Conduct and Practices Handbook Course (CPH) Quiz 48

OI numbers go up or down based on how many new traders are entering the market and how many old traders are leaving. OI goes up by one when one new buyer and one new seller enter the market. This act creates one new contract. OI goes down by one when a trader who is long closing out one contract with someone who is already short. Because this contract is now closed out, it disappears from the OI statistics. If a new buyer buys from an old buyer (who is selling out), total OI remains unchanged. If a new seller buys back, or covers from a new seller entering the market, OI also does not change. The old bear had to buy to cover, with the other side of this transaction being a sell by the new bear.

Open interest
Open interest (OI) analysis is a powerful trading tool that futures traders use. (Stock traders do not have access to this tool.) OI is simply the number of contracts outstanding—the total number held by buyers or (not and) sold short by sellers on any given day. The OI number gives you the total number of longs and the total number of shorts because, unlike in stocks, in futures, the short interest is always equal to the long interest. Each long is willing to either accept delivery of a particular commodity or offset a contract(s) sometime before the expiration date. Each short is willing to either make a delivery or offset a contract(s) before the expiration date. With this in mind, you can plainly see that OI is a measurement of the willingness of longs and shorts to maintain their opposing positions in the marketplace. It is a quantitative measurement of this difference of opinion.

OI statistics is a valuable tool that you can use to predict price trends and reversals. The size of the OI reflects the intensity of participants’ willingness to
hold positions. Whenever prices move, someone wins and someone loses—a zero-sum game. This is important to remember because when you think about the ramifications of changes in OI, you must think about it in the context of which way the market is moving at the time. An increase in OI shows a willingness on the part of the participants to enlarge their commitments. Let’s say the market is moving lower and OI is increasing. You can assume that some of the hurt longs have left the party, but they are being replaced by new longs, and many existing longs are still there. If they were liquidating en masse, OI would drop. Likewise, if the short holders were primarily taking profits and leaving the party, OI would also drop. However, because the OI is increasing and the price is dropping, you can assume that the bulls are losing money, but many must be hanging in there or they are recruiting buddies at an increasing rate. What are the ramifications of an OI decline? It is a sign that the losers are in a liquidation phase (it doesn’t matter which way the market is moving), the winners are cashing in, and new players are not entering in sufficient numbers to replace them.

An increase in OI shows a willingness on the part of the participants to enlarge their commitments. Let’s say the market is moving lower and OI is increasing. You can assume that some of the hurt longs have left the party, but they are being replaced by new longs, and many existing longs are still there. If they were liquidating en masse, OI would drop. Likewise, if the short holders were primarily taking profits and leaving the party, OI would also drop. However, because the OI is increasing and the price is dropping, you can assume that the bulls are losing money, but many must be hanging in there or they are recruiting buddies at an increasing rate. What are the ramifications of an OI decline? It is a sign that the losers are in a liquidation phase (it doesn’t matter which way the market is moving), the winners are cashing in, and new players are not entering in sufficient numbers to replace them.

1. If prices are in an uptrend and OI is rising, this is a bullish sign In this situation, the bulls are in charge. They are adding to positions and making
the money, thus becoming more powerful. Shorts are also being stopped out, but new sellers are taking their place. As the market continues to rise, the longs get
stronger, and the shorts get weaker.

If prices are in a downtrend and OI is rising, this is a bearish sign
The bears are in charge of this case. They are adding to their positions, and they are the ones making money. Weaker longs are possibly being stopped out, however, new buyers are taking their place. As the market continues to fall, the shorts get stronger, and the longs get weaker. Another way to look at the first two rules is that, as long as the OI is increasing in a major trend, it will have the financing it needs to draw upon and prosper.

If prices are in an uptrend and OI is falling, this is a bearish sign
The old longs—the smart money (I call them “smart money” because they have been right to this point)—are taking profits and liquidating. They are replaced by some new buyers who will not be as strong on balance, but the declining OI is an indication that the weak shorts are also bailing. They will be replaced to some extent by new shorts who are stronger than the old shorts were.

If prices are in a downtrend and OI is falling, this is a bullish sign—the mirror image of rule 3
The smart money, the shorts, is covering or liquidating. They will be replaced to a degree by new shorts who are not as strong as they were, but the declining
OI indicates that the weakened longs are largely throwing in the towel. They will be replaced by fresh longs who were not as weakened by the lower prices.
Another way to look at Rules 3 and 4 is that when the pool of losers is depleted, the party will be over.

Overbought basically means the market is too high in the respect that it’s running out of buyers; in effect, it’s about to fall of its own weight. Oversold is the antonym: The market is too low, running out of sellers (at least for the current time period), and ready for a bounce.

The RSI spends most of its time fluctuating between 25 and 75. At extremes, it moves under 25 or over 75. These are the standard oversold (less than 25) and overbought (greater than 75) areas.

To determine the RSI, a trader selects the number of days; nine is the standard, or default, in most programs

To calculate the nine-day RSI, you need to average the change of the previous nine up days and divide this number by the average of the change of the previous nine down days. The RSI ranges from just above 0 to just under 100, but it is extremely rare to see a number close to either of these extremes. The RSI spends most of its time fluctuating between 25 and 75. At extremes, it moves under 25 or over 75. These are the standard oversold (less than 25) and overbought (greater than 75) areas.

How do you use the RSI? When this number gets too small or too large, it is time to put your antenna up. The market could be getting close to a reversal point. Some traders attempt to buy when the RSI wanders into oversold range and sells in the overbought range. My opinion is that if you attempt to do this, you better have deep pockets. At times (range-bound markets), this can be an excellent way to pick tops and bottoms. However, in the major moves and at extremes (the most profitable time for the trend follower), the RSI can remain in the extreme ranges for long periods of time and for quite a few points. (And, hey, it’s “only” points, right?) This is the major drawback of the RSI: It works in normal markets, but when the market is in the blow-off or panic stage, it can remain in overbought or oversold territory for an extended period and become quite costly.
Still, I do believe the RSI is a useful tool, but only when used in conjunction with other indicators. You need to know what type of market you are in (trading range or trending, young or mature). If you can determine this, the RSI can help you identify the point in the life cycle of the market. The RSI tends to get high in the mature stages of a bull market and low in the mature stages of a bear, but there is no magic number that signals the bottom. In fact, I’ve found it is a good
practice to watch for the RSI to turn up after it falls under 25 to signal a bottom and vice versa for the bull. Yet, even this tactic tends to lead to numerous false and money-losing signals because the RSI is a coincident indicator. It moves with a price. A minor upswing has to turn the RSI up.

Stochastics
Stochastics are another popular oscillator. While George Lane is generally credited as the developer of stochastics, some in the industry contend that Ralph Dystant was actually the creator of this widely followed indicator. The stochastics formula is a bit more complex than the RSI and is readily available for those who want to see the mathematics. I won’t discuss it here (you can let the computer figure it out for you as most other traders do), but I will talk about the basics of how to interpret stochastics data.
The stochastics formula measures how the close impacts the trend. Here is the theory: In bull markets, the close is more likely to occur near the day’s high, and
in bear markets, the close is more likely to occur near the day’s lows. The way the market closes determines how the stochastic trends. In essence, stochastics
is a measurement of how the most current close relates to where prices have been during the period under study.
Stochastics consists of two lines: the %K, which is more sensitive, and the %D, which is slower moving. As with the RSI, the trader can choose the number of days for the formula. Shorter terms (5 days is popular) are sensitive and act quickly but lead to many more whipsaws. Longer terms (14 days is widely used) identify longer-term moves and eliminate some of the whipsaws of the shorter variety.

Overbought is generally considered to be a value in excess of 80, and oversold is less than 20.

Overbought is generally considered to be a value in excess of 80, and oversold is less than 20.

They can be used as in the RSI, but they tend to give better signals when they diverge from price (as with the RSI). Divergence can precede the market. Bullish divergence is when prices hit new lows, but the stochastic makes a higher low than its previous low. Bearish divergence is when prices hit a new high, but the stochastic makes a lower high. Both of these occurrences can give strong indications of market tops and bottoms. Traders also look for the stochastic lines to cross to exit an existing position or enter a new one. (See Figure 8.25.) The best signals come when divergence is present, and then the %K line crosses the %D line that confirms the divergence.

Elliot wave analysis
Ralph Elliot was an accountant who developed his theory on market cycles in 1939. Basically, Elliot believed that there is a “natural order” to the markets and
that they travel in predictable cycles. He believed that the market rallies in five waves when in an uptrend and falls in three-wave corrective moves. When in a
downtrend, the main trend is five waves down, with three-wave corrective up moves. This five-wave pattern is made up of three odd-numbered waves—1, 3, and 5—which are connected by two corrective waves—2 and 4. Each major odd-numbered wave can be subdivided into five waves, and corrective waves can be broken into three parts (the ABC correction). (See Figure 8.26.)

Point and figure charts
The point and figure (P&F) is another type of price charting; the unique thing about P&F is that it ignores time. Time is irrelevant; only price matters. Xs and
Os indicate price signals. A P&F chartist uses Xs to illustrate rising prices and Os for falling prices. As long as the price is rising, Xs are added. Os come into
play when they are dropping. The decision to start a new column of Xs or Os is based on the market making a price change of a certain amount designated by the technician. This would be a box. The technician also must designate (in addition to the size of each box) what determines a reversal. For example, a popular reversal size is three boxes. So, if you use a scale of 10 points for cattle, a reversal size would be 30 points. The values for the box and reversal are arbitrary, depending on how sensitive the trader wants the P&F chart to be.
The larger the box size and reversal values, the less sensitive the chart is and vice versa. A 1¢ box for wheat is obviously more sensitive than a 10¢ box. If the
chart is too sensitive and the boxes too small, you increase the chances of being whipsawed by insignificant fluctuations. If the boxes are too large, you miss out
on significant portions of some moves and take too much risk. Figure 8.27
illustrates a typical P&F chart.

Japanese candlestick charts
Candlestick charts are the third major charting method available on most charting programs. The Japanese used candlestick charts before charting ever became popular in the West (rice futures were active in Japan as early as the 1700s), and they are the earliest form of technical analysis. Whereas bar charts use bars and point and figure charts use Xs and Os, candlestick charts use rows of candles with wicks on either end. The body of each candle is the distance between the opening and closing prices. If the closing price is higher than the open, the body is left empty or white (or it could be one color, like blue). If the closing price is lower than the open, the body is filled in with black (or another color, like red). The upper wick represents the high, and the lower wick represents the low. The wicks are not as important as the body. In other words, candlestick chartists are not as interested in the day’s high or low as they are in the relationship between the open and the close. I am not an expert on candlestick charts; entire books have been written on the various patterns for those who want to delve deeper.

The bullish engulfing line consists of a white (or colored in, at times empty) body that totally engulfs, or covers, the previous day’s body. In other words, the
high of the body is higher than the high of the previous body, and the low is below the previous low. The white body is formed by a low opening met by strong buying, which pushes the price to close above the previous candle. This is a bullish indicator that is seen often at major bottoms. Bearish engulfing lines are the mirror image seen at tops—a long black (or colored in, at times empty) candle that totally engulfs, or covers, the previous day’s candle. This is often seen at a blow-off top. It is a powerful signal for candlestick people.

Spreads—a valuable forecasting tool
I’ve found that by monitoring the spread of action in many of the actively traded physical commodities, a trader can get valuable clues about how bullish or bearish a market is. Spreads also can be used to predict the market path of least resistance. Typically, commodity futures markets are in “carrying charge” or “normal” configurations. (In London, they would say the market is in contango.) This is when the distant months sell at a higher price (or premium) to the closing months.
This configuration is called an inverted market. (In London, it’s called backwardation.) What causes a market to invert? In most cases, an inverted market is the product of a perceived or real near-term shortage of the commodity in question. This can be caused by weather. For example, cold weather tends to push the nearby natural gas over the back or could even push the nearby cattle contracts above the backs because cattle do not gain weight efficiently in cold weather and could conceivably be “pushed back”—not ready for market in a timely manner. Inversion could be caused by a mining strike, a government program, big near-term export demand, or a classic short squeeze—actually, any number of things. The important point here is that the spreads can give you important clues about the strength or weaknesses within a market.

Here’s another powerful trading tip: Watch for spreads to cross “even money.” I’ve noticed that when spreads “cross zero,” more times than not, this indicates a
significant indicator of a change in the supply-and-demand balance of the commodity being studied. My advice is to go with the flow. If the spread in question crosses zero to the upside, play the bull spreads (long nearby, short the deferred) or play the market from the long side. If the market crosses zero to the
downside, play the bear spreads (short the nearby, long the deferred), or play the market from the short side. For example, consider the spread between May
2003 sugar and March 2004 sugar, shown in Figure 8.29. Note that this action took place during mid-2002 into early 2003 (the 2004 contract is listed two years
prior to its expiration).

Head and shoulders
The H&S is a reversal pattern that signals a change in the prevailing major trend. We’ll take up some ink reviewing this concept here because, in my experience, it remains one of the most reliable. (I also will add my own twists to identifying and analyzing this pattern.) When you see an H&S pattern, it’s time to either exit and take your profits, cut your losses, or establish a new position in the new direction. An interesting characteristic of the H&S is that it not only tells you a market is making a top or bottom, but it also tells you how far the ensuing move will travel. The H&S does not actually pick the top or the bottom, but it gives you the sign after the top or bottom is in place.

The head (H) is a price peak; another peak lower than the head to the left is the left shoulder (LS), and another peak lower than the head to the right is the
right shoulder (RS). The line connecting the lows of the declines from the shoulders and the head is called the neckline (NL). In a classic H&S, the neckline is often horizontal (similar to a support line). However, it can also be upward sloping (as in Figures 8.31 and 8.32), similar to an up trendline, or downward sloping, similar to a down trendline. This is where your analytical skills come into play. Many of the best H&S patterns are mutants, which resemble the original but in a skewed way.

You can spot an H&S developing when the left shoulder and the head are in place and the market starts to rally from the neckline. If it fails at a lower high than the major high, the right shoulder is in formation. A classic H&S often has a right shoulder of the approximate same size and duration as the left. However, it
can be lower or higher, longer or shorter, but its peak will ultimately end up lower than the head. The pattern is not complete until the right shoulder is completed and the decline from the right shoulder’s peak breaks under the neckline. When that happens, a top is presumed. It is time to exit longs and go short. After the initial breakout below the neckline, the market often rallies back up to approximately the neckline, giving the trader an excellent low-risk shorting
opportunity. H&S patterns can also sometimes provide false signals. Suspect a false signal if the market is able to rally back above the peak of RS (this is the
place to initially set your risk point). This will not occur with the best H&S signals; most will not rally beyond NL. If the market trades above the peak of
the right shoulder, you can safely assume that all bets are off and this one isn’t “right.”

An H&S occurs at major bottoms as well and looks like the mirror image of one that forms at the top. Some traders call these inverted head and shoulders or reverse head and shoulders. In this variety, the head is at the lowest point, with two higher shoulders, one on each side. Other than the fact that these are the mirror image of the tops, you trade them the same way. The gold H&S bottom shown in Figure 8.34 is of the simple, classic variety; the soybean is more complex. Note how the extended and complex bottoming pattern illustrated in Figure 8.35 signaled the start of a major move that greatly exceeded the minimum objective.

10 rules for trading H&S
Here are ten rules for successfully trading using H&S patterns:
1. Never anticipate. When I first discovered H&S patterns, I had a great trade, but then it seemed I started finding them everywhere. I would start to sell after a right shoulder and a head developed, only to lose money. I would see complete H&S patterns develop and take action before penetration of the neckline, only to have my head handed to me. As Yogi Berra said, “It ain’t over till it’s over.” Wait until the pattern is completed before you trade it.
2. The bigger the H&S pattern and the longer it takes to develop, the bigger the subsequent resulting move.
3. The count is a minimum measurement. Odds actually favor the move carrying much further. However, a warning here: As with all other chart patterns, you are not dealing with a certainty here. If your count says the market will fall 400 points, and it falls 380 and starts to reverse, it would be a shame to let all your profits evaporate over a lousy 20 points.
4. After the market breaks the neckline, watch for the return move back to the neckline. This occurs in at least half of all valid cases and offers a place to enter with a close stop.
5. Watch the slope of the neckline. Downward-sloping necklines for H&S tops increase the odds for a more powerful bear move to follow. Upward sloping necklines for inverted H&S bottoms increase the odds for a more powerful bull move to follow.
6. Be volume aware. The most reliable neckline breakouts are accompanied with higher-than-average volumes. I have sometimes seen the highest daily volume days of the year associated with H&S patterns.
7. Watch for the head to also form an “island” (see Figure 8.36). This combines two very powerful patterns and geometrically increases the validity of the signal.

When the pattern is complete, it should act correctly. These patterns are fairly reliable and do not often deviate from their true purpose, unless, of course, they are false. How can you tell if a pattern is false? One good indication is that your margin account will start to show a loss. Don’t freeze when it’s not acting properly; when in doubt, get out. Be suspicious if the pattern occurs at a low volume. Remember that the market can retrace to the neckline (this is normal and a good place to position), but if the pattern is good, the retracement really shouldn’t go much further.