Why is Chart Analysis So Important?
Is there a pattern to commodity prices? Can you predict
future prices based upon past performance? These questions are ones every
commodity market participant wonders about. To answer these questions requires
study of the factors that influence market prices. To accomplish this task
there are two methods available to the market analyst, fundamental and
technical.
Fundamental analysis is based upon the traditional study of
supply and demand factors that cause prices to rise or fall. Such factors
include drought, flood, war, politics, exchange rates, inflation and deflation.
The previous section on supply & demand and stocks/use ratios are methods
used by fundamentalists to arrive at an estimate of the equilibrium market
price of a commodity over time in order to determine if the current market
price is over or undervalued.
Technical or chart analysis, by contrast, is based upon the
study of the market action itself. While fundamental analysis studies the
reasons or causes for prices going up or down, technical analysis studies the
effect of the price movement itself. Technical analysts claim that markets do
trend and that by charting market prices you can control commodity price risk
management. They further claim that by combining the use of price charts with
appropriate marketing tools and pricing strategies can have a major positive
impact on your profitability and, therefore, the long term survival of your
business. Charting can be used by itself with no fundamental input, or in
conjunction with fundamental information. You will find that as you become more
skilled in charting and technical analysis, that the illusion of randomness in
the commodity market will gradually disappear. This will lead to more
confidence in making those very crucial marketing decisions.
Chart Patterns & Technical Analysis of Commodities
One of the major premises of technical analysis is that history
repeats itself. For the technician the recurrence of identifiable patterns
and formations that have preceded important movements of the market in the past
provide important clues as to the probable direction of price movement in the
future. Chart patterns are formations that appear on the charts which provide
you with forecasting tools of impending price movement. Some patterns are more
reliable than others for price forecasting. . None of the chart
patterns are infallible. They have a high probability of success but are
not guaranteed to work all of the time. Technicians must always be on the alert
for chart signs that prove their analysis to be incorrect. After trend lines,
support and resistance lines have been drawn on a chart, one of the most
important and most difficult decisions you will have to make is determining the
timing of entering and exiting the market as well as determining when a major
top in a rising market or a major bottom in a declining market has occurred.
There are two types of patterns that develop on charts, the reversal
pattern and the continuation pattern. Reversal patterns
indicate that an important reversal in trend is taking place. Knowing where
certain patterns are most likely to occur within the prevailing trend is one of
the key factors in being able to recognize a chart pattern. Some of the most
common reversal patterns include; the head and shoulders top and
bottom, double tops and bottoms, triple tops and bottoms, key reversals, island
reversals, rounding bottoms and tops, "V" formations or spike bottoms
and tops. There are a few important points to be considered which are
common to all of these reversal patterns.
1. The existence of a prior major trend is an important
prerequisite for any reversal pattern.
If a price pattern has not been preceded by an existing
trend, there is nothing to reverse and the pattern would therefore be suspect.
Knowing where chart patterns are most likely to occur within a price trend is
one of the key factors in identifying price patterns.
2. The first signal of an impending trend reversal is often
the breaking of an important trend line.
The breaking of a major trendline signals a change in trend,
not necessarily a trend reversal. The breaking of an uptrend line might signal
the beginning of a sideways trend which may later form either a reversal or
continuation pattern.
3. The larger the pattern the greater is the price movement
potential.
The height of the pattern measures the volatility, the width
of the pattern measures the amount of time required to build and complete the
pattern. The greater the height of the pattern ( the volatility ) and the
longer it takes to build - the more important the pattern becomes and the
greater the potential for the ensuing price move.
4. Topping patterns are usually shorter in duration and more
volatile than bottoms.
Price swings at major tops are wider and more violent. Tops
usually take less time to form than bottoms. For this reason it is usually less
risky to identify and trade bottoms than tops however the time spent in
establishing a top is generally shorter than the time spent establishing a
market bottom. Therefore, a market manager can generally do better by trading
the downside of the market rather than the upside of the market. This has
important implications for farm managers, due to the fact that the natural
tendency is to trade the former rather than the latter.
5. Volume is usually more important on the upside
Volume should generally increase in the direction of the
market trend and is an important confirming factor in the completion of all
price patterns. The completion of each pattern should be accompanied by a
noticeable increase in volume, particularly at market bottoms. Market tops tend
to fall on their own weight once a trend reversal is underway. At a market
bottom, if the volume pattern does not show a significant increase following
the upside breakout, the entire price pattern should be questioned. The second
type of chart pattern is the continuation pattern. Continuation patterns
suggest that market is only pausing for a while before the prevailing trend
will resume. Another difference between reversal and continuation patterns is
their time duration. Reversal patterns usually take much longer to form on the
chart and represent major changes in trend. Continuation patterns, on the other
hand, are usually shorter-term in duration and are often classified as
intermediate term chart patterns. Some of the most common continuation patterns
include; flags, ascending and descending triangles, symmetrical triangles,
pennants, gaps, and rectangles.
