First, be aware that there are puristsamong fundamental analysts who place all their faith in basic economic principles of supply and demand and often scoff, “All the ships that sank at sea had plenty of charts on board.”
They see charts as little more than a scorecard showing whether market bulls or market bears have been winning recently, and see charts having little to offer about prices going forward.
Pure chart technicians on the other hand, believe that at any given time, all that can be reasonably known about current trends in supply and demand are already reflected in price by Adam Smith’s “invisible hand of the marketplace.”
Further, they believe the charts themselves reveal which direction that invisible hand may be sweeping prices next. That faith is rooted in three basic assumptions:
Markets very quickly and efficiently factor in (discount) fundamental events in supply and demand before those events become common knowledge. In such cases the news follows the markets rather than the other way around.
Seeking fair value, price adjustments always take place over time in “trends” and that discerning that trend is a key to success, i.e. “the trend is your friend!”
History tends to repeat itself in commodity price cycles dictated by the tendency of commodities to oscillate between surplus and shortage over time.
For farmers, both fundamental and technical analysis play important roles.
Solid fundamental analysis often provides the strongest basis for adopting a bullish or bearish outlook for prices going forward and one’s resulting pricing strategy. But technical analysis serves two very important purposes, one complementary to the fundamental view and the other competitive with it:
Identifying the best timing for a move rooted in one’s fundamental outlook.
Letting one know when the fundamental analysis may be just plain wrong.
Bar Chart Basics: Identifying trend lines, support and resistance areas.
Futures charts follow zig-zag patterns up, down or sideways. By definition, an “uptrend” is a zig-zag pattern of higher highs and higher lows. But in an uptrend, technicians often refer specifically to the “uptrend line,” warning that a close below this line would be a clear sell signal by breaking the uptrend.
At the beginning of a new uptrend, you may have only two lows to connect with a straight line, but it won’t be confirmed or validated as the uptrend line until it’s tested a third time… and holds, sending prices higher again.
By definition, a downtrend is a zig-zag pattern of lower highs and lower lows. But again, chart technicians frequently reference a specific downtrend line, noting that a closing price above that line would be a clear buy signal by breaking the downtrend.
Notice a key difference: A downtrend line is always drawn connecting a series of highs.
There can also be sideways trends, confined to well-defined trading ranges with nearly horizontal lines of overhead resistance and underlying support. Note that sideways trading ranges are often a sign of a bull market that’s topping or a bear market that’s bottoming. When confirmed by either a downside breakout from sideways range at the top of a chart or an upside breakout from a sideways range at the bottom of a chart, these sideways ranges are now termed a distribution top or distribution bottom by chart technicians.
Also note that just as it takes at least three points of contact in a straight line to form an uptrend line or a downtrend line, it also takes at least three points of contact by near-parallel lines to confirm a sideways trend.
Underlying “Support” and Overhead “Resistance” Areas:
These are extremely common terms you often hear, even in text commentary without any graphics. Analysts will say something like, “The next support zone on weakness lies at $10.20, with overhead resistance at $10.80.”
If they include a chart, those lines will be clearly drawn on the chart to help you see why.
What causes overhead resistance to develop at certain price points: It’s rooted mostly in human psychology similar to the reasons uptrend lines and downtrend lines develop. The function of futures markets is price discovery. When an initial rally occurs, it typically halts for a breather at some point ,as buyers pause to see if any other buyers jump in to pick up the ball. If they don’t, then initial buyers begin to take profits and a break ensues.
Here is an example of underlying support.
It’s exactly the same human psychology reasoning as just described, but in reverse. For whatever reasons, a down-move comes to a halt at a certain price level. Buying interest exceeds selling interest and a rally ensues. But it’s short-lived and sellers regain the upper hand. But this time, selling again fades off at the same price point as before. Now more traders are thinking “the bottom might be in” and the next rally takes prices a bit higher yet before coming to a halt.
Common formations identifying major tops or major bottoms.
The 1-2-3 Top. This is one of the most common formations signaling the top of a significant bull market.
Notice the first step was # 1, a break in prices that violated the uptrend line, what technicians call a “downside breakout.” The next step in the formation is # 2, a rebound that failed to take out the prior high, breaking the pattern of higher highs. Confirmation of the 1-2-3 top was # 3, another decline that took out the prior low at #1.
The “Head-and-Shoulders” top is another formation signaling a top.
This one has an added benefit from the 1-2-3 top: a way of gauging how much further down the move might go.
Notice that once confirmed by the breaking right shoulder moving below the “neckline,” this formation portends the break will persist until it equals the distance from the neckline to the top of the head.
And finally, there are reverse images of both these topping formations that signal bottoms. As with the head-and-shoulders top, the inverted head-and-shoulders bottom has the added benefit of predicting the initial upside target - a distance equal to the distance from the “head” to the “neckline.”
That wraps up the primary assumptions behind technical analysis, as well as bar chart basics and what trend lines and common chart formations can tell us about market signals.
The views expressed in this article are the author's alone and not those of Farmer's Business Network, Inc., its affiliates or members.