CEB Finance: Three Techniques for Identifying the Formation of Tops in Futures Trading - Futures Account Opening

by donghang0728 on 2011-08-11 21:22:41

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Investors continuously trade in the futures market, attempting to uncover the essence of changes in long and short positions and profit from them. Futures trading involves making judgments about buying and selling directions, which are essentially long and short positions. The confrontation between longs and shorts in the futures market is akin to the strategic game played by two armies on a battlefield — advancing and retreating, engaging in fierce battles, or facing each other without moving. How to judge the situation between longs and shorts, especially the formation of tops or bottoms in futures prices, is a question that many investors care deeply about.

Determining long and short positions involves the use of analytical methods, which are mainly divided into fundamental analysis and technical analysis. Here, we primarily discuss technical analysis methods. The foundation of technical analysis is candlestick (K-line) analysis. Because technical analysis involves changes in price, and the four elements of price (opening price, closing price, highest price, and lowest price) are all contained within a single K-line, changes in K-lines largely reflect changes in the strength of long and short forces. Tops are constructed from a series of positive and negative K-lines. How can K-line changes be better analyzed to more accurately determine the situation between longs and shorts?

1. Indicator Judgment - Dual Divergence of MACD Indicators

The divergence pattern of MACD indicators can effectively judge top trends of medium level or higher. MACD indicator divergence comes in two types: one is divergence within the same cycle trend; the other is divergence across different cycle trends.

Divergence within the same cycle trend refers to the state where peaks of two adjacent MACD red histogram bars are diverging, meaning the peak value of the most recent red bar is lower than the previous one. This indicates that in the current upward trend, bullish energy is gradually being consumed and is becoming depleted, while bearish energy shows signs of emerging during this consumption process. Generally, when this internal divergence appears, a bearish trend may occur at any time, meaning a top could form anytime.

Divergence across different cycle trends refers to the situation where price peaks of two adjacent trend movements produce diverging values in their MACD red histogram bars, meaning the peak value of the most recent red bar is lower than the previous one. When this situation occurs, it suggests that the market reacts more sensitively to the pressure of the previous price peak, particularly in the case of gold futures account opening. The current market's bullish energy is unable to effectively break through the previous price peak, making it easy for false breakout scenarios to occur, leading to double-top formations.

These two types of divergence are illustrated with examples as follows. The PVC index formed a cross-cycle trend divergence in MACD indicators between April and October 2010. Additionally, the mid-October and early August 2010 movements of the PVC index formed an intra-cycle trend divergence in MACD indicators. The simultaneous existence of these two divergences significantly enhances the reliability of the divergence producing a top. Therefore, investors could make a judgment of a medium-level or higher top in PVC futures on October 15, 2010, and appropriately go short.

2. Application of Classic Patterns

Classic patterns include double tops, triple tops, rounded tops, head-and-shoulders tops, and inverted V shapes, among others. In the application of these patterns, many investors often find them unsatisfactory, even resulting in numerous errors or incorrect judgments. The main reason lies in inaccurate grasp of some detail issues in pattern judgment, primarily concerning the time span and construction strength of the patterns.

The time span of a pattern is very important. A pattern formed over too small or too short a time span generates little force, or should not be taken seriously, as it might even be a trap. Generally, patterns with a time span of around 34 months produce medium-to-high level trends, with high credibility and effectiveness.

The construction strength of a pattern refers to the traces left by the struggle between longs and shorts during the pattern's formation, i.e., the manifestation of a series of K-lines. Important positions in the construction of top patterns should ideally have large numbers of big bearish K-lines, or even large bearish K-lines with gaps downward, indicating that the top pattern contains significant bearish energy, which will generate greater force later on.

3. Secrets of K-line Combination Density and Length

K-lines represent the traces left by the struggle between longs and shorts, and the forms of this struggle vary. The main forms can be divided into: stalemate between longs and shorts (accumulation), intense fighting between longs and shorts, and acceleration of longs and shorts. The K-lines under different forms of manifestation differ. The density of positive and negative K-lines and the length of the K-lines themselves are important indicators for measuring the energy of longs and shorts. Based on these distinct characteristics of K-lines, investors can better judge the current situation between longs and shorts, understand the conditions faced by futures prices, and make better investment decisions.

Generally, if the position of the futures price is relatively low, the K-lines usually show very small fluctuations, mainly manifesting as small bearish K-lines, small bullish K-lines, and a lot of doji K-lines. The amplitude of price fluctuations over a phase is also not large. Of course, there is a special case, which is the bottoming out scenario after an extreme plunge, where the K-lines in this phase are likely to be consecutive accelerating large bearish K-lines.

When the futures price is in a relatively high stage, the K-lines generally show large fluctuations, mainly manifesting as large bearish or bullish K-lines, and the highs and lows of certain days' K-lines may reach the limit up or down prices.

When the futures price is in an intermediate stage of rising or falling, or in a sideways consolidation stage where it could move either way, the K-lines generally alternate between positive and negative ones, with moderate volatility.

Generally, if the K-lines over a period of time are predominantly bearish, it indicates that bearish forces are accumulating in this phase, and the futures price generally faces a decline or sharp drop afterward. For example, the PTA1009 contract in mid-late April 2010 and the rice ER1101 contract at the end of April both saw declines afterward.

Additionally, if after a period of upward movement, the futures price begins to show more bearish K-lines, especially large bearish K-lines, it indicates that bearish forces at this position are very strong, and the likelihood of forming a phase top is also quite high. For instance, the Zhengzhou sugar SR1009 contract in early January and late February 2010 showed large bearish K-lines, and its lows once reached the limit down position, indicating that the price above 5900 yuan/ton at the time was a phase bearish area, thus forming a phase important top.

In summary, there are many methods to judge the top of a commodity price, but they should be tailored to individual needs and applied accordingly. In different situations, different analytical methods should be used to achieve better results. If various methods fail to indicate the appearance of a phase top signal for a particular product, it means that the futures price of that product has not yet reached its top.