 100%

80. Rosalita purchased a put option with a strike price of $40. She paid a total of $160 for the contract. What is the break-even stock price? A. $38.40 B. $39.20 C. $40.00 D. $41.60 E. $42.80

Break-even stock price = $40 - ($160 / 100) = $38.40

86. A 6-month call has a strike price of $30. The underlying stock is priced at $32.80 and the option premium on the call is $3.60. What is the per share time value of the call? A. $0.00 B. $0.80 C. $1.40 D. $2.80 E. $3.60

Time value = $3.60 - ($32.80 - $30) = $0.80

26

87. A 3-month put has a strike price of $47.50 and an option premium of $1.40. The underlying stock is selling for $46.70 per share. What is the time value of the put? A. $0.00 B. $0.60 C. $0.70 D. $1.20 E. $1.40

Time value = $1.40 - ($47.50 - $46.70) = $0.60

Copy Right 2006 by Dr. M. Metghalchi. All Rights Reserved.

FIN 6364 Dow Theory

By M. Metghalchi

The Dow theory is the oldest and most publicized technical analysis to identify trends. Today many still believe in the basic components of Dow Theory. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow Theory (published in 1932), addresses not only technical analysis, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. While there are those who may think that it is different this time, according to Dow theorists the stock market behaves the same today as it did almost 100 years ago

As Pring (p. 36) mentions, if you had invested $44 in 1897 in Dow Jones Industrial Average (DJIA) and had followed each Dow theory signal (out of the market on sell signals and in the market on buy signals), your original investment of $44 would grow to $51,268 by January 1990. If, instead, you had adapted a buy and hold strategy, your original $44 investment would grow to $2,500 by January 1990. This example does not consider transaction costs nor does it consider capital gain taxes.

INTERPRETATION OF THE THEORY:

There are six basic tenets of the Dow Theory:

1. The index (stock) discount everything

The stock prices reflect all possible information, private and public. Any surprise news will be reflected in the stock price, commodity price, and stock index very quickly.

2. There are three types of stock market movements:

a. A primary or major trend takes place over the course of years. This could either be a bull or bear market depending to the direction of the trend.

b. Secondary (intermediate) or correction movements, which take place from weeks to months. These run contrary to the primary trend. These counter trend movements generally retrace from 33 to 68 %

(occasionally 100%) of the primary price change. Figure 1 shows a representation of primary and secondary trend for both bull and bear market.

Figure -1

c. There are minor movement (day-to-day fluctuations) which can move in either direction (bull or bear), and are of no particular importance. These are part of primary or secondary movements.

3. Lines

Sometimes the secondary movement is horizontal, and this is called line. It should last for few weeks. In a bull market, line formation implies smart money is accumulating and in a bear market, line indicates distribution from strong hand to week hand.

Figure 2

Figure 2 show an example of line formation in a bull market.

4. Price /Volume Relationship.

In general we should have the followings:

Generally volume should go with the trend and we have the following

relationship between volume and price:

Price Volume Interpretation

Rising Up Volume confirms price rise, bullish

Rising Down Volume indicate weak rally, correction

or reversal is possible. Bearish

Declining Up Volume confirms price fall, bearish

Declining Down Volume indicate weak price decline,

consolidation or reversal is possible.

In a rising market the volume should expand and in a declining market the volume should expand to confirm the trend. According to Dow Theory, If in a rising market volume contracts then this is a warning signal that the bull market may come to an end. Also, in a bear market if prices going down and suddenly the volume dries up, this could signal that the end of the bear market is very near.

5. Major Trends have three phases:

Accumulation phase, public participation phase, and distribution phase.

For example if the market is in a bear market and price is going down, the volume should increase as the market is going down, but if the volume is not increasing and price is going down, then it is the accumulation phase (Bottom of the market), the smart people are not selling any more.

As the bleeding stops, then prices keep going up and the bull market begins, (Economic news are improving) the trend followers get in and the market keeps going up.

Finally at the top prices are going up (News papers are publishing very good stories, many cover stories), public speculation keep increasing, here the smart money is selling. This is the distribution phase.

6. Price action determines the trend

In a bull market the peak of successive rallies should increase and also the trough of the secondary movements should increase too. It means we will see higher highs and higher lows in a bull market. The reverse is correct in a bear market; we should see lower lows and lower highs in a bear market.

Bear market example from (http://www.stockcharts.com/education)

“In a bear market the trend is down until a higher low forms and the ensuing advance off of the higher low surpasses the previous reaction high. Below is a chart of the Dow Jones Transportation Average in 1992. The line in figure-3 shows the bear market trend. Since the peak in February, a series of lower lows and lower highs formed to make a downtrend. There was a secondary rally in April and May (green circle), but the March high was not surpassed. The DJTA continued down until the high volume washout day (red arrow). After this high volume day, the DJTA dipped again and then moved above 1250, creating a higher low (green arrow). Even after the higher low is in place, it is still too early to call for a change in trend. The

change of trend is not confirmed until the previous reaction high is surpassed (blue arrow”

Figure -3

Bull market example from (http://www.stockcharts.com/education)

“An uptrend is considered in place until a lower low forms and the ensuing decline exceeds the previous low. Figure 4 shows a line chart of the closing prices for the DJIA. An uptrend began with the Oct-98 lows and the DJIA formed a series of higher highs and higher lows over the next 11 months. Twice, in Dec-98 (red circle) and Jun-99 (blue arrows), the validity of the uptrend came into question, but the uptrend prevailed until late September. There were lower highs in Jun-99, but there were never any lower lows to confirm these lower highs and support held. Any bears that jumped the gun in June were made to sit through two more all-time highs in July and August. The change in trend occurred on September 23 when the June lows were violated. Some traders may have concluded that the trend changed when the late August lows were violated. This may indeed be the case, but it is worth noting that the June lows represented a more convincing support area. Keep in mind that the Dow theory is not a science and Hamilton points this out numerous times. The Dow theory is meant to offer insights and guidelines from which to begin careful study of the market movements and price action.

Looking at the line chart above (DJIA 1998/1999 daily close semi-log scale), it may tion. rated

vember low? (red circle) After the November peak, a lower high formed in

volatility of today's markets comes the need to smooth the daily fluctuations and avoid false readings.”

7. The Averages Must Confirm.

One of the most important principles of the Dow Theory is that the Dow Jones Industrial Average and the Transportation Average must corroborate

5).

Figure -4

be difficult to distinguish between a valid change in trend and a simple correcFor instance: Was a change in trend warranted when the December low penetthe NoDecember and then the November reaction low was broken. In order to eliminate false signals, Hamilton suggested excluding moves of less than 3%. This was not meant to be a hard and fast rule, but the idea is worth noting. With the increased

or confirm each other's direction for there to be a reliable market trend.

Confirmation example from (http://www.stockcharts.com/education)

”The Dow Theory stresses that for a primary trend buy or sell signal to be valid, both the Industrial Average and the Rail Average must confirm each other. (Figure

Figure - 5

Figure 5 above shows an array of signals that occurred during a 7-month period in 1998.

1. In April, both the DJIA and DJTA recorded new all-time highs (blue line). The primary trend was already bullish, but this confirmation validated the primary trend as bullish.

2. In July, trouble began to surface when the DJTA failed to confirm the new high set by the DJIA. This served as a warning sign, but did not change the trend. Remember, the trend is assumed to be in force until proven otherwise.

3. On July 31, the DJTA recorded a new reaction low. Two days later, the DJIA recorded a new reaction low and confirmed a change in the primary trend from bullish to bearish (red line). After this signal, both averages went on to record new reaction lows.

4. In October, the DJIA formed a higher low while the DJTA recorded a new low. This was another non-confirmation and served notice to be on guard for a possible change in trend.

5. After the higher low, the DJIA followed through with a higher high later that month. This effectively changes the trend for the average from down to up.

6. It was not until early November that the DJTA went on to better its previous reaction high. However, at the same time the DJIA was also advancing higher and the primary trend had changed from bearish to bullish.”

Additional Considerations:

It isn't necessary for both averages to cross at the same time. However, the one should then follow the other not before too long. The Dow Theory does not specify the time period. Generally, the closer the confirmation, the following move will be stronger. As Pring points out, the 1929-32 bear market signal the transportation confirmed Dow 1 day after. In the bull market signal of 1962, the confirmation was made at the same day.

A criticism of the Theory is that many signals are too late, usually 20 to 25 percent after a peak or trough has occurred.

Some Dow Theorists make their move before confirmation according to following rule of thumb:

If the dividend yield on the DJIA is getting close to 6% (prices must be very low to that high a yield), this signals that we are close to a bottom.

The top is more difficult to pick. Some would say a dividend yield of 2-3 % indicates that we are close to a top.

Figure 6 shows the DJIA and DJT from 1970 to November 2005. In November 17th (when writing this lecture) the transportation has mad a new high but the DJIA has not. It seems that the Dow will also soon make a new high to confirm the bull market.

I am upgrading this lecture on December 30th 2006. Figure 7 presents both DJIA and DJT from 1970 to December 30th, 2006. As you can see from figure 7, the Dow has made a new high in December 2006, but this high is not confirmed by Transport. If within the next two months, Transport can not make new high, according to Dow Theory A BEAR Market will soon starts.

Figure- 6 Dow Jones Industrial Index and Dow Jones Transportation Index

Monthly Close: 1970 to November 18th, 2005.

Figure 7: Dow Jones Industrial Index and Dow Jones Transportation Index

Quarterly Close: 1970 to December 30th, 2006. Copy right M. Metghalchi, 2006, all rights reserved.

1

Finance 6364

Technical Analysis of Stocks and Commodities

Momentum Principles Chapter 10

By Dr. M. Metghalchi

Oscillator indicators can provide useful insights by alerting traders of short-term market

extremes commonly referred to as overbought and oversold conditions.

Oscillators are usually constructed with lower and upper boundaries; such as 0 to 100

or -1 to +1, or -10% to +10% As Murphy (Pp. 226) points out, oscillator must be

subordinated to trend analysis.

Caution: if used as a trend following indicator, one should be careful when an oscillator

reaches extremely high or low values (relative to its historical values), you should assume

a continuation of the current trend and not that the trend will reverse. For example, if the

oscillator indicator reaches extremely high values and then turns down, you should

assume prices will probably go still higher if trend analysis indicates that the uptrend is

continuing. The best use of oscillators are in a non trending market and when the trend is

changing or reversing its direction.

Note: momentum is an application of oscillator. Please read pages 228-232 of your

textbook.

We have Price Momentum and Breath Momentum. The first type is constructed by

using price series and the second type is constructed by statistical manipulation of various

market components. In this chapter we discuss various price momentums (Oscillator) and

in chapter 18 we will discuss some Breath Momentums. For me, I use the term

momentum and oscillator interchangeably.

Rate of Change momentum

Rate of Change momentum, ROC, like the whole group of momentum oscillators

involves the analysis of the rate of price change rather than the price level. The speed of

price movement and the rate at which prices are moving up or down provide clues to the

amount of strength the bulls or bears have at a given point in time.

ROC can be calculated by dividing the day’s closing price by the closing price X number

of days or weeks ago and then multiplying the quotient by 100.

ROC = ((Today's close - Close n periods ago) / (Close n periods ago)) * 100

Some simply use difference of prices as a measure of momentum:

2

ROC = (Today's close - Close n periods ago)

Most people use the ratio version of the ROC momentum.

When ROC momentum is above the 100 reference line and rising, prices are increasing at

an increasing rate. If momentum is above the zero line but declining, prices are still

increasing but at a decreasing rate. Usually, a rising momentum is bullish and a declining

momentum is bearish. Another way of constructing ROC reference line is to subtract the

result above from 100 so that the reference line is the zero line.

Trading rules for any Oscillator or momentum indicators:

Overbought/Oversold: Using a scale for a particular indicator and defining the

overbought and oversold conditions (establish bands) for the scale, traders would sell

when the indicator is in the overbought zone and turns down and buy when the indicator

is in the oversold zone and turns up.

Trading rules for any momentum indicators:

Overbought/Oversold: Using a scale for a particular indicator and defining the

overbought and oversold conditions (establish bands) for the scale, traders would sell

when the indicator is in the overbought zone and turns down and buy when the indicator

is in the oversold zone and turns up.

Example of Fedex stock taken from incrediblechart.com

Oscillator = ROC, (Rate of Change of Price) the band or overbought/oversold zone is

defined by plus or minus 10% around the zero line.

FedEx is plotted with 10 day ROC indicator and 21 day exponential moving average.

3

1. Go short [S, overbought] when ROC turns down above the overbought level.

Place a stop-loss above the recent High.

2. Go long [L, oversold] when ROC turns up from below the oversold level. Place a

stop below the latest Low.

3. Go short [S, overbought].

4. Go long [L, oversold]. This proves a false signal as price falls below the recent

Low - stopping out the position.

5. Go long [L, oversold] when ROC again turns up from below the oversold level.

6. Go short [S, overbought].

Another way of using any momentum indicator is by looking for higher lows, lower

highs, to determine positive and negative divergences.

Bearish divergence or negative divergence: when the price is making a new high but

this high is not confirmed by the momentum (Momentum is not making a new high) this

is a bearish divergence and is a signal to sell. Sometimes when the market is trending

very strongly, the first bearish divergence may not work; a conservative trader could wait

till the third bearish divergence to short the market.

4

The followings is taken from Pring.com (By permission). The concept of bearish

divergence (Or negative divergence is show in figure 3 of Pring.com)

Figure 3 shows how this works in practice. Point A marks the point of maximum

velocity, but the price continues to rally at a slower and slower pace until Point C. This

conflict between momentum and price is known as divergence, since the oscillator is out

of sync with the price. It is also called a negative divergence, because rising prices are

supported by weaker and weaker underlying momentum. The deteriorating momentum

represents an early warning sign of some underlying weakness in the price trend.

End of quote.

Example of Bearish divergence for Lucent stock in December 1999. As you

can see from figure 1 below (Generated from StockChart.com), during November,

5

Figure 1: Bearish Divergence

And December 1999 while Lucent stock price was making new highs, the 10 day ROC

momentum indicator was not confirming the highs in the stock price. This is a bearish

signal and an aggressive trader could in conjunction with other indicators or technical

analysis sell or short Lucent at that time.

Bullish divergence or positive divergence: when the price is making a new low but this

low is not confirmed by the momentum (Momentum is not making a new low) this is a

bullish divergence and is a signal to buy. Sometimes when the market is trending very

strongly, the first bullish divergence may not work, a conservative trade could wait till

the third bullish divergence to go long. In figure 2 below, we show the chart of Dow

Jones and 10 days ROC momentum indicator. As you can see in march of 2009, the Dow

made a new low but the 10-day ROC momentum did not confirm this low. This is an

example of bullish divergence that gave a buy signal on March 2009.

6

Figure 2 (Generated from advfn.com)

The concept of bullish divergence (Or positive divergence is show in figure 4 of

Pring.com)

Positive divergences, as shown in Figure 4, tell us that even though a price is

declining, it is declining at a slower and slower rate. In this instance, the technical

position is said to be improving, or getting stronger. Indeed, if you think a market is

in the process of reaching its bottom and you do not see a divergence, you may want

to reconsider your analysis, because most market bottoms are preceded by at least

one positive divergence.

Similarly, in the case of a negative-momentum divergence, a market observer

can see that the price is moving higher and higher. To him it would seem that

the trend is perfectly healthy. Indeed, the fact that prices are advancing gives a

misplaced sense of confidence. Yet, if he could see that the underlying

momentum is deteriorating, he would be far more inclined to sell. By the same

token, the driver of the car, aware from the din under the hood that some serious

trouble was developing, would be inclined to visit the repair shop or risk a

breakdown. Thus, if we accept the premise that a malfunctioning car is likely to

require more attention the longer an engine problem is ignored, then we should

7

agree that the greater the number of divergences an indicator shows, the more serious the consequences of a reversal in trend when it inevitably takes place.

In Summary:

Bullish divergence:

Price is making a new low, but the indicators do not making new low. (In a strong trending market, this will be repeated a few times, price

keeps making new lows but an indicator does not make new lows).

Bearish Divergence:

Price is making a new high but an indicator does not make the new

high. In a strong trending market, this will be repeated a few times, price keeps making new highs but an indicator does not make new

highs).

8

SOME WIDLY USED OSCILLATORS:

RELATIVE STRNGTH INDEX (RSI)

The RSI indicator, one of the most popular indicators was invented by Welles Wilder, it

measures the velocity of directional movement. The name is somehow misleading, as RSI

does not compare the relative strength of different markets (Like Nasdaq versus S&P500

or Chevron versus Exxon), but rather, measures the internal strength of a single security

or future contract. The RSI indicator calculates a value based on the cumulative strength

and weakness of price, over a specific time period.

Note: RSI is a momentum indicator or an oscillator. (Oscillates around a number like 50)

RSI is an oscillator that compares magnitude of a stock's recent gains to the magnitude of

its recent losses. It is used to interpret the strength of a security or a future contract.

Calculation of RSI

RSI is a ratio of the upward price movement to the total price movement over a given

period of days (Wells Wilder suggested using 14). Suppose the number of days is N. The

calculation of RSI is described below.

AU = Average of x days’ up closes

AD = Average of x days’ down closes

AD

AURS

Then, RS

RSI1

100100

Actually, RSI equals to 100ADAU

AU, so it is a number between 0 and 100.

RSI ranges from 0 to 100. A security is considered overbought if the RSI approaches

above the 70 level (some people use 80 in a bull market). If it falls below 30 (or 20 in a

bear market), it is considered oversold.

9

The RSI curve of natural gas (NG) is illustrated in Figure-1 (created in www.advfn.com

on February 2005).

Figure-1: 14-day RSI of Natural Gas (NG)

Trading Rules with RSI

Overbought/Oversold: Using a scale for RSI indicator and defining the overbought and

oversold conditions (establish bands) for the scale, traders would sell when the indicator

is in the overbought zone and turns down and buy when the indicator is in the oversold

zone and turns up. Usually, in a bull market overbought is above 80 and oversold is

below 30. In a bear market, overbought is above 70 and oversold is below 20. In an up

trending market RSI stays most of the time above 50 and in a down trending market the

RSI mostly stays below 50.

Bearish divergence: when the price is making a new high but this high is not confirmed

by the RSI indicator. This is a bearish divergence and is a signal to sell. Sometimes when

the market is trending very strongly, the first bearish divergence may not work; a

conservative trader could wait till the third bearish divergence to short the market.

10

Bullish divergence: when the price is making a new low but this low is not confirmed

by the RSI. This is a bullish divergence and is a signal to buy. Sometimes when the

market is trending very strongly, the first bullish divergence may not work, a

conservative trader could wait till the third bullish divergence to go long.

It is helpful to use moving average, trendlines, support and resistance lines along with

the RSI chart. For example, one can identify the long-term trend and then use extreme

readings for entry points. An entry point is observed when the long-term trend is bullish

and the RSI is in oversold reading.

Centerline crossover is also used by many investors. The RSI centerline is the horizontal

line at 50. A RSI reading above the centerline indicates that average gains are higher than

average losses, and a reading below the centerline suggests that losses are winning the

battle. If the RSI move from below the centerline to above it, it is a bullish signal.

Similarly, a downward cross the centerline produces a bearish signal.

Using the same NG example, Figure-2 below shows multiple buy/sell signals given by

the above trading rules.

Notes on RSI

The selection of N (the number of periods used to calculate AU and AD). If a

smaller N is used, RSI will become more volatile and more often to hit extremes.

A longer term RSI fluctuates a lot less. The threshold level to use depends on the

sectors and future contract. Stocks in some industries will rise as high as 75-80

before dropping back, while others have a tough time breaking 70. A good rule is

to watch the RSI over the long term to determine at what level the historical RSI

has traded and how the stock of future reacted when it reaches those levels. For

daily data, most people use 14 days RSI. However, you make experiment 9, 18,

25 and 30 days RSI to see which one works the best for a particular market. For

weekly data, most people use 9 or 14 weeks RSI.

11

Figure-2: Trading signals in 14-day RSI of NG

Big surges and drops in a security’s (future) price will dramatically affect the RSI

and can produce false buy/sell signals. Many investors agree that RSI is most

effective when it is combined with other technical indicators.

An Example for your term paper project using RSI:

You can back test the following mechanical trading system:

Buy days: you will be in the market (cover all shorts) as long as the RSI is equal or

greater than 50.

Short days: you will sell all ofyour portfolio and go short as long as the RSI remains

below 50

Moving Average Convergence Divergence (MACD)

MACD is a momentum of form of a trend deviation indicator. It is the difference between

two moving averages (MA). Usually these two moving averages are 26 and 12 days and

are calculated by using exponential moving average, however, other numbers than 26 and

12

12 periods can be used. The MACD is calculated by subtracting the value of a 26-period

exponential moving average from a 12-period exponential moving average. A 9-period

simple moving average of the MACD (the signal line) is then plotted on top of the

MACD.

MACD = EMA(CLOSE, 12) - EMA(CLOSE, 26)

Signal Line = SMA(MACD, 9)

Where EMA is exponential moving average and SMA is simple moving average. The

signal line could be constructed by using EMA rather than SMA.

Trading Rules for MACD indicator.

Crossover signals. When the MACD line crosses the signal line from below that is a buy

signal, when the MACD crosses the signal line from above, it is a sell signal. Another

crossover signal occurs when MACD crosses above or below the zero line. If it move

above zero, it is a buy signal and when it moves below zero, it is a sell signal.

Overbought/Oversold: Oscillators usually oscillate around a number like zero and are

confined in the 0:1, or -1 band. But this is not true for MACD, it means that we can not

use it to find overbought or oversold conditions. However, if the shorter moving average

pulls away from the longer moving average dramatically (i.e., the MACD rises), it

indicates the market may be coming over-extended and is due for a correction to bring

the averages back together. The same can be said for the oversold condition.

Bearish divergence: when the price is making a new high but this high is not confirmed

by the MACD indicator. This is a bearish divergence and is a signal to sell. Sometimes

when the market is trending very strongly, the first bearish divergence may not work; a

conservative trader could wait till the third bearish divergence to short the market.

Bullish divergence: when the price is making a new low but this low is not confirmed

by the MACD. This is a bullish divergence and is a signal to buy. Sometimes when the

13

market is trending very strongly, the first bullish divergence may not work, a

conservative trader could wait till the third bullish divergence to go long.

Example:

Figure 3 (Generated by StockChart.com) shows the buy signal for Merill Lynch chart. On top

of the chart we have MA12 and MA26. At the bottom of the chart, the bold black line is

the MACD line , the difference between MA12 and MA26, and the gray line is the signal

line (EMA(MACD, 9)). Note when the two MA crosses, the MACD line is zero.

Figure 3: MACD crossover signal

As you can see from Figure 3, when the MACD line crosses the signal line, the buy or

sell signal is generated. As usual, you should use the MACD indicators with other

technical indicators.

14

Figure 3-a shows a sell signal for FedEx using MACD indicator. (Generated by

stockcharts.com). As you can see from figure 3-a, there is a bearish divergence (price is

making new high but the MACD is not making a new high) sell signal in late May/early

June. Also we see the bearish crossover at the same time and the histogram becomes

negative. In late June the indicator makes a lower low which is negative,

Figure 3-a

In both figure 3 and 3-a, the charts also show the MACD-Histogram; the MACD

Histogram plots the distance between MACD and its signal line. (The bars in figures 3&

3-a). Some day trades use the histogram signals (Buy if the bars above zero, and sell

when below zero; or go long/short as the bars turn direction), because these signals are

ahead of regular crossover or bullish/bearish divergence. When the histogram is around

zero, it means that the market is not trending and is ranging, in that case signals are not

very reliable.

15

The Stochastic

Created by Dr. George Lane in late 1950s, the Stochastic Oscillator is a very popular

technical indicator that shows the location of a security’s current close price relative to its

price range over a given time period. The idea is that when a stock or future is trending

up, the price tends to close near the high of the day (on a daily chart), however, when the

trend is maturing the price closes away from the high of the day. When a stock or future

is trending down, the price tends to close near the low of the day (Daily chart), however,

when this down trend is maturing, the price tends to close away from the low of the day.

The Stochastic is shown as two lines. The main line is called %K. The second line, called

%D; the % D is a moving average of %K. The %K line is usually displayed as a solid line

and the %D line is usually displayed as a dotted line.

Calculation of the Stochastic

The basic calculation is called the raw stochastic (also known as %K) specifies the

relative position of the closing price within the range of the previous N days.

daysNpastofrangelowhigh

daysNpastoflowlowesttodaycloseTodayK

)(

)(100)(%

Where N is a given number that indicates the time period. Most people use a 14-day

stochastic, but N can be 9, 28, 33. It is tp to you what number to use. This % K is the first

line (Usually bold line).

A smoother version of the raw stochastic (%K) is known as %D, which is essentially the

moving average 3 of %K. An even smoother version is %D-slow, which is the moving

average 3 of %D. We therefore have two stochastic oscillators:

1. Fast stochastic ( %K and %D lines)

2. Slow stochastic (%K and %D-slow lines)

There are three parameters for the stochastic. The first is the number of period (N) used

in the %K calculation. The second is the number of periods of moving average used to

calculate %D, and the third is the number of period of moving average in %D-slow

16

calculation. For example, a slow stochastic (14, 3, 3) is a slow stochastic that uses 14

periods to calculate %K and 3-period moving average for %D and %D-slow.

The value of the stochastic is within the range of 0 and 100. If the stochastic is above 80

(some people use 70 if it is not a strong bull market), the security is considered

overbought. If stochastic is below 20 (some people use 30 if it is not a strong bear

market), the security is considered oversold. If the market is trending up, the stochastic is

usually above 50 and when the market is trending down, the stochastic generally stays

below 50.

A slow-stochastic (14, 3, 3) chart is shown in Firgure-4 (Created in www.advfn.com).

Figure 4: Slow stochastic for S&P 500

Trading Rules with the Stochastic

.Overbought/Oversold: Using a scale for Stochastic indicator and defining the

overbought and oversold conditions (establish bands) for the scale, traders would sell

when the indicator is in the overbought zone and turns down and buy when the indicator

is in the oversold zone and turns up. Usually, in a bull market overbought zone for

stochastic is above 80 and oversold is below 30. In a bear market, overbought is above 70

and oversold is below 20.

17

Crossover signals. Crossovers of %K and %D generate buy/sell signals. The signal is

stronger when both %K and %D have extreme values. The rule is to buy when the %K

line rises above the %D line when they are in oversold area, and to sell when the %K line

falls below the %D line when they are both in overbought territory. However, crossover

signals occur frequently and may result in a lot of whipsaws.

Bearish divergence or negative divergence: when the price is making a new high but

this high is not confirmed by the Stochastic indicator. This is a bearish divergence and is

a signal to sell. Sometimes when the market is trending very strongly, the first bearish

divergence may not work; a conservative trader could wait till the third bearish

divergence to short the market.

Bullish divergence or positive divergence: when the price is making a new low but this

low is not confirmed by the Stochastic. This is a bullish divergence and is a signal to buy.

Sometimes when the market is trending very strongly, the first bullish divergence may

not work; a conservative trader could wait till the third bullish divergence to go long.

It is helpful to use moving average, trendlines, other indicators, support and resistance

lines along with the Stochastic indicator.

Given that crossover signals occur frequently and may result in a lot of whipsaws. Bullish

and bearish divergences provide more reliable signals. So as a trader, wait for the

oscillator to reach overbought levels, wait for a negative divergence to develop and then

go short. For a buy signal, wait for a positive divergence to develop after the indicator

moves below the oversold level. After the positive divergence forms, the second break

above the oversold level confirms the divergence and a buy signal is given.

18

Figure-5: Stochastic signals

Using the same SP 500 example in Figure-4, many buy/sell signals can be found

according to the above trading rules (Figure-5).

StochRSI

In their 1994 book, “The New Technical Trader”, Tushard Chande and Stanley Kroll

explained that RSI sometimes trades between 80 and 20 for extended periods without

reaching overbought and oversold levels. Traders looking to enter a stock based on an

overbought or oversold reading in RSI might find themselves continuously on the

sidelines. To increase the sensitivity and provide a method for identifying overbought and

oversold levels in RSI, Chande and Kroll developed StochRSI that uses RSI as the

foundation and applies to it the formula behind Stochastics:

daysNpastofrangelowRSIhighRSI

daysNpastofRSIowlowesttodayRSIStochRSI

)(

)(

The stochRSI oscillator is between 0 and 1. The oversold level is usually set at 0.20 and

overbought level at 0.80. The trading rules used in the stochastic and RSI, such as

19

overbought and oversold crossover, divergence, and centerline crossover, are used in

stochRSI.

All of the above indicators should be studied using daily, weekly, and monthly

charts. For day traders, these indicators can be used on 5, 15, 30, and 60 minutes

charts.

Average Directional Movement Index - ADX

The ADX indicator was developed by Welles Wilder in his book "New concepts in

technical trading systems". The ADX indicator helps to determine whether there is a

price trend. This indicator is based on the comparison of two directional indicators: the

14-period +DI and the 14-period -DI. The standard time period is 14 periods, although

other time span can be used. The calculations of DI’s are a bit complex, however, most

chart providers provides this indicator. Wilder suggests putting the charts of +DI and -DI

one on top of the other. Wilder recommends buying when +DI is higher than -DI, and

selling when +DI sinks lower than -DI.

There is additional indicator bases on +DI and –DI, namely, Average Directional

Movement Index (ADX). The ADX is an average of +DI and –DI over a specific period,

usually 14 periods; the ADX is constructed in such a way that it plots between 0 and 100.

A high reading of the ADX means that the stock or the future contract is in a trending

mode (Directional movement) whereas a low reading means that the stock or the future

contract are not trending (They are in trading range).

IMPORTANT NOTE: Unlike other oscillators, the ADX does not tell about the direction

of price (Up or down), it only implies whether the security is trending or not. In figure 6,

we generate the Japanese Yen chart (From Barchart.com) and the ADX indicator on

December 27, 2006. The violet colored line is +DI, the green line is –DI and the red line

is the ADX.

20

Figure 6: +DI, -DI, and ADX for Japanese Yen

According to this indicator, one should go long when the violet line is above the green

line and go short when the green line is above the violet line. As you can see, the red line

(The ADX line) does not go to extreme high or low, indicating the price is not trending.

In figure 7, we generate the Euro currency chart (From Barchart.com) and the ADX

indicator on December 27, 2006. The violet colored line is +DI, the green line is –DI and

the red line is the ADX.

According to this indicator, one should go long when the violet line is above the green

line and go short when the green line is above the violet line. As you can see, the red line

(The ADX line) has gone to extreme in late November and early December of 2006,

indicating a trending price for the Euro currency.

21

Figure 7: +DI, -DI, and ADX for Euro Currency

Note: some technicians believe that an extreme number for ADX line implies a change in

trend. But it is not clear whether the change in trend is from up to down or from up trend

to trading range (No trend or consolidation).

The Parabolic Indicator

Wells Wilder’s the Parabolic SAR is used to set trailing price stops. Parabolic SAR (Stop

and Reversal) Technical Indicator was developed for analyzing the trending markets. It is

a stop-loss system. The stop is continuously moved in the direction of the position. The

indicator is below the prices on the bull market (Up Trend), when it’s bearish (Down

Trend), it is above the prices. It is estimated as follow:

SAR(i) = SAR(i-1)+AF*(EPRICE(i-1)-SAR(i-1))

SAR(i-1) = value of the indicator on the previous bar;

AF = Acceleration Factor; default = .02; and is increased by 0.02 every time a new high

or a new low price is reached.

22

The maximum AF value is 0.2.

EPRICE(i-1) = the highest high or the lowest low for the previous period.

(EPRICE=HIGH for long positions and EPRICE=LOW for short positions).

The Parabolic SAR is an excellent indicator for providing exit strategy. Long positions

should be closed when the price goes below the SAR line, short positions should be

closed when the price goes above the SAR line. It is often the case that the indicator

serves as a trailing stop line. Remember, a lot of money can be lost when you have a

position which is against the main trend. If you use this indicator you can avoid large

losses. Figure 8 shows the chart of crude oil (Generated by advfn.com) over the period of

March through December 2006.

Figure 8: Parabolic SAR

I would use this indicator as a stop on my position. For example, if I am long Crude oil,

as soon as this indicator tells me the trend is down (Red check mark sign) I will get out of

23

my long position. On the other hand, if I am short Crude oil, as soon as this indicator tells

me that the trend may reverse (Green check mark sign) I will close my short position.

In the project icon, you can see a paper from one of my student from previous semester

who used the PSA for his mechanical trading system. He is working on the paper to

present it at a finance conference.

I could not program the PSAR in Excel, if you are expert with Excel programming and

you think you can program the PSAR formula and gets its value, I appreciate if you let

me know how to do it. You get a bonus if you do it. Other indicators beside +/-DI (RSI,

Stochastics, MACD are easy to estimate using Excel).

ON Balance Volume (OBV)

OBV was introduced by Joe Granville. This was one of the first and most popular

indicators to measure positive and negative volume flow. OBV Technical Indicator is a

momentum technical indicator that relates volume to price change.

Calculation

OBV is calculated by adding the day’s volume to a running cumulative total when the

security’s price closes up, and subtracts the volume when it closes down.

Example:

If today the closing price is greater than yesterday’s closing price, then the new

OBV = Yesterday’s OBV + Today’s Volume

If today the closing price is less than yesterday’s closing price, then the new

OBV = Yesterday’s OBV – Today’s Volume

If today the closing price is equal to yesterday’s closing price, then the new

OBV = Yesterday’s OBV

This OBV line can then be compared with the price chart of the underlying security to

look for divergences or confirmation.

How OBV is used:

24

The concept is: volume precedes price. This means that a rising volume can indicate

the presence money flowing into a security. A rising (bullish) OBV line indicates that the

volume is heavier on up days. If the price is also rising, then the OBV can serve as a

confirmation of the price uptrend. We can conclude that the rising price is the result of

an increased demand for a security. However, if the prices are moving higher while the

volume is dropping, the OBV line does not confirm the new high in volume, a bearish

divergence is present, which suggests that the uptrend in price is not healthy and should

be taken as a warning signal that the trend will reverse.

Example of divergence.

Intel Corporation plotted with On Balance Volume. (Generated by exclusivechart.com)

Figure – 4

Looking at figure 4, we can observe the followings

1. Price trades in a range during March before a bearish divergence occurs. The

signal is fairly weak - price makes an equal high while On Balance Volume

makes a lower high.

25

2. The signal at [1] appears to have been incorrect - price rises to a higher peak -

but a far stronger triple divergence (price makes a higher high while OBV makes

a lower high) signals weakness.

3. A further bearish divergence occurs - price makes an equal high and OBV makes

a lower high. Shortly thereafter price falls sharply.

If you can remember from previous discussions in chapter 11 on momentum indicators, I

warned you that sometimes when a market is trending very strongly, the first bullish

(bearish) divergence may not work, a conservative trader could wait till the third bullish

(bearish) divergence to go long (Short). The above example is a case in point, the first

two bearish divergences are not working, however, the third one is a good point to short

the market.

Accumulation/Distribution Line

The Accumulation/Distribution Line (ADL) was developed by Mark Chaikin. Similarly to the

OBV, ADL is another popular volume indicator using the volume-precedes-price concept. The

ADL indicator is a variant of the OBV indicator. They are both used to confirm price changes by

means of measuring the respective volume of sales.

Calculation

The value is calculated based on the location of the close, relative to the range for the

period. This value is called the “Close Location Value” or CLV. It ranges from plus one

to minus one with the center point at zero.

The CLV is then multiplied by the corresponding period's volume, and the cumulative

total forms the Accumulation/Distribution Line.

26

Trading signals

The strongest signals on the Accumulation/Distribution line are based on divergences:

Go long when there is a bullish divergence.

Go short when there is a bearish divergence.

Stop-losses should be placed below the most recent low (when going long) and above the

latest high (when going short).

Figure 5 and 6 (Generated by stockchart.com) present an example of the bullish and bearish

divergences for Alcoa and Delta Air Lines stocks. As you can see from figure 5,

Figure 5: Bullish Divergence

27

The A/D line forms a bullish divergence over several months. From August to

November, the stock price was going down whereas the ADL was going up. The stock

price finally caught up with the A/D line when it broke the resistance line in November.

In figure 6, during the June-July rally, the stock recorded a new local high, but the

Accumulation/Distribution Line failed to confirm the new local high, thus setting up the

negative divergence.

Figure 6: Bearish Divergence

MONEY FLOW INDEX (MFI)

The Money Flow Index (MFI) is a volume-weighted momentum indicator that measures

the rate at which money is invested into a security and then withdrawn from it. It is

28

related to the Relative Strength Index, but where the RSI only incorporates prices, the

Money Flow Index accounts for volume. It compares "positive money flow" to "negative

money flow" to create an indicator that can be compared to price in order to identify the

strength or weakness of a trend. The MFI is measured on a 0 - 100 scale and is often

calculated using a 14 day period (Stockcharts, 2006)

Signals:

The common interpretation of the MFI is similar to the RSI in that readings above 80

imply overbought while readings below 20 imply oversold. MFI can also be used to

imply reversals, when prices trend higher and the MFI trends lower (or vice versa), a

reversal may be imminent.

Formula :

The "flow" of money is the security and its volume shows the demand for a security at

certain price. The money flow is not the same as the Money Flow Index but rather is a

component of calculating it. So when calculating the money flow, we first need to find

the average price for a period. Since we are often looking at a 14-day period, we will

calculate the typical price for a day and use that to create a 14-day average.

The MFI compares the ratio of "positive" money flow and "negative" money flow. If

typical price today is greater than yesterday (uptick), it is considered positive money and

if typical price today is lesser than yesterday(downtick) it is considered negative money

flow. For a 14-day average, the sum of all positive money for those 14 days is the

positive money flow. The MFI is based on the ratio of positive/negative money flow

(Money Ratio).

29

Money Flow Index (MFI) = 100 - (100/(1 + Money Ratio))

The fewer number of days used to calculate the MFI, the more volatile it will be.

Trading rules: The MFI can be interpreted much like the RSI in that it can signal

divergences and overbought/oversold conditions.

Figure 7 (Generated by stockchart.com) shows example of overbought/oversold

conditions for People Soft and figure 8 shows bearish divergence for Washington Mutual

stock using MFI indicator. Overbought conditions in September resulted to a minor

correction and in January resulted in reversals of the uptrend, and the oversold condition

in March resulted in a minor correction.

Figure 7: Overbought/Oversold Concept

30

Figure 8 shows how the MFI bullish/bearish divergences can be used to anticipate trend

reversals. If prices are trending upwards and the MFI is trending downwards, reversals

such as those December and March may occur. However, divergences between price and

MFI can exist for long periods of time. Therefore, as with all indicators, the MFI should

be used in combination with other indicators that can provide confirmation of any signals

it sends.

Figure 8: Bearish Divergence

Chaikin’s Money Flow (CMF)

Developed by Marc Chaikin, the Chaikin Money Flow oscillator is calculated from the

Accumulation/Distribution Line that we saw above. CMF argues that buying support is

normally signaled by increased volume and frequent closes in the top half of the daily

31

range. On the other hand, selling pressure is evidenced by increased volume and frequent

closes in the lower half of the daily range.

Chaikin Money Flow is calculated by summing Accumulation/Distribution for 21 periods

and then dividing by the sum of volume for 21 periods.

Trading Signals: When CMF is greater than zero, it is bullish and when it is negative it

is bearish. In addition the concept of bullish/bearish divergence can be applied to CMF.

Williams PRO-GO Indicator

This indicator has two lines. The Public Buying (green line) and the Professional Buying

(red line). I really like this indicator, it give great buy and sell signal.

This technique is to create two Advance/Decline lines.

The Public Advance/Decline line is constructed by using the change from

yesterday's closes to today's open.

The Professional Advance/decline line is constructed by using the change from

today's open to today's close.

The lines are calculated by taking a moving average, usually 14-days, of the results.

This study can be used on daily charts or weekly charts like all other indicators. The

common interpretation of this study is if the Professional line (red) goes below the Public

line (green) it is a sell signal and if the Professional line (red) goes above the Public

line (green) it is a buy signal.

Figure 9 (Generated from Barchart.com) shows the chart of DJIA and Euro currency

from July to December 2006. Below the price chart, the 14-day Pro-Go indicator is also

drawn. According to this indicator, as long as the Red Line (Professional A/D line) is

above the green line (the public’s A/D line) a trader should stay long. And when the Red

line goes below the green line one should go short. In Figure 9, since the DJIA was

trending strongly, the Pro-Go did not generate many signals. However, for the same

period, the Euro has generated a few buy and sells signals. Again, we emphasize that this

indicator should be used with combination of other indicators.

32

Figure 9

33

VIX - CBOE Volatility Index: The following definition is taken from: (http://www.investopedia.com)

Vix is “The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility

Index, which shows the market's expectation of 30-day volatility. It is constructed using

the implied volatilities of a wide range of S&P 500 index options. This volatility is meant

to be forward looking and is calculated from both calls and puts. The VIX is a widely

used measure of market risk and is often referred to as the "investor fear gauge".

There are three variations of volatility indexes: the VIX tracks the S&P 500, the VXN

tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average.”

So VIX is a volatility gauge or investors sentiment. You can trade vix in the

future market or as an option trader.

Many investors use VIX as a contrarian indicator to gauge the market direction. The

higher the VIX value, the more panic there is in the market. The lower the VIX value, the

more complacency there is in the market. A Prolonged period of low VIX values indicate

a high degree of complacency and are generally regarded as bearish. Some investors view

readings below 20 as very bearish. On the other hand, prolonged period of high VIX

values indicate a high degree or nervousness or even panic among options traders and are

regarded at bullish.

The following chart of the S&P 500, SPY (Top part of the chart), taken from: http://www.onlinetradingconcepts.com/TechnicalAnalysis/VIXVXN.html

34

Shows the general inverse relationship between S&P500 and the VIX volatility index,

bottom half of chart. In figure 11, I generate the VIX chart usingStockcharts.com.

Figure 10

As you can see, the VIX has been very high in the first quarter of 2009

which corresponded to low of stock market. As the VIX cam down from

March to June 2009, the stock market went up.

35

Average True Range (ATR):

ATR shows the volatility of the market under consideration. Developed by Welles Wilder

in his book "New concepts in technical trading systems”. Extreme levels (both high and

low) usually predict turning points and prices will reverse direction soon. Also a

prolonged periods of low volatility implying low ATR values are followed by large price

moves.

Estimation:

The True Range is defined as the largest difference of:

Current high minus the current low.

The absolute value of the current high minus the previous close.

The absolute value of the current low minus the previous close.

The ATR then is estimated as a moving average of the True Range over a series of days,

usually, 14-days.

Some investors use the ATR indicator to establish a trailing stop that is based on the

volatility of the security.

Stop when the price falls 1*ATR or 2*ATR below the recent maximum. Most use

2*ATR in order to avoid whipsaws.

Important consideration is that the ATR does not predict the market direction but it gauge

market volatility. And from market volatility some investor can conclude price

movements.

Figure 11 (Taken from: http://www.incrediblecharts.com/technical/average_true_range.php) shows

Microsoft Corporation chart with 14 day exponential moving average of Average True Range. Here are the observation from Incrediblechart.com:

1. Average True Range peaks before price bottoms.

2. Low Average True Range readings - the market is ranging.

3. Average True Range peaks before the market top.

4. Average True Range peaks after a secondary rally.

5. Average True Range peaks during the early stages of a major price fall.

36

Figure 11

A general note on oscillators:

i. In my view and also in Pring’s view, the strongest interpretation of

oscillators is their use of bullish/bearish divergence and not

overbought or oversold interpretation. Also, please remember that

in a strong trending market, the first bullish/bearish divergence

usually will not work if using the daily chart, a conservative trader,

usually should wait for the third signal in a trending market if

using daily chart. Personally, for my retirement account, I look at

weekly charts and move funds between equity and Treasury

Inflation Protect bond or money market funds. When weekly charts

are over bought (oversold) with bearish (bullish) divergence, in

37

combination with daily chart to time the intermarket transfer, I

usually trade between 3 to 5 times in my retirement account

looking basically at weekly chart.

ii. Here is an example of looking at weekly charts of Dow Jones:

Looking at the above chart, there is many negatives around the end of 2007

and again around may 2008.

Around end of 2007, the Dow has made a new high and none of the

indicators confirmed this new high, MACD did not conformed, RSI neither,

stochastic neither. So around this high, one could move par5t of retirement

equity money to a bond found. If the new high is taken, and indicators would

confirm, then one could go back to equity.

The negative signal around May 2008 is even better; all of moving averages

have been turned down, and the price coming back to MA40 week, this is

38

the time to get out of the equity market, if not all, at least 50% should be

taken out of equity. Wait till the MAs turn up with bullish divergence to get

gradually back to market.

Copy right M. Metghalchi, 2010, all rights reserved.

Finance 6364

Technical Analysis of Stocks and Commodities Chapter 4

Basic Concept of Trend

By Dr. Massoud Metghalchi

Whether you invest in futures, stocks, bonds, mutual funds, or options, first you always need to understand the primary trend. Remember “trend is your friend”.

Almost all successful trading requires the determination of the market’s prevailing trend. Is the primary trend up or down?

Is the market involved in secondary counter trend or choppy sideways action? Making these determinations (for the short-, mid- and long-term) is very important for successful trading.

As you know from the Dow Theory chapter the “primary trend” is a long-term trend that usually last for several months (9 months) to 2-4 years. Knowing what the current primary trend is allows you to trade with the trend and caution you “Do not play against the market”.

The technicians look for a trend in their charts. Chart analysis is based on the theory that prices tend to move in trends, and that past price behavior could provide clues to the future direction of the trend.

The easiest trend determination is a trendline construction. Schabacker defines (Technical Analysis and Stock Market Profits by Richard Schabacker) a trendline as follow:

"a trendline is a straight line drawn on a chart through or across the significant limits of any price range to define the trend of market movement”

As Pring points out, in order to construct a trendline in a rising market, you connect a series of rising bottoms by a straight line, this line becomes your support line in a rising market. Figure 1 depicts a simple trendline for a bar chart.

1

Trend line is broken.

Figure-1: Simple Trend Line

In order to construct a trendline in a declining market, you connect a series of declining tops by a straight line; this line becomes your resistance line in a declining market. Figure 2 depicts a simple trendline in a declining market.

We could construct short term trendline (60 minute chart), intermediate trendline (daily chart) and long term trendline (weekly chart). However, the primary trend is seen best if you use weekly or monthly charts.

For example on November 22, 2005 I have constructed two trendlines for DJIA 60 minutes chart (Figure 3). I have two support lines (or redraw trendline as market evolves). These are short term trendlines because I am using 60 minutes bar chart. (Advfn.com was used to generate the chart).

2

Trenline is broken

Figure – 2

Figure 3

3

TECHNICAL PRINCIPLES: constructing trendline is an art not a science.

Figure 4 shows the daily chart of DJIA constructed on 11/23/05 (Advfn.com was used to generate the chart). As you can see from this chart, I have drawn three trendlines. The first one (July-September) represents a resistance line (trendline can be horizontal). The second one (September – October) is a down trendline (secondary or intermediate reaction). The third one (October – November) is an upsloping trend line. The down trendline was broken in early November, one would cover his/her short and go long

Figure 4

In Figure 5, I have drawn the weekly chart of DJIA (Advfn.com was used to generate the chart) on November 23, 2005. As you can see from this chart, there are few trendlines. The first parallel lines (2003 – Early 2004) defines support and resistance line of the primary movement (lasting more than a few months). From March 2004 to October 2004, the parallel lines define the support and resistance of the Secondary (intermediate) trend. From October 2004 till

4

March 05, Dow moved up without a trendline and made a double top on March 2005 (or M formation). From March 2005 till November 2005, it seems that Dow is consolidating. If Dow can break the high of March 2005 (10,985) convincingly, then it is possible we could have another up trend. In that case, I would consider the whole price action from Early 2004 to November 2005 as a consolidation (secondary reaction). At the time of writing (November 23, 2005), DJIA closed at 10,916 with today high of 10,950.

Figure 5

NOTE: Trendline can also be drawn on line or candlestick chart. For example Figure 6 shows monthly candlestock chart for DJIA From 1995 to 2005. (Advfn.com was used to generate the chart). Figure 5-a is also a weekly candlestick chart taken from ExpressTrade. Figure 5-a is similar to Figure 5.

5

Figure 5-a

6

Figure 6

TRENDLINE BREAKS: Trendline breaks have two interpretations:

1. A break of trendline could mean the end of the trend. This shown in Figure 6 by line A. As the trendline A is broken, the trend is over.

2. A break of trendline could also mean a CONTINUATION pattern.

Line B in Figure 6 presents a continuation trendline break; this time the trend does not reverse but it still it is up, however, the price is moving up at a reduced rate.

Unfortunately, we cannot tell at the time of break whether it is a reversal break or a continuation break. However, if the slope of the trendline is very steep, probably the first break is a continuation break. Also looking at other indicators that we will learn in later chapters can guide us whether the break is a reversal or a continuation break. All these discussions also apply in a bear market down trendline.

7

NOTE: If a trendline is broken (reversal), then after the break, this trendline becomes the resistance line. For example in Figure 7, the beginning of the line is the support line, but after it is broken (reversal), the line becomes the resistance line.

Figure 7 Figure 7

TREND INTERPRETATION: As we mentioned above that we cannot tell at the time of break whether it is a reversal break or a continuation break, we can however interpret its significance. As Pring points out, a trend significance depends to the following three factors:

1. The length of time the trend is being made 2. The number of time the trend has been touched 3. The slope of the trendline

The longer the trend, the more important it is. If a few week’s trend is violated it is less important than if a two years trend is violated. Big trend results in important signal whereas small trend results in minor signal.

8

The more the trendline touches prices, the more significant will be its violation. Each time the price reaches its support (trendline) the buyers come in and the trend continuous. A very steep trendline will sooner or later be broken; therefore, a break of steep trendline usually does not mean that the trend is over. A new trendline should be redrawn with smaller slope (see Figure 6). The break of steep trendline is continuation rather than reversal. OTHER FACTORS: Thomas A Meyers (The Technical Analysis Course, MC Graw Hill, 2003) discusses the following factors to decide on the Validity of trend line penetration:

1. The extend of penetration: How far do prices should move before we call it a valid break? It depends to the volatility of the security. Most technicians apply a one (less volatile) to three (more volatile) percent rule from the trendline

2. Some technicians use a filter. For example, if price closes above a downsloping line or below a up trendline for two days in a row, it is viewed as a valid penetration.

3. On occasion, prices will break a trendline on intraday basis (but not at

the close of the day). Is this a valid break? No, most technicians look at the closing price for trendline penetration. (However, one could redraw the trendline).

4. The validity of break is enhanced if it is accompanied by extending

volume; however, it is not essential. Also looking at other indicators (Stochastics, RSI, MACD, Moving Averages, etc..) that we will learn in later chapters can guide us to determine whether the break is a valid break. Trading Strategies for Long Positions:

1. Go long when the price closes above the downtrend line 2. Go long as soon as the price penetrates the downtrend line

9

3. Go long in a bull market every time price comes down toward the trendline.

The exit for the above strategies would be to get out of your position if price breaks below the trendline as soon as possible or at the close of the day. Trading Strategies for Short positions:

4. Go short when the price closes below the uptrend line 5. Go short as soon as the price penetrates the uptrend line 6. Go short in a down market every time price comes up toward the

trendline. The exit for the above strategies would be to get out of your position if price breaks above the trendline as soon as possible or at the close of the day. MINIMUM PRICE EXPECTATION AFTER A BREAK OF A TRENDLINE: In figure 8, we measure the maximum vertical distance from the trendline (AB). After the trend breaks, the minimum price objective would be C. C is AB length (distance) lower from the breaking point. This C is the minimum price objective, but it could go lower. If you short the market when price goes below the trendline, you could cover your short when price reaches C. The same principle applies if the trendline is downsloping, we could deduct a minimum price objective if the price breaks above the down trendline. TREND CHANNELS: Many times, prices repeatedly move approximately the same distance away from a trendline before returning to the trendline. In an up trendline, when we connect the peaks of rallies, then we have a line that is parallel to the trendline and this line is called a Return line or channel line, see figure 9 for uptrend channel and figure 10 for downtrend channel. Trend channel can be used in couple of ways: 1. Sell when prices are near the upper channel line, buy when price is about lower channel line.

10

Figure 8

Figure 9

2. In an uptrend channel, if prices break above the upper channel, it means the price advance has begun to accelerate (buy). In a downtrend channel, if

11

prices break below the lower channel line, it means the price decline has begun to accelerate (sell).

Figure 10

CAUTION: There could be false signal: For example, figure 11 (taken from http://www.stockcharts.com/education/ChartAnalysis/priceChannel.html) shows a false

Figure 11

12

Break out for Chevron Texaco in February-Mach 2000. A false break out usually is accompanied with high volume and signal a major reversal. In figure 11, if we assume that the breakout is false, then its significance would be that the downtrend in Chevron Texaco is over. Therefore, a breakout in the direction of the channel has two interpretations:

1. Prices are over extended; this implies a major reversal (false break). 2. Prices are at the beginning of a runway market.

Therefore, we should evaluate these breakouts in context of other indicators and studies and time frame to gain clues about the true market conditions. A third way to trade a channel or trend is when the break occur, we should wait for the market to make a reaction back to the channel (usually it happens) and then take a position as the price comes back toward the original breakout. Usually, breaking out from a horizontal channel is very profitable. During the horizontal duration, the price has consolidated and when it breaks out, it means it has ways to go in the direction of break (except false break). In chapter 15 we will discuss more on trends, especially speed resistance fan lines and Fibonacci numbers. Summary:

We have three types of trends:

1. Major or primary trends - is a long-term trend that usually last for several months (9 months) to 2-4 years. The price rise or decline is at least 20% for this trend. When the primary trend is up, this is called a bull market. When it's down, it's referred to as a bear market.

2. Intermediate or secondary trends - Secondary (intermediate trend) or correction movements, which take place from weeks to months. These run contrary to the primary trend. These counter trend movements generally retrace from 25%, 33% to 62 % (occasionally 100%) of the primary price change. A secondary trend could be an intermediate decline during a bull market or an intermediate rally during a bear market.

13

3. Minor trends - brief fluctuations (One to three weeks). These are random fluctuations without any meaning.

Note: A secular trend is the longest possible trend that last a few decades and composed of many primary and secondary trends. (Example is the bull market in stocks from 1982 to 2000). Excerpts from an interview with Bob Prechter, the Editor of Elliott Wave International (Taken from Elliottwave.com on 11/23/05).

“Will you at least admit that professional traders have an unfair advantage because they have instantaneous access to resources that part-timers and amateurs do not?

Bob Prechter: Think a minute. Isn't that the case with every business? Why would anyone expect a professional commodity trader to trade as poorly as does the general public? So they have an advantage, but it is not an "unfair" advantage.

Even then, there are several points to make. First, if anyone would like to become a professional, he or she can choose to give up regular life and crawl into the pits with the professional traders, thereby gaining all the latest "information." Secondly, the "information" a professional trader gets is, nine times out of 10, erroneous or misleading or irrelevant to the trend of the market. Finally, even a cursory examination of commodity charts shows a remarkable propensity to trend, and split-second timing is really unnecessary. If you call the trend right, you'll make money.

If you make a lot of casual assumptions about hot, up-to-the-minute "information" without studying the way markets act, you'll deserve to lose every penny you put at risk. In fact, it's long been shown that the in-and-out trader who relies on the latest news flash has the worst results. Many so-called insiders blow themselves out in just that way.”

SUPPORT AND RESISTANCE

In their classic book Technical Analysis of Stock Trends, Edwards and Magee define support as buying a stock or future in sufficient volume to halt a downtrend in prices for an appreciable period. While resistance is defined as selling a stock or future sufficient in sufficient volume to stop prices going higher for a time.

The following is taken from Pring.com

Quote:

Think of resistance as a temporary ceiling and support as a temporary floor, as illustrated in Figure 2. In order to become a floor, a support area must represent

14

a concentration of demand. I emphasize the word concentration because supply and demand, by definition, are always in balance. At whatever price a stock trades, there will always be the same amount bought as is sold. It is the relative concentration or enthusiasm of either buyers or sellers that determines the price level. A support area, then, is one in which sellers become less enthusiastic or less willing to part with their assets and buyers, at least temporarily, are more strongly motivated.

End of quote.

PROPORTION TECHNIQUE: Support and resistance should tell us where a trend may temporarily be halted or be reversed, the principle of proportion can also do the same when support or resistance cannot do the job (Like new price area where there is no support or resistance). Two of the most important ratio principles are the Gann Fans and Fibonacci ratios. Fibonacci ratios Nothing will move straight forward. All major trends will have corrections or retracements. The most important retracement that technicians look is the Fibonacci ratios. In order to find the Fibonacci ratios, let’s look at the Fibonacci numbers: You add the last two numbers or two adjacent numbers and you get the followings: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 and so on are known as Fibonacci numbers.

15

After the first couple of numbers, the ratio of each number to its next higher is .618 (61.8 %). The ratio of each number to its next lower is 1.618. Keep these two numbers in mind for forecasting. Also look at following numbers for retracements: .618 * .618 = .382 or 38.2 % Square root of .618 = .786 or 78.6 % 1.618 - .618 = 1 or 100 % Or 1.618 * .618 = 1 or 100 % 1 - .618 = .382 or 38.2 % 1.618 * 1.618 = 2.618 or 261.8 % 1 divided by 2 = .50 or 50 % (using second and third Fibonacci numbers) 3//13 =5/21 = 8/34 = 13/55 = .238 or 23.8 % To summarize, according to Fibonacci ratios, the retracements or the correction will stop at the followings:

• 23.8 % • 38.2 % • 50 % • 61.8 % • 78.6 % • 100 % •

Therefore, in order to forecast the end of a correction or retracement we take two extreme points, a peak and a trough on a security chart, and dividing the vertical distance by the above key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, 78.6% and 100%. Most people use 38, 50, 62 %. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance. The direction of the previous trend would probably continue once the price of the security has retraced to one of the ratios listed above. Figure 12 (Taken from: http://www.tradingday.com/c/tatuto/funwithfibonacci.html) shows how Fibonacci numbers are used to find resistance for Telllabs stock.

16

Figure 12 Figure 13 (Taken from: http://www.tradingday.com/c/tatuto/funwithfibonacci.html) shows how Fibonacci numbers are used to find support for Compaq stock. Figure 14 (Taken from: http://ensignsoftware.com/tips/tradingtips39.htm) shows how Fibonacci numbers are determined for Xilinx stock. Point A in figure-3 is the high ($92) and point C is the trough ($35). When price bounces back from the low of $35, the next resistance is determined as follows: First resistance: ($92 - $35 = $57 * 23.8 =13.57 + 35 = $48.57).

Second resistance: ($92-$35 = $57 * 0.382 = $21.77 + $35 = $56.77).

Third resistance = ($92-$35 = $57 * 0.50 = $28.5 + $35 = $63.50).

17

Figure 13

Figure 14 - Xilinx, Inc. (XLNX)

18

FIBONACCI FANS (Speed Resistance Lines):

To draw Fibonacci fans we first find two extreme points, one trough and one peak. Then we draw a vertical line through the second extreme point (The peak). This vertical line presents 100 percent. Then we mark on this vertical line the Fibonacci levels of 38.2%, 50%, and 61.8% . The next step would be to draw three lines from the first extreme points to the vertical line at the Fibonacci levels and extend them.

For example figure 15 (Taken from:

http://www.metaquotes.net/techanalysis/linestudies/fibonacci_fan) shows construction of Fibonacci fans. The bottom of the red line is the extreme point 1 and the top of the red line is the extreme point 2. From extreme point 2, you draw an imaginary vertical line and mark three Fibonacci levels on it. Then from extreme point 1 you draw three lines to those marks and extend them. This way you can forecast support and resistance in the future.

19

Figure 15

Figure 16

20

Figure 16 (Taken from: www.fibonaccisolution.com/fibonacci_studies.doc) also shows fan lines that are drawn using two extremes (blue circles). The fan lines will determine support and resistance in the future. Another important proportion principle is the concept of Gann Fans. Gann Fans W. D. Gann (1878-1955) was a famous commodity trader in early 1900s. The concept of Gann fans is similar to Fibonacci fans of previous section. Gann postulated that geometric patterns and angles had unique characteristics that could be used to predict price action. The most important concept of Gann was that a 45-degree angle was perfect balance between price and time. The characteristic of 45 degree line for a security chart is that the distance between the price and the time is the same (arithmetic scale). This 45-degree line is called 1 x 1 trend line or angle. The 1 x 1 or the 45-degree line being the most important line, 8 other lines are also advocated by Gann, four larger than 45 degree and four smaller than 45 degree as follow: 1 x 2 or 63.75 degree (1 for time scale, 2 for price scale) 1 x 3 or 71.25 degree (1 for time scale, 3 for price scale) 1 x 4 or 75.00 degree 1 x 8 or 82.50 degree 2 x 1 or 26.25 degree (2 for time scale, 1 for price scale) 3 x 1 or 18.75 degree (3 for time scale, 1 for price scale) 4 x 1 or 15.00 degree 8 x 1 or 7.50 degree Note: some people’s notation could be different, for example 1 x 2 could be: 2 x 1 or 63.75 degree (2 for price scale, 1 for time scale). Gann fans (angles) are drawn between a significant bottom and top or a major high and low at the above 9 angles. Gann felt that the 1 x 1 or 45-degree fan line provides major support during a bull market; when this 45-degree line is broken, according to Gann it signifies a major reversal in the trend.

21

On the other hand, during a bear market prices are falling and are below the downward sloping 1 x 1 or 45-degree line.

Practical way of drawing the Gann lines: we first locate or observe a major top or a major bottom, let's assume it's a major bottom, we then draw a 45 degree line that increases by one unit of price for every one unit of time. Then we draw the other 8 Gann lines from that point, then draw these Gann fan lines at the above degree. Note: in order for the values of angles (e.g., 1 x 1, 1 x 8, etc.) to match the actual angles in degrees, the x- and y-axes must have equally spaced intervals, in other words one unit on the x-axis must be the same distance as one unit on the y-axis. Most char providers calibrate the chart in such a way that a 1 x 1 angle produces a 45 degree angle. For example Figure 17 (Taken from: http://www.dd.bib.de/~ai11rich/taaz/gannangles.html) shows various Gann fans for S&P500 at a major low. Gann advocated that each of these angles can provide support and resistance depending on the trend.

Figure 17

Another way of finding support and resistance would be to place a Gann fan on the relevant high AND on the most relevant low. This will give you one Gann shooting up and another shooting down.

22

Figure 18 (Taken from: http://www.macleanreport.com/ccchapters/42_gann_fan.html ) shows Gann lines from the relevant high AND on the most relevant low.

Figure 18

Figure 19 is taken from www.tradersnetwork.com: Hello Massoud, Trader's Network gives authorization to make reference John Crane's "Advanced Swing Trading" for the Reversal Date timing system and Joe Kellogg's technical analysis in the Traders Market Views (TMV) newsletter. This also includes authorization to access our web site link,www.tradersnetwork.com for the Traders Market Views (TMV) newsletter andReversal Date updates. Please send me an email for confirmation, including University of Houston letter head and class name in which this will be used with your name as the instructor. Thank you for your interest in Traders Network. Jeff

23

Traders Network Jeff Staley Office 800-521-0705 Local 970-663-5016 Fax 970-663-1767 E-mail <mailto:Jeff@tradersnetwork.com> Web Site <http://www.tradersnetwork.com/>

MARCH SILVER (12/15/06) The fund buying we’d expected late last week hasn’t materialized yet, and if we don’t see it by Friday, one would have to wonder if that’s it…the top?

FEBRUARY GOLD The 1 X 1 Gann support line is at $620.00 and a correction down to that level should generate buying interest.

24

MARCH JAPANESE YEN I had projected a rally to 89.12 and I was wrong. Friday’s steep decline pushed the market down to 87.00.

MARCH WHEAT Cancel winter! Reports of spring-like conditions along the Austrian Alps where green, not white, cover the slopes has some wondering if winter will be cancelled this year. But the drought in Europe may threaten more than the ski industry. With reduced world wheat stocks and drought conditions in Australia, China and Europe, wheat could become the new gold. A few weeks ago, I had recommended buying wheat on a dip to 4.75. I missed it then, but wheat is again correcting

25

—closing today at 3.90, and that 4.75 buy order still looks good.

MARCH CORN Technically, one might look at this market and conclude that it’s topped. I’m not one of those folks, not as long as those ‘Long Only’ index funds continue buying. Yes, there’ll be corrections, but the smarter bet may be in waiting for the correction and buying. MARCH COFFEE Despite coffee’s strong rally today, the chart pattern looks quite bearish. A break below 124.25 should kick in the selling programs.

MARCH EURO CURRENCY (1/5/07) Chart-wise, the Euro looks heavy, even more so after breaking it’s 1 X 1 Gann line this morning. Friday, I’d

26

expect a small rally, as the market tests the 1 X 1 breakout area, but such rallies should be viewed as selling opportunities. Look for this market to work down toward 129.80.

MARCH WHEAT (1/5/07) Heavy wet snow blankets much of the western wheat belt after last week’s double blizzards, causing some fund trades to lighten up wheat positions and brace for lower prices. To many, the storm couldn’t have come at a better time, possibly ending the three-year drought and blanketing the crop from January’s sometimes fledged temperatures. Through much of December, I’d been suggesting a dip to 4.75 should be a good buy. We reached that point and dropped through it today—closing at 4.67 ¾. Pattern-wise, the market still holds promise, but we’ll likely witness a more sideways trend—possibly testing 4.55 before turning higher again.

Figure -19

27

Copy right M. Metghalchi, 2006, all rights reserved.

28

Finance 6364

Technical analysis of Stocks and Commodities Very Short Term Price Patterns

M. Metghalchi

In the previous chapters we discussed reversal chart patterns and continuation chart patterns that take some times to complete (10 to 30 days, reversal patterns are usually longer than continuation patterns). In this chapter we cover one to two bar price patterns, this applies to all charts from 5 minutes bar charts, 15, 30, 60 minutes bar charts, daily, weekly, and monthly charts. NOTE: one to two bar price patterns should not be used for intermediate or long term forecasts, their influences on prices are very short term. They are, however, somehow reliable signals for very short term trend reversals. Outside Bars: (Usually reversal): On a daily bar chart when a price makes both a higher high and lower low, technicians call this an Outside Bar. In this situation the trading range (today’s bar) totally encompasses yesterday’s range or bar. It usually happens at the top or bottom of a minor or major trend. Figure 1 shows outside bar top and bottom.

Outside Bar

Outside Bar

Figure 1

1

General Guidelines according to Pring:

• The wider the outside bar vis a vis the previous one, the stronger the signal.

• The sharper the previous trend, the stronger the signal. • The more previous bars are encompassed, the stronger the signal. • The greater the volume relative to previous bars, the more significant

the signal. • The closer the price closes to the extreme of the bar, away from the

direction of established trend, the stronger the signal. As we have said, one- or two-bar price patterns generally reflect an exhaustion point that will reverse the prevailing or established trend. As Pring points out for these patterns, the implications are for a very short-term reversal. How short depends to time span of the bars. On a daily bars, the new trend can normally be expected to last for at least three to five days, often longer. On the other hand, a one- or two-bar formation that can be observed in a 10-minute bar chart, is likely to be effective for the next hour or two. In conclusion, I would say that Outside days can occur frequently on daily charts. The important point for outside day is the bigger the better and it has more meaning if found at the end of a trend. It is usually a reversal, but could be continuation.

Figure 2 shows two examples of Outside Days taken from: (http://www.actionforex.com/articles_library/technical_analysis_articles/outside_day_trading/). The first occurred at the end of a down trend and the second occurred at the end of an up trend.

2

Figure 2 Inside Bars: (Usually reversal, but it also represents consolidation) For a bar to qualify as an inside day the high must be lower than the high of the previous day and the low of the day must be higher than that of the previous day. Or today’s bar must be inside of yesterday’s bar. Figure 3 shows two inside days, one at the top of a trend and the other at the bottom of a trend.

3

Inside Bar

Inside Bar

Figure 3 General Guidelines according to Pring:

• The wider the first bar relative to inside bar, the stronger the signal. • The sharper the previous trend, the stronger the signal. • The smaller the volume of the inside bar relative to previous bars, the

more significant the signal. Inside days also can be found on candlestick charts. For example in Figure 4, taken from (http://www.actionforex.com/articles_library/technical_analysis_articles/inside_day_trading/), We show a few inside days. In conclusion, I would say that inside days can occur frequently on daily charts. An inside day could signal a reversal or a continuation, but very often it is followed by change of direction in the next few days. The important point for inside day is that the bigger the day one bar relative to inside day bar the better the signal and it has more meaning if found at the end of a trend. It is usually a reversal, but could be continuation.

4

Figure 4 Wide Ranging Day: Wide Ranging Day is a result of an event that will cause very strong move either up or down, it is suggested that a Wide Ranging Day usually will be followed be a reversal, but not for sure, a general guideline is that the direction of the close (whether the close is near the high or the low) would be a good indication of next few days’ move. Wide-ranging days have a true range that is far larger than the days on either side and are usually meaningful after a strong trend. In figure 5, we show two wide ranging bars. As you can see the range of these two bars are much larger than the other ranges.

5

Wide Ranging Bar

Wide Ranging Bar

Figure 5 KEY REVERSAL DAY: (Signal short term change of direction) Key reversal day is a new high during the day but closes lower than yesterday’s close. Or the price makes a new low during the day but closes higher than previous day’s close. Reversal days signal a change of direction. Figure 6 (Taken from: http://www.incrediblecharts.com/technical/key_reversal.htm) show two key reversal bars in the top and bottom.

• NOTE: A key reversal day may or may not be an outside day. In Figure 6, it is both a key reversal day and an outside day. For example Figure 7 (Taken from:http://trading-stocks.netfirms.com/tradingtriggers.htm) shows a key reversal bar that is not an outside day.

6

Figure 6

Figure 7

7

Figure 8 also presents a key reversal day for cattle that is not an outside day (Taken from: http://www.lambertganneducators.com/newsletters/reversalkeyreversal.php). Look at the CATTLE CHARTS of figure 7. On May 6th (Circled) you had a KEY REVERSAL that came after several days down. The rally that followed lasted for two weeks.

Figure 8

8

TWO-BAR REVERSAL: A two-bar reversal is also a signal for change of direction. Usually this signal will be more reliable after a prolonged advance or decline. Again, all of these reversal days should be looked with other indicators. For example, if the volume is high in the second day, then it will be a better signal than if the volume is low in the second day. The first bar has a range that is larger than the average bar (large bar) and is in the direction of the prevailing trend. The close of the first day is around the high of the first day. The second day bar is also large (similar to the first day bar) and the second day opens around or above the close of the first day but closes around the low of the second day. Figure 9 shows top and bottom two-bar reversal pattern.

2 bar reversal

2 bar reversal

Figure 9 – Two Bar Reversal In a two-bar reversal pattern, the second bar implies a change in psychology against the prevailing trend that could last a few days to 10 days. The following guidelines apply according to Pring:

• A trend must have been established • Both bars should be large relative to previous bars.

9

• The open and close of each day should be at the extreme point of each bar.

• Volume should be higher than previous volumes in both bars.

10

1

Finance 6364

Chapter 5

Major Reversal Patterns By M. Metghalchi

As we have seen in previous chapters, prices usually move in trends of

varying duration. Usually, chart patterns will develop for BOTH trend

continuation and trend reversal. Therefore we should look for two types of

chart patterns:

1. Reversal chart pattern

2. Continuation chart pattern

As Pring points out (page 64) “Transitions between a rising trend and falling

trend are often signaled by price patterns”.

We first discuss the following REVERSAL PATTERNS:

1. Head and Shoulder Tops and Bottoms

2. Double and triple tops and bottoms

3. Rectangle Tops and Bottoms

4. Rounding Tops and bottoms

5. Diamond formation

6. V formation

7. Broadening formation

8. Triangles (Caution: triangles are both continuation and reversal patterns).

9. Rising and Falling wedges

Some of the above patterns could be also a continuation patterns (Triangle).

However the continuation patterns are formed within three weeks on a daily

chart whereas the reversal pattern could take much longer. For example if a

triangle is formed in two weeks on a daily chart, then this probably is a

continuation pattern but if it takes two month for a triangle pattern to form,

then this could be a reversal pattern.

HEAD AND SHOULDER (H&S) TOPS AND BOTTOMS:

Head and shoulder most of the time is a reversal pattern, very rarely it is a

continuation pattern. A head and shoulders top consists of a peak (left

shoulder) followed by a higher peak (head) and then a lower peak (right

2

shoulder). A neckline can be drawn by connecting the bottom of two

shoulders. See Figure 1.

Figure 1

The neckline is drawn through the lowest points of the two intervening

troughs and could slope upward (Figure 1) or downward. Some technicians

believe that a downward sloping neckline is more reliable as a signal than

an upward sloping neckline, and the most reliable signal, according to some

technicians, is when the neckline is leveled (slope is zero).

After the right shoulder (RS) is formed and price come down and penetrate

the neckline, then we confirm that we have seen the top of the market (trend

has been reversed). After breaking the neckline, the MINIMUM price target

is estimated as follow:

a. Measure the peak of the price (highest price) from the neckline.

b. Then project down the above measure from the break outpoint to get

the minimum price objective. (See figure 1).

Head and should formation is usually of the most reliable reversal pattern.

Volume Confirmation:

High volume on the left shoulder,

Neckline

Minimum Price

target

H

L S R S

3

Moderate volume on the middle peak,

Low volume on the right shoulder,

A sharp increase in volume on the break below the neckline

Trading possibilities:

1. Go short at breakout below the neckline and place a stop-loss above the

right shoulder.

2. After the breakout, price often rallies back to the neckline which then acts

as a resistance level. when the price comes back to the neckline, then go

short and place a stop-loss above the neckline.

Head and Shoulder Bottom:

It is an inverted head and shoulder as can be seen from Figure 2. Usually the

inverted head and shoulder signals the end of downtrend (Reversal of trend).

Figure 2 (From www.incrediblecharts.com)

For a head and shoulder bottom, volume usually picks up on each rally. The

greatest volume will be on the right shoulder.

Caution:

4

On rare occasion, the H&S formation shows up as a continuation pattern and

not as a reversal chart pattern. If the H&S is continuation pattern, then the

H&S signal will be a failure. It means, in an uptrend, when there is a H&S

formation and price breaks below the neckline, it will come back and

violently moves above the neckline and will make a new high. In a

downtrend the reverse happens.

DOUBLE AND TRIPLE TOPS AND BOTTOMS:

After a established uptrend, price will peak, and then declines and again rise

to form a second peak at or about the level of the first peak, a double top is

said to have formed. A double top looks lime a M. Usually the second peak

has lower volume. If the volume on the second peak is higher than the first

peak, be cautious, it could be a false signal. A neckline can be drawn across

the base of the two peaks. When price breaks below the neckline, it

confirms the reversal in trend, see Figure 3. Minimum price objective is

similar to H&S pattern, see Figure 3.

Figure 3 – Double Top

A double top looks like a M. Usually the second peak has lower volume. If

the volume on the second peak is higher than the first peak, be cautious, it

may not be a double top.

Double Bottoms:

Minimum price

target

5

The double bottom is a major reversal pattern that forms after an extended

downtrend. Similar to double top, the pattern is made up of two consecutive

troughs that are roughly equal, with peak in between. It looks like a W.

Usually the second trough has higher volume. If the volume on the second

trough is lower than the first trough, be cautious, it could be a false signal. A

neckline can be drawn across the base of the two troughs. When price

breaks above the neckline, it confirms the reversal in trend, see Figure 4.

Minimum price objective is similar to H&S pattern, see Figure 4.

Figure 4 – Double Bottom

It looks like a W. Usually the second trough has higher volume. If the

volume on the second trough is lower than the first trough, be cautious, it

could be a false signal.

Note: With any reversal pattern, there must be an established trend to

reverse. Also please note that the double bottom or top is an intermediate to

long-term reversal pattern that will not form in a few days, it probably will

take between few weeks to few months for the formation to be valid.

Triple tops or bottoms are similar to double top and bottoms. For triple

tops, we will have three peaks approximately at the same levels. Volume

will be decreasing as we move from the first to second and then to third

peak.

Minimum Price

Objective

6

For triple bottoms, we will have three troughs approximately at the same

levels. Volume will be decreasing as we move from the first to second and

then to third trough. Very high volume when we break out up of the third

bottom. If the upside break-out is with low volume, that could be a false

signal. The price objective is similar to double tops and bottoms.

Triple tops and bottoms are more reliable signal than double tops and

bottoms.

Figure 4-a and 4-b taken from Stockcharts.com summarize the triple tops and bottoms reversal patterns.

Figure 4-a- Triple Tops (Stockcharts.com)

1. Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the triple top, an uptrend or long trading range should be in place. Sometimes there will be a definitive uptrend to reverse. Other times the uptrend will fade and become many months of sideways trading.

2. Three Highs: All three highs should be reasonable equal, well spaced and mark significant turning points. The highs do not have to be exactly equal, but should be reasonably equivalent to each other.

3. Volume: As the triple top develops, overall volume levels usually decline. Volume sometimes increases near the highs. After the third high, an expansion of volume on the subsequent decline and at the support break greatly reinforces the soundness of the pattern.

7

4. Support Break: As with many other reversal patterns, the triple top is not complete until a support break. The lowest point of the formation, which would be the lowest of the intermittent lows, marks this key support level.

5. Support Turns Resistance: Broken support becomes potential resistance, and there is sometimes a test of this newfound resistance level with a subsequent reaction rally.

6. Price Target: The distance from the support break to highs can be measured and subtracted from the support break for a price target. The longer the pattern develops, the more significant is the ultimate break. Triple tops that are 6 or more months old represent major tops and a price target is less likely to be effective.

Figure 4-b: Triple Bottoms (Stockcharts.com)

1. Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the triple bottom, a downtrend or long trading range should be in place. Sometimes there will be a definitive downtrend to reverse. Other times the downtrend will fade away after many months of sideways trading.

8

2. Three Lows: All three lows should be reasonable equal, well spaced and mark significant turning points. The lows do not have to be exactly equal, but should be reasonably equivalent.

3. Volume: As the triple bottom develops, overall volume levels usually decline. Volume sometimes increases near the lows. After the third low, an expansion of volume on the advance and at the resistance breakout greatly reinforces the soundness of the pattern.

4. Resistance Break: As with many other reversal patterns, the triple bottom is not complete until a resistance breakout. The highest point of the formation, which would be the highest of the intermittent highs, marks resistance.

5. Resistance Turns Support: Broken resistance becomes potential support, and there is sometimes a test of this newfound support level with the first correction. Because the triple bottom is a long-term pattern, the test of newfound support may occur many months later.

6. Price Target: The distance from the resistance breakout to lows can be measured and added to the resistance break for a price target. The longer the pattern develops, the more significant is the ultimate breakout. Triple bottoms that are 6 or more months in duration represent major bottoms and a price target is less likely to be effective.

End of the quote from Stockcharts.com

RECTANGLE TOPS AND BOTTOMS

Most of the time, rectangles are continuation pattern, but sometimes they

could be a reversal pattern (So, you can see technical analysis is not a

science). Rectangle chart pattern is formed by sideway price progressions

that are contained within to parallel lines. When this happens at the top

(bottom) of a uptrend line (downtrend line), we say that the reversal pattern

is a rectangle top or bottom formation. When we have a rectangle top

formation, we say we have a distribution from strong hand to weak hand.

When we have a rectangle bottom formation, we say that we have a

accumulation from weak hand to strong hand.

Note: Rectangles are also continuation patterns. I my personal experiences,

most rectangles are continuation patterns. Figure 5 presents a rectangle top

reversal and figure 6 shows a rectangle continuation pattern.

9

Figure 5- Reversal Rectangle

Rectangles are also referred as trading area or range. You buy a security at

the lower horizontal line and sell it at the top horizontal line. If price breaks

out from either of these horizontal lines, the trend will be on the direction of

the break out.

Technical Principles: Generally, the longer the duration of a price pattern,

the more violent will be the price move that follows.

10

Figure 6- Continuation Rectangle

Figure 7 shows a bottom rectangle reversal pattern

Figure 7- Bottom Rectangle Reversal

Minimum Price Objective of rectangle chart patterns:

Minimum

Price target

11

If the rectangle is a continuation pattern, then the minimum price objective

after a break out is the distance between the two horizontal lines from the

breakout point. Although this objective is the minimum price move, usually,

price will move more than the minimum objective (See figure 2).

Note:

In order to have a valid breakout, some technicians would wait for a 2-4

percent of penetration of boundaries. This 2-4 % penetration is very

arbitrary, here the analyst should use his/her judgment and experiences. For

example, 4 percent could be used for more volatile securities and 2 percent

for less volatile securities.

Also on a daily chart, a valid breakout should hold for at least a couple of

days. If we have a breakout, then if in couple of day price comes back within

the boundary lines, the breakout could be false signal. As a matter of fact,

this type of breakout would be the opposite possibility (Exhaustion), prices

move above the boundary for couple of day and than breaks out in the other

direction, see figure 8.

Figure 8 – False breakout

We could also use volume analysis to verify whether a breakout is valid. As

Pring points out “volume usually goes with trend”. In an uptrend, volume

should rise and in a downtrend volume should declined. Volume should lead

False breakout

12

the price, especially on upside breakouts. So, if we breakout from upper

boundary of a rectangle with low volume, this could signal that the breakout

could be a false signal.

ROUNDING TOPS AND BOTTOMS

Rounding tops (Saucers) happens as expectations gradually shift from

bullish to bearish. This steady gradual shift forms a rounded top. Rounding

bottoms (Saucers) happens as expectations gradually shift from bearish to

bullish. Figures 9 and 10 present rounding top and bottom respectively.

Figure 9 – Rounding Top

13

Figure 10 – Rounding Bottom

Typical Volume Action:

Volume should decline during the first portion of the saucer (For both Top

and Bottom). Volume should rise in the second portion of the pattern.

Rounding tops and bottoms are very rare, however, personally I like them if

I see them I will trade with their signals, they seem to be very reliable.

Trading is very simple because you have time to go long around bottom of

the pattern and also have time to go short around top of the pattern.

DIAMOND FORMATION

Diamond formation is reversal pattern that could happen at the top or at the bottom. At the top it signals the end of the uptrend and at the bottom it signals the end of the downtrend. Diamond formation is relatively uncommon. This pattern is called a diamond because of the shape it creates on a chart.

14

In the example of figure 11 (taken from Investopedia.com) we see an example of Diamond Top formation for Australian/US daollar exchange rate.

Figure 1 – Identifying a diamond top formation using the AUD/USD.

Figure 11

Diamond formation has some similarity with Head and Shoulder (H&S).

Trading the diamond top would be similar to H&S formation. The formation

is completed when price breakout from boundary line D. This breakout is the

area that a trader would short the security.

Volume usually increases during the first half of diamond formation and

decreases during the second half of the formation.

Diamond formation is usually a reversal pattern but sometimes in rare

occasion, the formation turns out to be a continuation pattern. Figure 12

(Taken from: www.gold-eagle.com) shows top, bottom and continuation diamond

formation.

15

Figure 12

V-FORMATION

A bottom V-formation price pattern indicating that the security price has

bottomed out, and is now in a bullish trend. Contrary to most reversal

patterns that gradually reverse direction, the V formation suddenly reverse

the trend. Examples of V formation top and bottom are provided in figures

13. Figure 14 shows the chart of Dow Jones on June 2009. It seems that in

March 2009, the bottom was a V-shaped bottom.

Volume is usually high throughout the pattern. Since this formation

happened quickly, profit opportunity is hard.

16

Figure 13

17

Figure 14 (Generated by: advfn.com)

BROADENING FORMATION

In a broadening top formation, price fluctuates and the fluctuations become

wider. This pattern its orthodox form is a series of three higher highs and

two lower lows, each swing occurring no more than two months apart. The

pattern can also have a flat top or bottom. Figure 15 (Taken from stockcharts.com)

show a broadening top formation for XO communications Inc.

18

Figure 15

Figure 16 (Taken from: http://www.trending123.com) presents both top broadening and

bottom broadening formation.

Figure 17 presents right angle broadening formations.

Caution: Most of the times broadening formations are reversal patterns,

however, on occasions, we could have broadening patterns that are

continuation patterns. Therefore one should always look at chart patterns

with other indicators for possible top or bottom detections.

19

Topping Pattern

Bottoming Pattern

Figure 16: Broadening formation

20

Figure 17

TRIANGLES Triangles, the most common of all price patterns, are a classic type of chart

formation that can signal either a reversal or a continuation (consolidation of

price) of a trend. Most of the times they are part of continuation trend. We

have two types of triangles: 1) Symmetrical and 2) right angled triangles.

Figure 18 (From North Dakota State University of Agriculture and Applied Science) shows a

descending right angled, an ascending right angled, and a symmetrical

triangle formations.

Figure 18

21

Right angle triangles have a horizontal boundary. Right angled

triangles are most likely continuation patterns. The ascending triangle

has a flat upper trendline while the lower trendline slopes upward. This

implies more aggressive buying than selling as the lows get progressively

higher, while the highs make it to about the same level each time before

breaking out to the upside.

Volume Analysis: usually, volume decrease as price moves toward the apex

of either descending or ascending triangle. The volume will increase at the

breakout. This also applies for symmetrical triangles.

Note: Whether a triangle formation is a reversal or a continuation pattern,

traders should take position on the direction of the breakout.

Figure 19 (Taken from: http://www.trade10.com/Triangles.html ) shows a reversal symmetrical triangle formation.

Figure 19

22

Note: In figure 19 and 20, the triangle formation takes a few months,

therefore most likely it is a reversal pattern.

Figure 20 (Taken from: http://www.trade10.com/Triangles.html ) shows a

descending triangle formation.

Figure 20

RISING AND FALLING WEDGES

Wedges are similar to triangles, but they are irregular triangles, wedges are

characterized by two boundary lines being at a slant that converge. Wedges

should not be mistaken for pennants, which are much shorter in duration.

Rising wedges

Rising wedges can be identified by both boundary lines heading up, the

slope of the lower line is greater than the upper one, indicating fluctuating

23

and strengthening price activity, with the lines eventually meeting. The

formation of a rising wedge takes between three weeks to a few months.

Falling wedges

Falling wedges can be identified by both boundary lines heading down, the

slope of the lower line is smaller than the slope of the upperline, with the

lines eventually meeting.

Figure 21

A falling wedge is generally considered bullish. Foe example the top part of

Figure 21 shows two falling wedges, the first one (in an uptrend) is a

continuation pattern. The second one (In a downtrend) is a reversal pattern.

and is usually found in uptrends.

A rising wedge is usually considered bearish. For example in the bottom

part of figure 21, we have two rising wedges, the first one (In an uptrend), it

is a reversal pattern. The second one (In a downtrend) it is a continuation

pattern. (Caution: not all technicians believe in the above. Some say rising wedges are

bullish and falling wedges are bearish)

24

Traders should play any wedges in the direction of the breakout. Breakouts

usually occur at least 2/3 of the way to the apex of converging lines.

In figure 21, we present many triangle formations that are continuation

patterns, usually they are formed within 3 weeks in a daily chart.

Figure 21 (Taken from: blogs.siliconindia.com)

All rights reserved, 2009, Massoud Metghalchi

1

Finance 6364

Chapter 6

Technical Analysis of Stocks and Commodities

Continuation Patterns By M. Metghalchi

As we have seen in previous chapters, prices usually move in trends of

varying duration. Usually, chart patterns will develop for BOTH trend

continuation and trend reversal. Therefore we should look for two types of

chart patterns:

1. Reversal chart pattern

2. Continuation chart pattern

Last chapter we discussed reversal patterns and in this chapter we discuss

the following consolidation or continuation patterns:

1. Flags

2. Pennants

3. Triangles

4. Rising and Falling wedges

5. Broadening formation

The continuation chart patterns usually take a few days up to three weeks on

a daily charts (a few weeks on a weekly charts). Their formations usually are

faster than reversal patterns that last few weeks on a daily chart.

FLAGS

A flag occurs when there is a straight move up (or down) in a security. This

movement is almost nearly vertical, and at the very least is very steep and

very rapid. This rapid and steep move is the pole of the flag (Flagpole) and

usually is accompanied with strong volume and lasts a few trading days.

Gaps may be present within this part of the move.

The flag part of this formation usually takes the shape of a parallelogram or

a rectangle that is tilted on its side and is sloping downward in an uptrend

and sloping upward in a downtrend (Flag part leans away from direction of

the trend). In Figure 1, Wyckoff believes that on 12/16/05 the Euro currency

2

is in the middle of a bullish flag continuation formation. (Taken from

Expresstrade.com).

Figure 1

FOREX: Potential Bull Flag in Euro Currency-U.S. Dollar

Jan. 12

Today, let’s examine the FOREX market and the Euro Currency-U.S. Dollar pair, also called Euro-Dollar. See on the daily bar chart that Euro-Dollar recently saw a solid rebound from the late-December low. This solid rebound was followed very recently by a pause, to form a potential bull flag chart pattern.

An upside “breakout” in prices from this bull flag chart pattern would suggest another solid leg up in prices in the near term.

See also that bulls are encouraged by the fact that Euro-Dollar is now trading above the key 100-day moving average that professional traders monitor very closely.

See support and resistance levels on the chart.

Stay tuned!—Jim Wyckoff

3

Figure 2 (Taken from: http://chart-patterns.netfirms.com/bearflag.htm) shows a bearish

flag continuation pattern.

“Bear Flag is a sharp, strong volume decline on a negative fundamental development, several

days of sideways to higher price action on much weaker volume followed by a second, sharp decline to new lows on strong volume. The technical target for a bear flag pattern is derived by subtracting the height of the flag pole from the eventual breakout level at point (e).

Bear flag formations involve two distinct parts, a near vertical, high volume flag

pole and a parallel, low volume consolidation comprised of four points and an upside breakout.

The actual flag formation of a bear flag pattern must be less than 20 trading

sessions in duration.

Most bear flag patterns occur at the middle of the larger move lower for a stock.

Downside breakouts often lead to small 2-3% declines followed by an immediate test of the breakout level. If the stock closes above this level (now resistance) for any reason the pattern becomes invalid.

Figure 2

P.S. – Swing Trading is the art of capturing profits in trending stocks in a relatively short amount of time. SwingTrades.com offers Swing & Day Trading Strategies for the full or part-time trader. » Go here to learn more…

Bear flags are favored among technical traders because they almost always lead to large and predicable price moves. Like all continuation patterns, bear flags represent little more than a brief lull in a larger move lower. Indeed, in many cases the flag pattern will actually take shape in the middle of the ultimate move lower. Like bull flags, bear flags occur because stocks rarely move in

one direction for an extended period, instead, the move is broken up by brief periods where traders

catch their breath. These periods are flags and pennants. “

4

Traders should play a flag formation in the direction of the trend.

PENNANTS

A pennant is similar to a flag formation except that instead the parallelogram

or rectangle; we will have a triangle (Mostly irregular triangles). Figure 3 (Taken

from: http://www.wallstreetsecretsplus.com/contributors/tom_ventresca/art120605.aspx)

shows both bearish and bullish pennant formation.

“Pennant Formations: Pennant formations are very common and can be either bullish or

bearish depending on how the formation is formed. A pennant or triangle resembles a

flag with the pole being on the left side of the formation created by either a sharp rise in

the stock’s price or an acute decline. The flag or pennant is formed as the stock trades in

an increasingly narrow range for several days, usually five to twenty. The longer that the

flag process takes, the larger the ensuing move will be.

Figure 3

Typically, the stock will come out of the flag formation in the same

direction that it came in. If a pennant is formed after a sharp rise, the odds favor a resumption of the advance once the stock breaks out to

the upside. Conversely, a pennant formation formed after a sharp decline will see lower prices once the flag is broken to the downside.”

In Figure 4, Wyckoff believes that Dollar-Swissy is in the middle of a

bearish pennant formation in January 2006.

5

Figure 4

“FOREX: Bearish Pennant Pattern Develops in “Dollar-Swissy”

Jan. 11

Today, let’s examine the FOREX market and the U.S. Dollar-Swiss Franc currency pair, also called “Dollar-Swissy.” See on the daily bar chart that Dollar-Swissy has formed a potentially bearish pennant pattern with recent price action. Prices dropped sharply and then paused to form the bearish pennant.

A downside “breakout” from the pennant pattern would suggest another solid leg down in prices in the near term. The bears are in firm technical command.

See support and resistance levels on the chart.

Stay tuned!—Jim Wyckoff (Expresstrade.com)”

TRIANGLES:

Triangles, the most common of all price patterns, are a classic type of chart

formation that can signal either a reversal or a continuation (consolidation of

price) of a trend. Most of the times they are part of continuation trend. We

have two types of triangles: 1) Symmetrical and 2) right angled triangles.

Figure 5 (From North Dakota State University of Agriculture and Applied Science) shows a

6

descending right angled, an ascending right angled, and a symmetrical

triangle formations.

Figure 5

Right angle triangles have a horizontal boundary. Right angled

triangles are most likely continuation patterns. The ascending triangle

has a flat upper trendline while the lower trendline slopes upward. This

implies more aggressive buying than selling as the lows get progressively

higher, while the highs make it to about the same level each time before

breaking out to the upside.

Volume Analysis: usually, volume decrease as price moves toward the apex

of either descending or ascending triangle. The volume will increase at the

breakout. This also applies for symmetrical triangles.

Note: Whether a triangle formation is a reversal or a continuation pattern,

traders should take position on the direction of the breakout.

Figure 6 ( taken from: http://www.tradersexchange.com/trianglepatterns.html)

Shows a right angle triangle (Continuation) pattern and a reversal symmetrical triangle formation.

7

Figure 6

Figure 7 (Taken from: http://www.investopedia.com/articles/technical/02/031102.asp)

shows a descending triangle formation that is a continuation

pattern.

The minimum number of lows and highs required to form any triangle is two

of each, for a total of four. If this pattern were followed by a breakout to the

downside from within the triangle formation, it would be a reversal pattern.

As has happened in figure 7, if the price breaks out to the upside, it would

become a continuation pattern rather than a reversal.

Figure 7-a (Taken from: http://www.alpari-idc.com/en/market-analysis-guide/technical-

analysis/triangles.html) also shows a symmetrical triangle formation that is a continuation. The dollar versus Yen in figure 7-a shows that a trader should play a triangle formation in the direction of the break.

8

Chart Created with Tradestation

Figure 7

Figure 7-a

9

Note: The continuation pattern of chart 7-a is an exception to our general

rule that implies that most continuation patterns should form within three

weeks.

There must be at least four reversal points in order for a triangle to be

recognized, but there may be more (for example, six: three peaks and three

troughs).

RISING AND FALLING WEDGES

Wedges are similar to triangles, but they are irregular triangles, wedges are

characterized by two boundary lines being at a slant that converge. So

wedges are similar to a Symmetrical Triangle but generally stubbier or not

as elongated. Wedges should not be mistaken for pennants, which are much

shorter in duration.

Rising wedges

Rising wedges can be identified by both boundary lines heading up, the

slope of the lower line is greater than the upper one, indicating fluctuating

and strengthening price activity, with the lines eventually meeting. The

formation of a rising wedge takes between three weeks to a few months.

Falling wedges

Falling wedges can be identified by both boundary lines heading down, the

slope of the lower line is smaller than the slope of the upperline, with the

lines eventually meeting.

10

Figure 8

A falling wedge is generally considered bullish. Foe example the top part of

Figure 8 shows two falling wedges, the first one (in an uptrend) is a

continuation pattern. The second one (In a downtrend) is a reversal pattern.

and is usually found in uptrends.

A rising wedge is usually considered bearish. For example in the bottom

part of figure 8, we have two rising wedges, the first one (In an uptrend), it is

a reversal pattern. The second one (In a downtrend) it is a continuation

pattern. (Caution: not all technicians believe in the above. Some say rising wedges are

bullish and falling wedges are bearish)

Traders should play any wedges in the direction of the breakout. Breakouts

usually occur at least 2/3 of the way to the apex of converging lines. Figure

9 (http://chart-patterns.netfirms.com/risingwedgec.htm) shows a rising continuation wedge

pattern formation for Qlogic stock.

11

Figure 9

The falling wedge can also fit into the continuation category. As a

continuation pattern, the falling wedge will still slope down, but the slope

will be against the prevailing uptrend, see figure 9-a, or see figure 8 top left

chart. As a reversal pattern, the falling wedge slopes down and with the

prevailing trend, see figure 8, top right chart. Regardless of the type (reversal

or continuation), falling wedges are regarded as bullish patterns.

12

Figure 9-a

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:fal

ling_wedge

1. Prior Trend: To qualify as a reversal pattern, there must be a prior trend to

13

BROADENING FORMATION

In a broadening top formation, price fluctuates and the fluctuations become

wider. This pattern in its orthodox form is a series of three higher highs and

two lower lows, each swing occurring no more than two months apart. The

pattern can also have a flat top or bottom. Figure 10 (Taken from stockchart.com)

show a broadening top formation for XO communications Inc.

Figure 10

Figure 11 (Taken from: http://www.fx-dealer.com/articles/broadening.asp) presents both

reversal and continuation broadening formation.

Caution: Most of the times broadening formations are reversal patterns,

however, on occasions, we could have broadening patterns that are

continuation patterns. Therefore one should always look at chart patterns

with other indicators for possible top or bottom detections.

14

Figure 11

Volume is difficult to characterize though at the market tops volume is very

high. Broadening formation with flattened top is usually very bullish.

It can also develop as continuation patterns.

Cup and Handle

The Cup with Handle is a bullish continuation pattern that marks a

consolidation period followed by a breakout. The Cup and Handle has

recently been developed by William O'Neil in his 1988 book, How to Make

Money in Stocks.

Figure 12

15

Figure 12 (Taken from invstopedia.com) show a cup and handle bullish

continuation pattern. As John Murphy in his Stockcharts.com points out, a

cup and handle has two parts: the cup and the handle. The cup, forms after

an established trend, looks like a bowl or a rounding bottom. As the cup is

completed, a trading range develops on the right hand side and the handle is

formed. A subsequent breakout from the handle's trading range signals a

continuation of the prior trend. Below we explain a bit more what are the

requirements for a cup and handle:

1. Trend. Since this is a continuation pattern, a trend of at least a few

months should have been established.

2. The Cup. The cup could either be a U-shaped or a rounding cup.

3. Cup Depth: The depth of the cup should ideally retrace 1/3 of previous

advance. Although it is possible that we could have ½ retracement.

Rarely, we could even have 2/3 retracement.

4. Handle: After the top of the right side of the cup, there is a pullback

that forms the handle. It is possible that this pull back resembles a

pennant or flag. The handle represents the final consolidation or

pullback before the breakout. The handle can retrace up to 1/3 of the

cup's advance, but probably not more. The smaller the handle

retracement is, the more bullish the formation and significant the

breakout.

5. Duration: according to John Murphy the cup formation can take from

1 to 6 months, sometimes longer on weekly charts and . The handle

can be from 1 week to many weeks and ideally completes within 1-4

weeks on a weekly chart. On a daily chart, it also takes a few months.

6. Volume: Tremendous volume increase at breakout.

7. Target: The projected price rise after the breakout can be estimated

by measuring the distance from the right peak of the cup to the bottom

of the cup.

Copy right 2009, Massoud Metghalchi, all rights reserved.

1

Fin 6364

Technical Analysis of Stocks and Commodities

MOVING AVERAGES By Dr. Massoud Metghalchi

One of the most important trend determinations is the moving average (MA)

technique. There are three major variation of moving averages in technical

analysis:

1. Simple moving average

2. weighted moving average

3. Exponential moving average

A simple moving average shows the average value of a security's price over

a period of time. To find a10 - day moving average of S&P 500, you would

add up the closing prices from the past 10 days and divide them by 10. Since

prices are constantly changing it means the moving average will also

change.

Assume the following daily prices for NASDAQ tracking stock, symbol:

qqqq. (Taken from Yahoo.com)

Date Open High Low Close

29-Nov-05 41.76 41.85 41.34 41.34

28-Nov-05 41.97 42.00 41.50 41.54

25-Nov-05 41.84 41.94 41.73 41.89

23-Nov-05 41.73 42.02 41.71 41.80

22-Nov-05 41.46 41.87 41.36 41.70

21-Nov-05 41.40 41.58 41.24 41.55

18-Nov-05 41.51 41.65 41.27 41.45

17-Nov-05 40.91 41.32 40.85 41.31

16-Nov-05 40.65 40.78 40.46 40.77

15-Nov-05 40.73 40.90 40.38 40.52

14-Nov-05 40.77 40.86 40.60 40.71

11-Nov-05 40.77 40.92 40.68 40.71

10-Nov-05 40.18 40.69 39.92 40.60

9-Nov-05 40.12 40.33 40.03 40.16

2

Calculate the sample (Arithmetic) moving average of 3 days (MA3) of

QQQQ for the closing price.

Solution:

On November 29th, 2005, the MA3 is:

MA(3) = (41.34 + 41.54 + 41.89)/3 = 41.59

On November 28th, 2005, the MA3 is:

MA(3) = (41.54 + 41.89 + 41.80)/3 = 41.74

On November 25th, 2005, the MA3 is:

MA(3) = ( 41.89 + 41.80 + 41.70)/3 = 41.80

It is very easy to estimate Moving Averages in Excel. Moving average will

smooth price fluctuations; the longer moving averages are smoother than

shorter moving averages. For example moving average of 50 days is much

smother than moving average of 5 days.

Compare: QQQQ vs S&P Nasdaq Dow

Compare

Figure 1

3

As you can see from Figure 1, the MA50 of NASDAQ index (QQQQ), the

green line, is much smoother than MA5, the red line. (Taken from

Yahoo.com).

For stocks and stock indexes, the most common use of MA is the MA50,

MA100, and MA200.

Many technicians believe that as long as the stock price or Index price are

above these moving averages, the trend is up. On a daily chart, many use

MA50 for short term trend and MA200 for long term trend. For example in

Figure 2, we show the daily bar chart and MA50 and MA200 for QQQQ.

(Taken from Yahoo.com on 30/11/05).

Compare: QQQQ vs S&P Nasdaq Dow

Compare

Figure 2

As figure 2 shows, the price is above both MA50 and MA200 on November

30th 2005 (At the writing of this lecture), that means the short term and long

term trends are up. As Pring points out

CHANGE IN TREND HAPPENS IF PRICE CROSSES ITS MOVING

AVERAGE, NOT BY A REVERSAL IN THE DIRECTION OF THE MOVING

AVERAGE.

4

Not all believe in the above statement, some technicians believe that you

should be in the market as long as the moving average is going up and be out

of the market when the moving average slopes down. (I prefer price

crossing MA method because reversal of MA direction method is too slow

or too late for short term trading, however, reversals are more reliable and

therefore could be used for long term positioning).

For short term trades when using price crossing moving average method,

please keep in mind that:

If price crosses a MA but the MA is still moving in the direction of

the prevailing trend, this could be a preliminary warning that the trend

may be ending soon. However, if the slope of the MA is very steep, a

crossing of moving average my not result in a trend reversal, similar

to a violation of a steep trendline (see chapter 4).

The longer the MA, the greater the significance of a crossing the MA.

Moving averages can also be drawn on weekly and monthly charts for

longer term trend analysis and on 60 minutes and 30 minutes charts for very

short term trend analysis.

MA crossover should be looked in the context of all other clues (Indicators,

price pattern, breath, trendline, ..etc) to decide whether a crossover is a valid

signal or possibly a false signal.

For example in Figure 3 (Nov. 2005) of daily DJIA, The price crossed over

the MA20 (the blue line) approximately at the same time as the down

trendline was broken. In addition looking at the stochastic at the time of the

cross, this indicator was signaling a buy, therefore, one could reasonably

assume that the crossing of MA(20) was a valid signal. (although one could

look at additional indicators like RSI, MACD, price patterns, ..etc).

NOTE: it is possible to calculate MA of high, low, open, however, most of

the time we construct MA by using closing prices.

5

Figure 3

CHOICE OF TIME PERIODS:

How many periods (5, 10, 20, 40, 50, 100, 200) should we use to construct

moving averages?

There is no best answer to the above question. We need to consider the

followings:

Are we studying the short term, intermediate, or the primary trend?

What market is being studied? Since Gold market cycle is different

than oil and stock market cycles, the best MA for gold probably will

be different than the best MA for oil and stock market.

Most technicians use the following time periods:

6

Suggested Time Period for MA

Short Term Intermediate Term Long Term

5-day 30-day, 40-days 40-week

9-day 50-day (10 weeks) 45-week

10-day 65-day (13 weeks) 52-week

15-day 80-day (16 weeks) 78-week

20-day 100-day (20 weeks) 104 week

25-day 150-day (30 weeks)

30-day 200- day (40 weeks)

For example, Jim Wyckoff of Expresstrade.com uses MA(9) and MA(18)

for his analysis. If MA(9) crosses MA(18) from below, then this will be a

buy signal. On the other hand if MA(9) crosses MA(18) from above, then

this will be a sell signal.

Figure 4 (generated from: ADVFN.COM)

7

For example figure 4 shows the daily bar chart of DJIA including MA(9),

the green line and MA(18), the blue line. As you can see from figure 4, in

late October of 2005, the MA9 crossed MA18 from blow and this would be

a buy signal. The insert figure 4-a is from Jim Wyckoff’s commentary on

12/2/05:

To view this email as a web page, go here.

FOREX: U.S. Dollar-Japanese Yen Remains in Strong Uptrend

Dec. 2

8

Today, let’s take a look at the FOREX market and the U.S. Dollar-Japanese Yen currency pair, also called “Dollar-Yen.” See on the daily bar chart for Dollar-Yen that prices are in a strong uptrend as prices just recently hit a fresh 27-month high.

See on the chart that the shorter-term moving I follow (9- and 18-day) are still in a bullish mode as the 9-day is above the 18-day moving average. One early clue that the uptrend in Dollar-Yen is losing power would be if these two moving averages produced a bearish crossover signal, whereby the 9-day crossed back below the 18-day moving average.

At present, the uptrend in Dollar-Yen is indeed powerful. See at the bottom of the chart that the Directional Movement Index has an ADX line reading of 39.46. Any ADX line reading above 30.00 is suggestive of a powerful trend being in place in a market. However, there has been some bearish “divergence” with the ADX line. See that the ADX line has recently turned down from its higher level, while at the same time Dollar-Yen has moved to new highs. This is one early bearish clue that a top may be in place.

See support and resistance levels on the chart.

Stay tuned!—Jim Wyckoff (Expresstrade.com)

Insert figure 4-a

CONVERGENCE OF MOVING AVERAGES:

Some technicians plot three moving averages on top of a bar chart.

Personally, I prefer MA 9, 18 and 40 (Others prefer 4, 9,18). In my

experience in future trading, the convergence of three MAs is one of the

most reliable signals. You should trade on the direction of the break out.

Here is the buy and sell signals:

Buy Signal:

When three moving average converge and MA9 is just above MA18 and

MA18 is just above MA40 and all three MAs have positive slopes.

Sell Signal:

When three moving average converge and MA9 is just below MA18 and

MA18 is just below MA40 and all three MAs have negative slopes.

For example in figure 5, we show weekly bar chart of S&P 500 from

January 2002 to November 2005. It also shows MA9 (red), MA18 (green),

and MA40 (lemon).

In that chart I have market four areas:

9

Convergence 1 (Con-1): where three MAs converge and MA9 is below

MA18 and MA18 is below MA40. This would be a good sell signal.

Convergence 2: where the three MAs converge and give a buy signal.

Convergence 3: where the three MAs converge and give a buy signal.

Convergence 4: where the three MAs converge and give a buy signal in

early November 2005. At the time of writing this lecture note (12/1/05), the

convergence studies has given a buy signal for intermediate term (since we

are using a weekly chart, this signal is good for next few months).

Figure 5 (generated from: ADVFN.COM)

10

Figure 6 (generated from Barchart.com)

In Figure 6, we show the daily bar chart for Japanese Yen. As you can see

from Figure 6, the MA of 9, 18, and 40 were converging in late September

of 2005. As MA 9 was below 18, and 18 below 40 that was a good sell

signal.

WEIGHTED MOVING AVERAGE AND EXPONENTIAL MOVING

AVERAGE:

In the above discussion we used simple or arithmetic MAs (SMA), where all

past data have EQUAL weights. Some technicians would prefer to give most

recent prices more weights than older prices. This can either be done if we

use a weighted MA (WMA) or an Exponential MA (EMA).

In a WMA, each period’s price weight is based on its age. The oldest period

price is given weight of 1, the next oldest is given a weight of 2, the next

oldest is given a weight of 3 and so on. Computer programs will do this very

easily.

Here is an example of WMA calculation taken from

http://www.investopedia.com:

For example, suppose we 5 days prices and we would like to calculate a 5-period WMA. The calculation would be as follows:

11

An EMA takes a percentage of today's price and adds in the prior day's exponential moving average times 1 minus that percentage.

For instance, suppose you wanted a 20% EMA. You would take today's price and multiply it by 20% then add that figure to the prior day's EMA multiplied by the remaining percent or 80%

(Today's close * .20) + (yesterday's exponential moving average * (1-.20))

To obtain the Exponential Percentage, we use the following formula:

Exponential Percentage = 2 / (Time Periods + 1).

So if you wanted a 40 period EMA you would use (2/(40+1)) = 4.88 % as your percentage for the calculation.

The most important point for both WMA and EMA is that they both give

more weights to recent data than simple MA. Many chart providers, will

give the user the option to choose any of these MAs.

12

Figure 7 (generated from: ADVFN.COM)

For example figure 7 shows daily closing chart for DJIA for two years. I

have included three MA100s in this chart; they are SMA100, WMA100, and

EMA100. As you can see, they are very similar.

ENVELOPES

Trading bands or envelopes are based on moving averages. The MA will be

the basic line and two lines, one above and one below, are drawn parallel to

the MA line. The distance of these upper and lower lines to the MA line is a

certain percentage. This percentage will be different for different security,

the more volatile the security, the higher will be the percentage. Many

technicians use 2% to 5%. This would mean that most of the time, prices

should trade within 2- 5% of the moving average.

Interpretation: if prices break above the upper envelope line, it signal

strength and predicts higher prices in the future. On the other hand, if prices

break below the lower envelope line, it signal weakness and would predict

lower prices down the road. (Caution: we could have false signal: prices

13

break above the upper envelope and than collapse). For example Figure 8

show daily DJIA chart with a MA9 and a 2 percent envelope.

Figure 8 (Created from: ADVFN.COM)

BOLINGER BAND

Bolinger Band (developed by John Bolinger) is also based on moving

averages. The MA will be the basic line and two lines, one above and one

below, are drawn to the MA line. The distance of these upper and lower

lines to the MA line is a two moving standard deviation of prices (if MA20,

then you estimate standard deviation of these 20 prices and then multiply the

standard deviation by two to get the upper and lower distance from moving

average line).

When prices become very volatile, the band widens, when prices are quiet

stable, the band narrows. Figure 9 shows the one year daily chart of DJIA

and January 06 Crude Oil with a Bolinger band of MA 20 and stochastic

indicator.

14

Figure 9 (Created from: ADVFN.COM)

15

Interpretation:

1. When Bolinger band narrows, usually a sharp price change will

follow.

2. If prices break above the upper band, this is a sign of strength, on the

other hand, if prices break below lower band, this would be sign of

price weakness. Usually the price breaks several times the band before

it reverses. Question is how do we determine that when the price

breaks for the last time, or prices will reverse very soon? It is usually

difficult, but use of other indicators and price patterns should guide us

to determine the top and bottom of the Bolinger band. For example in

crude oil chart of Figure 9, the price kept touching the upper band

from May to July, however, in July the stochastic (see later chapter)

showed a bearish divergent, therefore, raising the red flag. The same

for price action in July-September, in September again the stochastic

showed a bearish divergence, that could give the signal that may be

this is the last time that the price is touching the upper band. The same

reasoning could be down for lower band.

3. Some technicians follow the following rule: in an up market (the slope

of MA is up), buy every time price moves close to moving average

(the middle line)and sell (get out of your position) when price moves

toward upper band. In a down market (slope of MA is down), sell

every time price moves close to moving average (the middle line) and

cover your short when price moves toward lower band.

Below is a commentary on Dollar-Yen using Bolinger Band by Jim

Wyckoff, provided by Expresstrade.com on 12/13/05.

16

FOREX: U.S. Dollar-Japanese Yen Bulls Still in Technical Command

Dec. 13

Today, let's examine the FOREX market and the U.S. Dollar-Japanese Yen currency pair, also called "Dollar-Yen." See on the daily bar chart that Dollar-Yen remains in a strong price uptrend and has just recently hit a fresh 2.5-year high. There are no early technical clues that a market top is close at hand.

See on the daily chart that the Bollinger Bands indicator shows Dollar-Yen continues to trade near the top of the upper Bollinger Band. This is a bullish signal. If Dollar-Yen moves into the lower portion of the Bollinger Bands and trades near the lower band, then that would be a warning signal that the currency pair is seeing the uptrend weaken and that a market top may be close at hand.

See support and resistance levels on the chart.

Stay tuned!--Jim Wyckoff

The following is taken by permission from Pring.com:

Envelopes and Bollinger Bands

One popular method of moving-average interpretation is to plot envelopes or

bands around the moving average at a set interval, as in Chart 1. If the bands

are selected carefully, they serve as support or resistance points. In effect, this

17

approach plots a dynamic form of momentum indicator. In my opinion, these

envelopes may look good on paper, but they have relatively little practical use

since the price often exceeds the envelope boundaries.

Chart 1, however, does demonstrate one very helpful pointer. First of all, we

have two simple moving averages at 5 percent of a 30-day moving average.

Let’s say the moving average itself was at 50. Then, the + 5 percent average

would be plotted at 52 ½ (i.e., 5 percent above the average). If you look at the

period on the left, a bull market, you will see that the upper envelope was

touched quite a bit, but the lower one not at all. When the lower one was

touched for the first time, in October, it was a warning that the trend had

changed to the downside. In fact, the price was never able to touch the upper,

overbought envelope during the whole period of the decline; yet, it did touch the

lower envelope several times. The rule, then, is that periods are likely to be

bearish when the upper envelope is not touched and those when the lower line is not reached tend to be bullish.

Chart 1 - JP Morgan

Bollinger Bands are an alternative to the envelope approach. They were

developed by the innovative technician John Bollinger. Unlike envelopes, which

are plotted as fixed percentages above and below a moving average, Bollinger

bands are plotted as standard deviations (Chart-2). What this means in a

practical sense, is that the two bands expand and contract as the volatility of the

price series changes.

The lower panel of this chart compares the price with two 20-day moving-

average envelopes. The top panel does the same thing with 20-day Bollinger

bands. The 20-day time span is recommended for shorter-term intermediate

price moves. It is apparent that the Bollinger series in the upper panel is much

more sensitive to price changes in sharp up or down trends.

18

Chart 2 - International Paper

Chart-3 eliminates the lower panel so that we can take a closer look at the

Bollinger band. You can see that the price occasionally moves outside the band

for a day or two, but is normally unable to sustain itself in this position. When

the trend moves persistently in one direction, such as in early 1991 at Arrow 1,

touching the upper band no longer offers a timely signal. This is much the same

was as a momentum indicator, which is virtually useless when a persistent trend

is in force. It is the exception rather than the rule, for in most cases, when the

price moves above the band and then back below it, an exhaustion move has set

in from which a correction follows. Look at what happened to the price at Arrow 2, and again at Arrow 3 These were clearly great places to take profits.

Chart 3 - International Paper

19

Also, if you have a good idea from the other technical indicators of the

direction of the primary trend, it is possible to use those few occasions when the

price moves to the lower band to enter long in a short-term trade. Look at the Arrows numbered 4, 5, and 6 and see what good opportunities they were.

Moving Averages Applied to Long Term Charts

As we have already said, any technical analysis should start with the long

term chart. We need first to see the primary trend in the market; we can do

this by looking at the weekly chart superimposed with moving average of 10

and 40.

As you can see from figure 10 below, I generated the chart of S&P 500 by

using stockcharts.com. This is a weekly chart with moving average of 10

and 40 weeks. As you can see from the weekly chart, in late 2006 and early

2007, The moving average 10 is above MA40, and both moving averages

are going up, this is positive. But then in January 2008, the big picture

changes, from 1/2008, the big picture becomes negative since MA 10 is

below MA40 and both MAs are sloping down.

The long-term picture at the time of writing (6/27/09) has become mixed to

slightly positive. MA 10 is sloping upward and has crossed MA 40, this is

positive, however MA 40 has not turned upside yet. Off course, since it is

moving average of 40 weeks, it takes a long time for it to turn its direction.

So, as a technician, the long term picture is a little positive; we need a

confirmation of change in direction of MA 40 to say that tall is clear to go

aggressively long.

Also note that if we come down toward 80 in SPY, and then move up, this

could be a reverse head and should bottom. It is very important to look at

long term chart and have an understanding of the big picture. MAs are

excellent tool for trending market, but if a market is not trending, it is

difficult to use MAs, we should use oscillators for non-trending markets

(See next chapters).

20

Figure 10

Mechanical System Trading: The 4 week rule:

According to this rule, buy signals (cover all short) are emitted when the

price exceeds the high of past 4 weeks and sell signals (liquidate longs and

go short) are emitted when price goes lower than the low of the past 4.

21

You can use this model or a variant of this model for your mechanical

trading project.

A variant of the model is that you is as follow:

Buy: buy signals (cover all short) are emitted when the price exceeds the

high of past 4 weeks.

Neutral: if you are in the market, if price goes lower than the low of the past

two week, sell your position (don’t short) and be out of the market (Neutral).

Short: sell signal, go short if price goes lower than the low of the past 4.

For variation of this 4-week rule, see your textbook, pages: 216:221.

Another good mechanical system trading project for this course could be the

channel Breakout System.

Copy right M. Metghalchi, 2006, all rights reserved.