Technical analysis covers an extremely broad spectrum of concepts and techniques. Many technical methods are quite complex, relying on reams of statistical information. Other technical methods may be simple and are based on rather simple visual interpretation of a price chart.

One thing which is clear is that technical analysis is in commonplace usage in financial markets, prominently including futures markets. In fact, it is not an exaggeration to suggest that technical forecasting methods may be more widely followed and form the basis for more trading activity in the context of futures markets than any fundamental indicators.

This is evident when you consider that there are thousands of commodity trading advisors (CTAs) and macro hedge funds offering their funds management services largely on the strength of their technical market forecasting expertise. Many of these traders are using the most modern computerized trading technologies to program mechanical or automated trading systems, sometimes under the banner of “algorithmic trading methods. In any event, the market frequently is driven by these technical factors. Accordingly, we suggest that astute traders cannot afford not to
pay attention to these interesting and potentially quite rewarding technical
forecasting methods.

Why Technical Analysis?

Technical forecasting techniques have been in use, in one form or another, at least as long as organized markets have been in existence. But technical methods are not the only means by which one may attempt to gain an insight into potential future market movements. This section attempts to answer the question "why should I be interested in technical analysis?" by discussing the distinction between a technical and fundamental approach to market forecasting as well as a bit about some of the origins of technical trading methods. Fundamental and Technical Analysis - Technical and fundamental analysts have often been at odds regarding the validity and relevance of the two approaches to market forecasting. Let's discuss the role that each method may play in a trading situation and why technical analysis plays
so prominent a role in many futures trading applications.

Fundamental analysts are most concerned with the question 'why?' Why does the market move the way it does? What fundamental economic conditions may cause the market to fluctuate upwards or downwards? I.e., fundamental analysts busy themselves studying cause and effect relationships.

Technical analysts believe that the market price already incorporates all known fundamental information. As new economic data is released, it is incorporated into the market price level efficiently and almost instantaneously. Therefore, it becomes difficult to trade profitably on the strength or weakness of known fundamental information. Thus, you should focus on a study of the price level and patterns in price movements directly!

The market trades, from day to day on the strength or weakness of unknown fundamental factors. More specifically, on the strength or weakness of what traders believe these factors will portend as they become known. More than anything else, therefore, the market trades on the basis of market psychology or the bullish or bearish attitudes of market participants in the aggregate.

Many academics question the validity of technical trading methods. In fact, these same academics frequently warmly embrace the so-called "random walk" theory. The random walk theory suggests that market prices respond as fundamental market information is made known quickly, efficiently and without serial autocorrelation. The absence of serial autocorrelation in a price series or more specifically, in a series of
price movements, is said to occur because today's fundamental economic release may bear little correlation to tomorrow’s fundamental economic release. Random walk theorists believe, therefore, that market prices fluctuate unpredictably and randomly over time.

But this is not inconsistent with the technical viewpoint that the market may fluctuate considerably between the points in time at which fundamental information is made known. During those intervals, market perceptions become more important than the most recently issued bit of fundamental market news.

Random walk theorists may assert that market movements are random and unpredictable. But a simple inspection of any chart book will probably satisfy most observers that the market tends to move in trends. Not only does the market tend to move in trends, but pricing patterns tend to repeat themselves and are witnessed over and over again. There are very few if any traders, for example, who have never seen a so-called "head and shoulders" formation. And very few who are unfamiliar with the
traditional interpretation and pricing implications of the pattern.

If the market trends and behaves in accordance with repeating patterns then traders will take action accordingly. If many traders rely on similar technical systems (and there is evidence to suggest that most trend following systems will trigger buy or sell recommendations in rough unison), then technical analysis becomes a kind of "self-fulfilling prophesy." If you believe the market will advance or decline and buy or
sell accordingly, then the market may very well tend to rise or fall. This may be particularly true if there are a large number of like-minded traders.

Many of the "principles" of technical analysis are quite unusual and might even seem to lack a common sensical basis. But if enough traders believe that a given technique will work, it may very well work. If technical analysis is useful at all, therefore, it is because traders believe it will provide useful information. Their subsequent actions enforce those predictions. This implies that one should only be concerned about
methods which fall in the mainstream of technical thought. Other, more arcane methods cannot work because too few traders will utilize those methods and, therefore, enforce their predictions.

Technical Analysis and the Futures Markets - Most of the technical work which has been done throughout the years has centered on the stock markets. In particular, famous analysts such as Dow and Elliot concentrated exclusively on equity markets. Nonetheless, a case may be made that technical analysis is more relevant in the context of the futures markets than in any other segment of the marketplace.

This is due largely to the fact that futures trade on low margin or performance bond requirements relative to the value of the underlying instrument. It is not uncommon for the margin on a futures contract to be anywhere between 1-5% of the total value of the delivery instrument. Compare that to the minimum 50% margin requirement associated with stocks. As such, futures traders enjoy extreme leverage compared to equity traders. But these comparisons do not tell the entire story.

When you buy stock, that 50% minimum margin requirement represents a down payment on the purchase price of the stock. The balance is typically borrowed at interest from the broker. This is appropriate because when you purchase stock, you acquire an equity interest in the issuing firm.

But when you buy (or sell) futures, the difference between the value of the commodity and the margin or the "unpaid balance" is not lent at interest. This is because the margin associated with futures transactions serves an entirely different purpose than a stock margin. A futures margin simply represents a "good faith deposit" or "performance bond." It is intended to secure the integrity of the contract by covering the risk associated with a single day's price movement. The margin need only cover a single day's maximum possible risk because margins are administered daily. I.e., there are no paper profits or losses because traders "mark-to-market" daily.
Profits or losses are distributed or paid daily and in cash.

But the initial margin is deposited in the form of collateral and this collateral is often accepted in the form of securities, generally T-bills, on which the futures trader continues to earn the interest. Thus, there is no explicit opportunity cost associated with the initial purchase or sale of futures. Thus, futures traders enjoy 100% leverage. Because of this extreme leverage, futures traders generally cannot afford the luxury of a "buy and hold" strategy. Equity traders may buy a stock and hold it in the face of adverse market movements because they know that they have already paid the full purchase price. But futures traders may not be able to fund variation cash payments associated with a losing futures position.

Futures trading, therefore, is much more of a short-term proposition.  Because futures positions are not likely to be held for an extended period of time, timing is paramount! A futures trader who is right in the long-term but wrong in the short-term loses money. Futures traders who are wrong in the long-term, but right in the short-term, usually make money. The "trick" is to be right in the short-term.

This means that technical analysis may be much more important than  fundamental analysis in the futures markets. Fundamental analysis may provide useful insights in the long- term. But often short-term market trends run contrary to long- term trends. Technical analysis is a tool which is much more useful in the short-term.

Dow Theory - If any single individual may be credited with the introduction of modern technical thought, it is probably Charles Dow.  Dow was an owner and editor of the Wall Street Journal in its early formative years. Dow's “Theory” appeared in a series of editorials carried by the paper in the late 1800s until Dow's death in 1904. Some people may question the relevance of Dow's ideas in an age of advanced
telecommunications, computerized trading methods and extremely fast paced markets. Yet, much of his work endures today and has heavily influenced vastly disparate schools of financial thought.

Among Dow's achievements was the introduction of a series of stock market indexes, one of which became known as the Dow Jones Industrial Average (DJIA). The first of Dow's stock averages, published initially on July 3, 1884, was an eleven stock rail average. In 1885, that average was expanded to include twelve rail stocks and two industrials. By 1896, the composition of the average was altered such that it contained exclusively industrial stocks. Finally, by October 7, 1896, Dow created two averages:
a twelve stock industrial and a twenty stock rail index.

Dow relied heavily upon these indexes for technical forecasting purposes. In particular, Dow believed that it was more worthwhile to study the movement of the indexes rather than movement in any individual stock. Dow believed that the price of any individual stock may be affected heavily by unique factors which may not impact upon other firms. In order to identify broad market trends, therefore, it was important to focus on the averages. Further, Dow believed that bullish movement in either
the rail or industrial average should be confirmed by similar action in the
other index.

Although Dow is not generally credited with the idea, it is clear that he recognized that the risks associated with any individual stock were a function of general economic conditions as well as conditions which might uniquely impact upon a given stock. I.e., Dow recognized early on what has become an axiom in modern financial thought: the total risk associated with any given stock is comprised of "systematic" and "unsystematic" market risks. Systematic risks refer to those general economic factors which impact upon all stocks to one degree or another. Unsystematic risks may uniquely affect a given firm with little or no impact upon other firms.

These ideas represent a cornerstone of the "capital asset pricing model" (CAPM). The CAPM was hammered out largely in the 1950s and early 1960s by a variety of academics who might have little sympathy for many of Dow's theories. Nonetheless, they owe a large debt of gratitude to Dow. In particular, it is interesting to note that systematic market risks are today measured by stock market averages or indexes such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor's 500 (S&P 500).

Not only did Dow's thought feed into the CAPM, his work also deeply affected other financial theorists of a quite different ilk. Ralph Nelson Elliot, a leading technician of the 1930s whose theories known cumulatively as "Elliot Wave Theory" are in common usage today, was an ardent student of Dow Theory.

Dow believed that market movements may be categorized as (1) minor, (2) secondary; or (3) primary trends. A minor or "near- term" trend may broadly be considered as movement which lasts anywhere from 2-3 days to 2-3 weeks. A secondary or "intermediate-term" trend may last from 2-3 weeks to 2-3 months. A primary, major or "long-term" trend may last upwards from 2-3 months.

(In today’s world of futures trading, characterized by high-velocity electronic trading techniques, our horizons may be shortened a bit relative to Dow’s world of a hundred years ago. Thus, we m ight trade futures on an intra-day basis; “swing” trades may be characterized as those lasting from a day or two or three upwards to two to three weeks. Beyond that, long-term futures trades may be held for two to three weeks and beyond.)

Elliot believed that he refined these ideas considerably. In particular, Elliot was far more specific in identifying various trends. In addition to the primary, secondary and minor trend, Elliot refers to trends of smaller  duration - the minute, minuette and sub-minuette. Further, Elliot has identified trends of larger degree in the cycle, super-cycle and grand supercycle, which may last upwards to 200 years!

Dow also suggested that a primary trend breaks down into three stages: (1) the accumulation stage; (2) the technical trend-following stage; and (3) the distribution stage. Let's consider a primary bull trend. The accumulation stage represents the initial stage of a primary market movement. This is where the "smart money" begins to take a position by buying the bull trend. The technical trend following stage occurs later when a variety of technical trading systems confirm the existence of a trending market and trigger buys. The distribution stage is the final upward surge where the "smart money" begins to take its profits.

Elliot wave theory is based primarily upon the idea that the market moves in distinguishable patterns. In particular, the market may rally in a bull market in a five step pattern and subsequently correct itself in a three step pattern. These "5s" and "3s" represent the core of the Elliot wave theory.

The five step upward movement is denoted with the numbers 1, 2, 3, 4 and 5. The subsequent corrective phase is denoted with the letters a, b and c. Hence, these 5s and 3s may be referred to as the "numbered" and the subsequent corrective "lettered" phases. The numbered phase breaks down into three "impulse waves," specifically waves 1, 3 and 5 in the general direction of the market trend. The intervening waves 2 and 4 represent "corrective waves." The point is that these three impulse waves
1, 3 and 5 are highly reminiscent of Dow's accumulation, technical trendfollowing
and distribution phases.

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