In the first several chapters we laid out the basic building blocks of Point & Figure charting as they pertain to the commodity markets. These previously discussed topics provide a solid framework for analyzing the commodity market on a more macro level. Now, we want to expand your knowledge even further, adding to your toolbox other techniques and strategies for you to use when trading in this marketplace. In this chapter, we focus on supplemental topics and indicators, ones that will aid in refining your entry and exit points—and basically give you tools that drill down a little deeper, to a more micro level of decision making with respect to initiating and managing the position.
SUPPORT AND RESISTANCE
When talking about support and resistance, and what these termsmean, we are referring back to the trend chart of a given commodity. (This will be the case with respect to several of the new topics we will be discussing in these next pages.) One of the keys to trading commodities on a technical basis is being able to properly analyze the technical condition of the underlying commodity.
Support is basically a level where the commodity stops moving lower in price. For whatever reason, selling pressure begins to wane as buying pressure begins to takes control at a given price. The commodity is in essence passing from weak hands to strong hands at this point. On a Point & Figure chart we would begin to see some back and forth motion generally producing slightly higher bottoms and higher tops.
Conversely, resistance is a level at which a commodity stops rising in price. Again, for whatever the reason, demand becomes less significant than it previously was and supply begins to take control of the underlying commodity. This is the beginning of a decline in price where the chart will produce a series of lower tops and lower bottoms. The commodity is moving from strong hands to weak hands. Each time the commodity tries to rise it is met with supply. The reasons for this are unimportant; that it is happening is all that is important.
Being able to identify significant support and resistance on a chart can greatly improve your overall trading success. As a general rule of thumb, scale into purchases on pullbacks close to support; or scale into short sales on rallies to resistance, provided your macro analysis of trend, relative strength, and chart patterns has already been completed and corroborates your posture. Buying at support can oftentimes mitigate your risk to the stop loss point, while at the same time increase your upside potential. The same is true for shorts when selling near overhead resistance. As well, rallies up to key longer-term resistance can provide a profit-taking level for long positions, (or drops to significant long-term support for short sales). An example will probably make this explanation more clear-cut.
Exhibit 5.1 is a chart of corn, July 2005 (C/N5). On this chart, you can see definitive support had formed in August 2004 at the 246–248 range. This level was tested numerous times, and held, until the fifth attempt when support was unable to be held at that level. In other words, as corn declined to the 246–248 level, buyers were there to support corn. On the fifth retest of this support the buyers had exhausted all their demand, and corn slipped below that level. This created a spread quadruple bottom breakdown occurring on this drop in price to 244. This was considered a strong sell signal. Anyone long July corn should have stopped out on that breakdown. But with the trend clearly negative, any long positions would have been considered “bottom fishing” or aggressive in nature. Corn resumed its downward bias after the breakdown at 244, and subsequently formed resistance — first at 224, then more so at 232 (as the chart indicates). Rallies up to the 232 area in October–November 2004 presented shorting opportunities; and then in January 2005 shorts could have been initiated on rallies up toward the 224 level. A short position would then be covered on any break through this overhead resistance. Resistance is just as the name implies. The underlying commodity is resisting any further upside movement. The reason for this is simply that selling pressure, for whatever reason, overtakes demand at these levels and the price is forced down. It would be interesting to get into the minds of those who sell at resistance levels but that is impossible. The next best thing is a Point & Figure chart.
EXHIBIT 5.1 Corn July 2005—Support and Resistance Example.
The soybean meal July 2005 chart, shown in Exhibit 5.2, is another good example of resistance and support. In particular, bean meal displays why you must recognize where significant resistance lies before embarking on a trade. Notice in early January 2005 that a triple top buy signal was given at 169. Technically speaking, you could have drawn a short-term bearish resistance line from the December peak at 172, so the move to 169 would have violated this downtrend line, suggesting you could have considered a long posture. But such a trade would not have been in your best interest. Here's why. Evaluating bean meal more closely, you would have seen that formidable overhead resistance resided at 172—a level that it retreated from three previous times. In addition, the longer-term bearish resistance line was hovering just above that 172 level. This serves to show that you can't be myopic about just the chart pattern itself–in this case a triple top buy signal, but instead need to inspect the chart with a broader view; by doing so, you would pick up on the key overhead resistance at 172, and no trade would be taken. It would be best to wait instead for a better set-up. Bean meal failed again, just shy of the 172 resistance, and promptly resumed its downward bias. Not only that, the support that had existed in the 160–161 area was penetrated, too.
EXHIBIT 5.2 Soybean Meal, July 2005—Support and Resistance Example.
This leads us to one last point we want to make on support and resistance. There is an old adage on Wall Street that says, “What was support becomes resistance; and what was resistance becomes support.” Once a violation of major support occurs, that level will often become a level of key resistance. In looking at the July soybean meal chart once again, we noted that support in the 160–161 level was penetrated. Notice how on two rally attempts back up, the contract failed at the 160 level—what was support then became resistance for bean meal. Being aware of this phenomenon can also aid in the process of scaling in to new long or new short positions.
BIG BASE BREAKOUTS
The preceding commentary leads us to our next discussion on big base breakouts. For all intents and purposes, this topic is really a combination of two previously discussed points on support and resistance, along with the science of ballistics and the horizontal count. Over the years, with both stocks and commodities, we have found it useful to watch our charts for the formation of “big bases” of accumulation or distribution. In keeping with the horizontal count, the bigger the base, the larger the price objective; or said another way, the bigger the base, the bigger the move (or “bang for your buck”) up out of the base. So it stands to reason that you should be looking out for such a pattern, with the action point for initiating a position being when the commodity breaks out of the base. Think back to our recent discussion on support and resistance; you would not want to be a buyer of a commodity when it has rallied up to resistance, but instead want to see it penetrate the key resistance. Think of resistance as a bunch of gremlins hanging around on that street corner with sell orders in hand. The only exception to this would be if you are merely trying to trade the “range” of a base—meaning you buy on the pullback to the bottom of the base (support), and sell on the rally to overhead resistance (or the top of the base); such a posture would be considered more of a short term trading tactic.
Exhibits 5.3 and 5.4 should help to clarify the “big base breakout.” Sugar, July 2005 (SB/N5) had experienced a strong, orderly up move during the first part of 2004. But then starting in July, the contract went through a period of consolidation, working sideways for several months, and digesting its previous move up. As sugar worked sideways in a fairly tight range, support was formed in the 7.95–8.10 range; while noteworthy resistance was at 8.45. It wasn't until late September that sugar finally managed to breakout to the upside, after its fifth attempt at testing this resistance level at 8.45. The contract gave a spread quintuple top buy signal at 8.50, and from there saw a straight spike up to the 9.15 level. This is not an unusual occurrence following the break out of a huge base. Again, remember the phrase, “the bigger the base, the bigger the move up out of that base.” A horizontal price count yielded an objective of 10.35, given there was 16 columns in the base, and a box size of .05.
EXHIBIT 5.3 Sugar, July 2005—Big Base Breakout Example.
The eurodollars, March 2005 (ED/H5) chart, conversely, displays a commodity breaking down out of a base, following a period of distribution. Observe the base of distribution that March eurodollars formed during the second half of 2004. After a spike up to 97.65 by August, March eurodollars started to show signs of distribution, working sideways in a range between 97.35 and 97.65. After plenty of back-and-forth action on the chart, eurodollars resolved itself to the downside, breaking down out of the base at 97.30. With this breakdown also came a change in trend to negative, as the bullish support line was violated. At this juncture, short positions could have been considered with a downside price target of 96.65, based on the horizontal count, and a buy stop loss point of 97.70.
EXHIBIT 5.4 Eurodollars, March 2005—Big Base Breakout Example.
CHANGING BOX SIZE
When analyzing a commodity on a technical basis, your main tool is the actual trend chart of the commodity. As you have learned, the trend chart will show you important data such as the overall trend, where key support or resistance exists, and particular Point & Figure patterns. All told, it is this chart that depicts who is winning the battle of supply and demand for a given commodity. Often, the commodity chart will progress in a very orderly fashion, showing a series of higher tops and higher bottoms (if in an uptrend), or a consistent series of lower tops and lower bottoms (if in a downtrend). But there are times when a commodity will experience a straight spike up (or down) in price, resulting in an extended condition with no apparent support (or resistance) at hand. This can be troublesome for two reasons—no viable stop loss point is apparent, nor are any pullbacks shown to allow for new entries into the commodity.
This is where changing the box size can be used. When necessary, reducing the box size on the chart can be a very helpful method to employ to gain insight into levels of support and resistance, areas of consolidation, potential entry levels, and viable stop loss points. If the regular default chart shows a very discernible supply and demand picture, typically we would not arbitrarily reduce the box size to multiple lower sizes, as this can serve to only confuse you in your decision-making process. But when no nearer-term support or resistance levels are shown on the chart (or pullbacks), as was the case with the euro FX December 2004 (EC/Z4), then elect to take a look at the smaller box size. It can aid you both in your entry and exit.
The Euro FX, December 2004 contract (EC/Z4) broke out of a big base in mid-October at 1.245. This was a strong buy signal, and one that we actually took in our in-house commodity investment account. The euro quickly spiked straight up to 1.283 without a breather. Exhibit 5.5 obviously displayed an extended condition, with the contract well above any near-term support. At this point, new entries would have been tenuous given the lack of near-term support or a viable stop loss point. This is where bumping the box size down, cutting it in half from .005 per box to .0025 per box, could help with the management of trading the euro. By doing this, the chart exhibited a textbook shakeout pattern that wasn't apparent on the .005 per box chart. Therefore, had you consulted the smaller box size chart, you would have been afforded an entry point on the reversal up from the shakeout pattern. The smaller box size also gave you a slightly tighter stop loss point of 1.317 where it broke a double bottom following a lower top. As a result of bumping the box size down, you could have bought the December euro at 1.275 on the reversal up from the shakeout pattern. (Had you never looked at the smaller box size, no reasonable entry level would have presented itself.) In buying the December euro at 1.275 and selling at 1.317 resulted in a profit of $5,312.50 per contract, rather than totally missing out on the trade altogether.
EXHIBIT 5.5 Euro FX, December 2004—Changing the Box Size.
Just as you can reduce the box size to gain shorter-term insight and help with trade management, the opposite can be done to allow for longerterm perspective. By increasing the box size, it permits you to see longer-term resistance and support levels, as well as longer term trends. An example of this can be seen with copper, March 2005 (HG/H5). This contract had been trending higher for several years, but during this time frame copper had been prone to wild swings in price; this was quite evident in the second half of 2004 and early 2005. Such erratic chart action can often times scare most investors away; yet copper actually offered some viable trading opportunities in the face of this volatile action, if only you had consulted the 1 point per box chart, rather than just looking at the default .50 per box chart. Take a look at the 1-point chart of copper in Exhibit 5.6, and you will see several instances where copper sold off hard after making new highs, only to correct down to (and hold) its bullish support line. These retreats to the uptrend line could have been used as tradable entry points for new long positions. One occasion in particular to zero in on is October 2004. Notice how copper had rallied to a new high of 139.50 early in the month. But then, as the saying goes, copper stepped on the proverbial banana peel and slipped quickly from 139.50 down to 120.50. This sell-off was violent as copper literally gave up all of its gains from September and October. Had you just looked at the default .50 per box chart (with fear in your eyes), you would have likely had nothing to do with this base metal contract. But the 1-point chart revealed a much different picture—a bona fide trading opportunity. The massive sell-off in copper basically just brought the contract right back to significant August-September support, and back to its bullish support line. Not only was March copper back at support, but a very affordable stop loss point of 118 was presented (which would have been a triple bottom sell signal and violation of the uptrend line). By increasing the box size, you were presented with an excellent entry point for new long positions while also preserving a very palatable stop loss point. Copper proceeded to rally 25 points from there, equating to $6,000 per contract. As an addendum, the price of copper is now quoted with the decimal two places to the left, so the above prices would now appear as 1.18, for example. Also, copper is a great example of how you must be willing to adapt the box size of your main default chart based on volatility. We currently use a .04 point per box chart (or what would be 4 points per box, based on the above example) for copper. It is important to be flexible with your box sizes in order to be provided with the most discernible and useable trend chart.
Generally speaking, by changing the box size, you can gain longer-term or shorter-term perspective on a commodity. This is useful for longer-term investment decisions, or for shorter-term trading plays; and for providing you viable entry points and stop loss points, when none other may be of fered. This is one more facet of Point & Figure analysis to add to your toolbox when trying to manage your commodity trading decisions.
EXHIBIT 5.6 Copper, March 2005—Changing the Box Size.
USING PULLBACKS AND RALLIES TO IMPROVE RISK-REWARD
Risk-reward analysis is a very important component of both stock and commodity selection. Before initiating any trade, whether it be a long or a short, it is imperative that you go through this process. Overall success in investing, in large part, is a function of proper risk management—basically, you must strike a balance between focusing on gains, while not ignoring the risk of loss. Preservation of capital by keeping your losses small and maximizing the size of your winners will be a key to your commodity trading success. This is the essence of risk-reward analysis.
Risk-reward is just what the name implies. It is the process of evaluating how much risk you will take, compared to how much reward you can expect to have on any given trade. Or said another way, how many points could the commodity fall if the trade doesn't work out, versus how many points you could expect to gain if the commodity rises in your favor (assuming a long position); the opposite would be true for a short sale. Typically, when evaluating risk-reward, we like to see a two-to-one ratio, at a minimum. In other words, for every point (or dollar) at risk, we want to have 2 points (or $2) of potential reward. This suggests you need to be able to figure out what the expected reward is, and what the potential risk is. Let's examine how we might analyze the risk-reward before we take a trading position:
- Determine where significant resistance lies, or where the commodity would be overbought on its trading band. (One might use these price objectives in lieu of a vertical or horizontal count.)
- Determine where significant support lies. Remember, this support lies below the current price of the underlying commodity. Support levels are often times good areas to consider buying a commodity.
- Calculate the price objective for the commodity, using either the vertical or horizontal count. It's important to have an idea of what could happen if things go right.
- Determine your stop loss point—where the commodity will break a significant bottom or violate its trend line—basically, a point at which you no longer want to be long the commodity. You must be able to handle the worst-case scenario. The potential loss must be in keeping with your risk tolerance and the size of your account.
- Know the price you plan to purchase the commodity. The current market price or your limit price.
Let's go through an example of evaluating risk-reward using live cattle, April 2005 (LC/J5) in Exhibits 5.7 and 5.8.
EXHIBIT 5.7 Live Cattle, April 2005—Risk-reward Analysis Example.
EXHIBIT 5.8 Live Cattle, April 2005—Risk-reward Analysis Example.
In summary, by waiting for a pullback in live cattle, you greatly improved your risk-reward situation. In scenario one, the risk was unacceptable, making only .70 points for every point of risk. But with cattle pulling back to the 87.00 level in scenario two, your potential reward increased while your risk was mitigated—at 3.25 points of reward for every point of risk. This is much more acceptable from a risk management perspective. When you are trying to determine which commodities to buy and which to short, be sure to take the time to determine your risk-reward ratio. There will be times when you don't necessarily have to wait for a “pullback” to initiate a position. In other words, you can go long on a breakout, as long as the risk-reward situation is still an acceptable two-to-one ratio (or better).
MOMENTUM
Momentum, along with trading bands discussed later, are two more tools to add to your “technical analysis toolbox.” But in the hierarchy of importance, these two indicators have a secondary role. That is not to say they aren't extremely useful in refining your entry and exit points—they are, but you must remember that they are supplemental to the more important analysis of trend, pattern, relative strength, and risk-reward.
There are many different “momentum” indicators in the field of technical analysis, but all basically are applied in a similar fashion—being oscillators that are calculated from price data. At Dorsey, Wright we calculate three momentums—monthly, weekly and daily—which are proprietary. Weekly momentum is the indicator we mostly turn to for guidance, as it provides an intermediate-term indication of price direction. The monthly momentum provides a long-term indication of trend and price action, so it can be very useful in detecting a change in trend or turnaround situation, whereas daily momentum is a short-term tool to use for timing your entry (or exit) into a trade. With commodities, we typically rely most on the weekly and monthly momentums.
All three momentums are calculated the same, with the only difference being the time period. In the case of the weekly momentum, it is slow enough to prevent many whipsaws between positive and negative, and faster than the long-term monthly momentum, making it a useful trading tool. For this discussion, we focus on the weekly momentum, but the concept is the same when applied to the other momentum time frames. The calculation, in simplest terms, is an evaluation of two moving averages that are weighted and smoothed. These two averages are based on 1 and 5 data points. For example, the weekly momentum uses one-week and five-week moving averages that are weighted and smoothed. When the shorter-term average (one-week) is above the longer-term average (five-week), the momentum is “positive” and we would expect to see strength from the commodity (or at least a pause if in a downtrend). When the oneweek moving average falls below the five-week moving average, it turns to “negative momentum,” suggesting weakness in the commodity, or at least a breather if in a strong uptrend. Each week we calculate the averages and determine at what price the commodity will have to trade to cause the one week average to cross the five-week average. We call this price the “cross point,” which is helpful to know when trying to determine if the momentum is close to changing. Remember that these moving averages are weighted and smoothed to help prevent whipsaws compared to what you can find with simple averages. Typically, when a momentum changes from positive to negative, or vice versa, it will stay in that condition for 6 to 8 data points (weeks, days, or months). These time frames are just guidelines, so it is not uncommon to see momentum stay positive or negative for a much longer or shorter time period.
Momentum becomes most useful once you have established your overall posture on the commodity, as a function of trend, chart pattern, risk-reward, and so on. In other words, if you have determined that you want to buy a given commodity because of the above-mentioned technical criteria, then look to the momentum to help define if “now” is the best time to purchase it. If the weekly momentum has just turned back to positive after having been negative for numerous weeks, it is a good sign that now is the time to buy. Momentum will help to pinpoint the right time to enter, as well as exit or take profits. It gives you that extra bit of confidence to pull the trigger. A couple of examples, which we outline below, will likely help you to see the effectiveness of incorporating momentum into your timing of a trade. These can be found on the charts at www.dorseywright.com.
We have selected two particular momentum examples for you—one for weekly momentum using the U.S. dollar, December 2004 (DXZ4) contract; and the other using corn, March 2005 (C/H5), to show you the application of monthly momentum.
The U.S. dollar, December contract is a textbook illustration of weekly momentum. As a sidebar, from our experience we have found weekly momentum to be exceptionally effective as a timing tool with respect to currency and financial futures contracts. In the case of the December dollar contract, it should come as no surprise to you, based on our previous discussions, that the December 2004 dollar trended lower for several years, as the chart in Exhibit 5.9 confirms. When you couple this trend chart together with the weekly momentum signals, you come up with a winning hand. In Exhibit 5.9, we have overlaid the dollar's trend chart with its weekly momentum reading, doing so by shading the chart according to the weekly momentum reading, whether positive or negative. Notice how the weekly momentum had been negative from late May 2004 until late July, with the dollar selling off throughout this time. Then momentum turned to positive the week of July 30, suggesting a bounce in the dollar, or at least a pause in the precipitous decline. This was borne out over the next couple of months as the dollar chopped around with no clear direction. This “breather” for the dollar came to an abrupt end by the first of October as momentum again crossed back to negative, suggesting a resumption of its downward bias. The greenback's demise didn't come to a halt until it had dropped from 87.40, after a triple bottom sell signal, to a December low of 81.00. By mid-December, the dollar managed to not only find a bottom, but also broke out to the upside with a double top buy signal at 82.80. This came concurrently with a change back to positive weekly momentum, suggesting a bounce back up. This momentum change, coupled with the breakout to the upside, was a prime indication that shorts should be covered and profits locked in. In essence, the momentum served as a confirmation that prices were likely to head higher (which they did). You can more easily see the actual weekly momentum changes in Exhibit 5.10, which shows the U.S. dollar December 2004's weekly momentum in a tabular format.
EXHIBIT 5.9 U.S. Dollar, December 2004—Weekly Momentum Example.
EXHIBIT 5.10 U.S. Dollar, December 2004—Weekly Momentum Table.
Our second example of momentum focuses on the viability of it as a longer-term indicator, using the monthly momentum. In this case, we turn our attention to March corn (C/H5). In Exhibit 5.11, we display a trend chart of corn dating back to September 2003; in Exhibit 5.12 you can view its corresponding monthly momentum table. In glancing at the chart, you can see that corn bottomed in September–December 2003. At this same time (in October), the longer-term monthly momentum turned to positive, suggesting a trend change was at hand. This came to fruition as corn trended noticeably higher over the next few months. In fact, had you bought corn on the notable triple top buy signal given at 256, you would have been nicely rewarded as the contract rallied to 342, and did not break down until 332 (which would have been the stop loss point on the double bottom sell signal). This would have equated to a profit of $3,800 per contract. But just as the monthly momentum was a harbinger of higher prices while positive, it was equally on the mark when it turned back to negative in June 2004. Corn was trading at roughly 282 when the monthly momentum flipped to negative. After doing so, the contract fell to a low of 196 with momentum staying negative throughout the decline; at $50 per point, that equated to a $4,300 gain per contract (if you shorted corn). As you can see, this longerterm supplemental tool can be very supportive in confirming changes in trend, giving you extra confidence to play both sides—both long and short.
EXHIBIT 5.11 Corn, March 2005—Monthly Momentum Example.
EXHIBIT 5.12 Corn, March 2005—Monthly Momentum Table.
TRADING BANDS
Trading bands are the second supplemental timing indicator we use when trying to refine our timing of the trade. The concept of trading bands relies on that law of nature called “regression to mean,” and the oft-learned bell curve from Statistics 101 class. Given a set of data, we can construct a range that is depicted as a bell curve—this is the basis of our trading band indicators.
At Dorsey, Wright we calculate both daily and weekly distributions, which are also referred to as trading bands. These calculations are also proprietary; however, they are similar to a standard deviation calculation (bell curve). Another term for standard deviation is volatility. Ten data points are used to determine the trading bands—for the daily it is 10 days, and for the weekly it's 10 weeks. Obviously, the daily is short term in nature, while the weekly is longer term and slower to change. There are six standard deviations to a bell curve. The calculation evaluates the range between the high and low prices of the commodity for the 10 data points. A volatility variable is then applied to the data and it is smoothed to create the distribution or trading band. The calculation results in a 100 percent overbought value based on the 10 data points, as well as a 100 percent oversold value. From these values we calculate the midpoint or a “normal” position in the trading band. This is the center of the bell curve. The 100 percent overbought and oversold levels are displayed on the chart (on the right-hand side) using TOP and BOT respectively, while the middle of the distribution is marked MED. Three standard deviations to the left of the midpoint are also analogous to being 100 percent oversold, while three standard deviations to the right of the norm are considered 100 percent overbought. In keeping with the theory of a bell curve, stocks and commodities tend to stay just one standard deviation to either the left or right most of the time (68 percent). So when you have a circumstance when a commodity moves to either the top of the trading band or the bottom, it is an extreme instance, and suggests a “regression back to mean”—a movement back to a more normal condition on the trading band. This is where trading bands can be of use in timing your purchase or sale. Entries can be made on moves back toward the midpoint, or best at the 100 percent oversold level for longs or at the 100 percent overbought level for shorts. Profits can be locked in (on a long position) with rallies to the top of the trading band; or in the case of shorts, on a drop in price to the bottom of the band.
We find that strong, upward trending commodities typically trade in the upper half, overbought side, of their weekly band, therefore a pullback to the midrange is often a great entry point, provided the chart still shows a bullish technical picture. Technically weaker commodities that may be experiencing a short-term rally often make their way up to this weekly midpoint but have difficulty sustaining an overbought condition. This is a good scenario to consider shorts, provided the chart confirms such a position.
With respect to the shorter-term daily trading band, a commodity will often move into a more extreme overbought and oversold condition. This is not unusual given the fact that only 10 days of data are used. But such a scenario also aids in entry and exit, just in a more refined capacity. For example, if a bullish configured commodity has reached very oversold territory on its 10-day distribution, and while doing so has pulled back on its chart providing an attractive entry point for new long positions, we then consult the ten-day band, watching for what we call a “curl” back toward the midpoint. This “curl” or first day of lessening the oversold condition suggests to us that the pullback has ceased—the rubber band is no longer being stretched downward, but instead has been released—and the commodity is set to bounce back up in price from there. So by using the 10-day band, you can help pinpoint your entry (or exit) more efficiently. Of course, this concept can be applied to shorts on rallies to overbought territory, but can also be used for short-term profit taking. Examples of both the weekly and daily trading bands are shown below.
The S&P 500, March (SP/H5) is a classic example of using the 10-week trading band. As the chart in Exhibit 5.13 depicts, the S&P 500 has a bullish pattern, and is in an overall uptrend. So our general posture toward the commodity is a long position. SP/H5 had broken out to the upside, breaking a spread quadruple top at 1198. The contract rallied to 1206, into overbought territory, but then pulled back on the chart right to the middle of the trading band, at 1192. A quick glance at the chart shows this 1192 level to be MED. The contract ceased to pull back further, finding support in essence at this midpoint. This pullback provided an excellent chance to buy the SP/H5. The chart was bullish, trend positive, weekly momentum had been negative for nine weeks, and the pullback greatly improved the risk-reward situation. The SP/H5 contract quickly rallied right back up to 1210 level, resulting in a winning trade within days.
An application of the daily trading band is shown with April live cattle (LC/J5). Recall that we just viewed this contract in our lesson on riskreward. In that exhibit we showed you how waiting for a pullback was advantageous and that by doing so, your risk-reward ratio was greatly improved. Now let's look at how the daily trading bands could have aided you in this process of timing your entry into a long position in cattle.
First let's take a look again at cattle after it had rallied up to 90.00 on its chart (shown in Exhibit 5.14). Not only do we know from our previous calculations that the risk-reward was unacceptable at that level, but when we consult the daily (10-day) trading band, we see that cattle was 76.1 percent overbought on January 10. The next day the 10-day band “curls” back down—this basically happens as a result of a drop in prices, and tends to suggest a waning in upward short-term momentum. This curl down suggests to us that the contract will pull back or regress back toward themean. So this was a sign that you could be patient and wait for lower prices, and a better risk-reward, before buying cattle. As we know, cattle did in fact pull back from 90.00 down to 87.00. But how would you know that April live cattle was going to cease to pull back any further after retracing back down to the 87.00 level? Well, of course, you never know for sure that a pullback has exhausted itself, but the daily trading band can be a great secondary tool to rely on in suggesting the pullback is complete. Live cattle pulled back to 87.00, in doing so the daily distribution (10-day trading band) indicated the contract was now 67.6 percent oversold. At this point we watch for an indication that this pullback is complete—this is where we wait for the “curl” back up on the 10-day band; this occurred on January 25. This curl then suggests the pullback is complete and that cattle is ready to resume its upward bias. With an attractive risk-reward in place, and a curl up from oversold territory on the 10-day band, a long position can be established.
EXHIBIT 5.13 S&P 500, March 2005—10-week Trading Band Example.
EXHIBIT 5.14 Live Cattle, April 2005—10-week Trading Band Example.
Remember, like momentum, trading bands play a secondary role in your technical analysis of a commodity. But they can be very helpful in making the final timing calls on your trade, once your primary analysis of trend, pattern, relative strength, and risk-reward has been completed.
There was a tremendous amount of information in this chapter. Get a cup of coffee, sit back, and think about it before you go on to the next chapter. You know what? Once you get the hang of it, it is pretty simple and becomes second nature. In fact, in the next chapter we will bring together everything that you have learned so far, with practical examples; this will likely bring you closer to “getting the hang of it.”