Quantifying Technical Analysis

In the last of our series of tutorials on risk management tools, Richard Weissman provides an overview of technical analysis for the energy business

The aim of technical analysis is the forecasting of future price trends. Here we give an introductory overview of some of the most popular techniques utilised in the field. The basic precept in all technical analysis is that through the study of past price history, along with the evaluation of volume or number of trades and open interest or the number of contracts outstanding, traders can forecast future price trends and identify low-risk/ high-reward trading opportunities.

This broad definition can be further narrowed into two distinct sub-categories: interpretative or subjective technical analysis and mathematical or objective technical analysis.

Interpretative technical analysis

Perhaps the most popular and well-known interpretative technical analysis formation is the 'head and shoulders' pattern (see figure 1).

Consider a market that is in a major uptrend – defined as successively higher highs and higher lows. Suddenly the upward momentum yields to a normal corrective downturn in prices – forming the left shoulder. This is followed by a breakout to new highs, forming the head.

Here the technical analyst often receives their first warning sign of an end to the uptrend. This latest upward breakout to new highs will typically occur when volume and open interest are falling. This action, in itself, does not suggest an end to the bull market, although it does make the move to new highs somewhat suspect, as we would normally want to see moves to new highs in an uptrend being accompanied by increased commitments of new capital.

Then our market gives another, more serious warning sign: a correction that, firstly, extends below the top of the left shoulder's peak and, secondly, nearly continues below the low of the left shoulder. After this correction, the market rallies again, usually on even lighter volumes, but fails to reach the top of the prior peak. This failure then completes the formation of the right shoulder. The completion of the right shoulder's decline allows us to draw a horizontal support line known as the 'neckline'.

In contrast to interpretative technical indicators, the success or failure of mathematical technical indicators is always indisputable, because they are based on objective and immutable rules

Now that our technician has identified a relatively low-risk/high-reward trading opportunity, he places a sell 'stop' below the neckline. Once the market weakens enough to satisfy the technician's sell order a protective buy stop is placed either above the left shoulder or above the head, thereby limiting and quantifying risk.

Our technician then continues lowering his buy stops as the new bear market – defined as successively lower highs and lower lows – progresses and matures until some new bullish charting pattern suggests exit and reversal.¹

Although interpretive technical indicators – such as the head and shoulders pattern – cannot be objectively quantified, they are nonetheless powerful tools, enabling both the quantification of risk and the identification of valid market trends. Despite their usefulness, the identification of such visual patterns is entirely subjective, as the name 'interpretative' suggests. As a result, the validity of such interpretative indicators cannot be statistically verified.

Mathematical technical analysis

In stark contrast to interpretative technical indicators, the success or failure of mathematical technical indicators is always indisputable because they are based on objective and immutable rules. The simplest and most popular of these types of indicator is the moving average (see figure 2).

The moving average is the average price of a specific data set. For example, if we were interested in knowing the 40-day moving average for New York Mercantile Exchange (Nymex) March natural gas futures contract, we would simply add up the settlement prices of the prior 40 trading days and then divide the total by 40.

Upon the completion of each new trading day, the data from the oldest day – 41 trading days ago – drops from our moving average calculation and is replaced by the new settlement price. Hence the term 'moving average'.

The theory behind using a moving average is that if the market is in a significant downtrend, prices should not be strong enough to rise above the 40-day moving average. Once the market is strong enough to breach the moving average, this theoretically suggests the end of the old downtrend and start of a new uptrend.

Although a 40-day moving average is usually too simplistic to act as a successful mechanical trading system in and of itself, it shows what technicians mean when they speak of objective, mathematical indicators.

Finally, it is important to acknowledge that interpretative and mathematical indicators are not mutually exclusive, and that technicians can and often do combine the best of both approaches in the hope of identifying high-probability trading opportunities – that is, those that are low-risk/ high-reward.

Trend-following versus counter-trend indicators

As stated at the article's outset, the main purpose of technical analysis is the forecasting of future price trends. Let us now delve deeper into this concept of 'price trends' by examination of the two basic 'flavours' of technical studies: trend-following and counter-trend indicators.

Most – around 70% – of the time, prices trade in a sideways or 'range-bound' pattern. By contrast, markets are only in a 'trending' mode around 30% of the time. In statistical terms, commodity and financial markets are said to be leptokurtic. That is, they display a strong tendency towards mean reversion – that is to say, prices tend to cluster around the mean.

Why then are such a large portion of technical analysts and mechanical trading systems dedicated to trend identification? It is because when prices do trend, those trends are often powerful and sustainable, offering traders low-risk/ high-reward opportunities, such that a single profitable trend-following trade will often offset numerous small losses, thereby resulting in an overall profitable trading system that often experiences win/loss ratios of 1:2.

The 40-day moving average examined earlier provides us with an excellent example of a trend-following indicator. Another popular variation on this mathematical trend-following indicator is known as the two-moving-average crossover system.

The two-moving-average crossover system entails the introduction of a second, shorter-term moving average, such as a seven-day moving average. Now instead of buying or selling whenever the market closes above or below the 40-day moving average, our trend-following trader buys whenever the shorter-term moving average crosses over and closes above the longer-term moving average and sells whenever the shorter-term moving average crosses over to close below the longer-term moving average.

In contrast, one of the most popular and widely used counter-trend indicators is another mathematical technical indicator known as the relative strength index (RSI) (see figure 3).

In 1978 Welles Wilder – who developed many commonly used mathematical technical indicators – developed the RSI to provide traders with an objective tool for measuring when a market becomes either overbought or oversold. The 'strength' of the market is measured by the following formula:

RSI = 100 – 100/1+RS

Fourteen periods – such as days or weeks – are most commonly used in calculating the RSI. To determine the average 'up' value, we add the total points gained on up days during the 14 days and divide that total by 14. To determine the average down value, add the total points lost during the down days and divide that total by 14. Most traders define a market as 'overbought' when the RSI closes above 70 and 'oversold' when the RSI closes below 30.²

Market psychology: why technical analysis works

To gain an understanding of why technical analysis works in terms of market psychology, let us examine the heating oil futures market, which began trading on Nymex during the late 1970s (see figure 4).

The late 1970s and early 1980s marked a strong uptrend in energy prices. During the summer of 1979, heating oil futures tested the $1.05 per gallon region and then quickly returned to around $0.72/gallon. This failure to rise above $1.05/gallon defined that area as resistance, or the level at which the upward price momentum was thwarted.

Over the next few years, the market would again test the $1.05/gallon resistance level and again that price level would act as a ceiling, preventing penetration to higher price levels. In fact, the $1.05 level would be retested in 1981, 1982 and 1984 without being breached.

In terms of market psychology, the $1.05/gallon level emerged as an important resistance mark. Consider the refiners who failed to hedge or distributors who failed to lift their hedge at the $1.05 area only to see prices fall to $0.72 /gallon.

Throughout the industry, traders have resolved that if the $1.05/gallon region is ever reached again they will sell all they can. As a result, when heating oil again reaches that level, the market must now have enough strength to absorb the selling pressure generated by those participants who view the area as an unsustainable, overvalued price region.³

Corrections/pullbacks

Another example of market psychology is the tendency of trends to experience temporary, minor counter-trend reversals within the context of the larger dominant market trend.

Such minor counter-trend reversals are called 'corrections' or 'pullbacks' and are typically measured from the lowest low of the prior trend to the most recent highest high in bull market trends, or from the highest high of the prior trend to the most recent lowest lows in bear market trends. The strength or weakness of the dominant market trend can be determined by the severity or mildness of these corrections.

For example, if our new bull market started from a low price of $10.00 a barrel (bbl), rose to a high of $20.00/bbl, then corrected down to $15.00/bbl, before continuing on to new highs (in excess of $20.00/bbl), that 50% price retracement suggests a weaker bull market trend when compared with a market that only pulled back to $16.18/bbl or 38% of the $10.00/bbl up move. In fact, markets often display a tendency to pull back either 50%, 33–38% on a stronger trend or 62–66% on a weaker trend from the ultimate high or low to recent low or high of a market trend (see figure 5).

The psychology behind market corrections is as follows. Hedgers and short-term counter-trend traders establish counter-trend positions into logical price target areas that are often long-term support or resistance levels as discussed above. As the market returns from its highs or lows, intermediate and short-term trend-followers take profits, accelerating the correction. Adding fuel to the corrective fire, there is a close out of weak or recent longs – those that are undercapitalised or have little tolerance for drawdowns in equity.

These corrective moves tend to climax at key retracement levels such as 38%, 50% or 62%, because counter-trend traders tend to take profits and trend-followers – that is, hedgers and long-term speculators – often add on to existing positions into these logical, low risk/high reward retracement levels.

Again returning to our prior bull market example, a trend following trader could buy when the market pulls back to $15.00/bbl – the 50% retracement level – and then place a protective stop loss order at $13.79/bbl, which is just below the 62% retracement level. If the bull market is still intact and the 50% pullback was just a correction within the context of a larger bull trend, then our trader can expect a minimum potential profit target of $20.01 and has therefore capitalized on a low risk ($1.21/bbl), high reward ($5.01/bbl) trade.

Technical versus fundamental analysis

As the market moves with corrections and pullbacks and other such market changes, the mindful analyst will look to various price forecasting methods. Often traders and analysts speak of technical and fundamental analysis as if the two terms were mutually exclusive. In reality, most participants use some rudimentary combination of both approaches.

Although fundamental analysis involves price forecasting based on supply-and- demand data, most fundamental analysts remain mindful of various key support and resistance levels in their attempt to effectively quantify risk and identify logical profit-taking areas.

Similarly, a significant portion of technical analysts will often disregard mechanically generated buy/sell signals if those signals are in conflict with some underlying qualitative shift in supply and demand.

For example, following September 11, the vast majority of trend-following technical indicators generated buy signals in the petroleum markets. However, many traders simply disregarded these signals because they represented market emotion and were in conflict with an underlying, weakened fundamental supply-and-demand picture.

Speculators versus hedgers

Another misconception regarding technical analysis is that it is only useful to speculators. Since the basic aim of technical analysis is the forecasting of future price trends, it is equally useful to both speculators as well as those seeking to protect themselves against adverse price fluctuations in the physical commodity markets.

Hedgers tend to use technical analysis in determining entry and 'lifting' – or exiting – levels for their hedges. Often they use technical analysis in deciding whether to hedge their physical market positions – with some type of derivative instrument, such as futures, options or swaps – or whether they are better served by simply accepting cash market fluctuations. By definition, most hedgers confine their operations to one 'side' of a particular market – otherwise, they are no longer hedging and are in fact speculators.

In contrast, speculators are not limited to placing orders on a particular side of the market – that is, long or short – and can implement a wide variety of strategies, including bullish, bearish, range-bound or volatile.

Benefits and limitations

One of the most obvious benefits of technical analysis lies in its ability to aid traders in quantifying and managing risk. Through the use of various technical indicators, traders can determine both the potential risk/reward ratio of a trade as well as the probability of the trade's success – based on a study of historical performance – prior to any commitment of capital.

The most serious limitation of technical analysis is the fact that trading decisions are based entirely upon historical precedence. Therefore, technical analysis is unable to accurately assess the risk/reward of markets that experience either a quantitative shift in supply/demand such as a change in basis between natural gas at Chicago City Gate and Henry Hub as a result of the creation of the Alliance Pipeline – which transports gas from Alberta to Chicago City Gate – or of new trading instruments that lack price history, such as sulphur dioxide allowances.

So, while technical analysis does not provide a 'holy grail' solution to the issues of price forecasting and risk quantification, it does nonetheless aid market participants in their quest for fulfilment of that timeless trader's adage: "Plan your trades and trade your plans."

Richard Weissman is a trading consultant and faculty member at The Oxford Princeton Programme in Princeton, New Jersey. He is based in Pennsylvania.
e-mail: rweissman@oxfordprinceton.com

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