A Complete Guide
to the
Futures mArket
The Wiley Trading series features books by traders who have survived the market’s
ever changing temperament and have prospered—some by reinventing systems,
others by getting back to basics. Whether a novice trader, professional or some-
where in-between, these books will provide the advice and strategies needed to
prosper today and well into the future. For more on this series, visit our website
at www.WileyTrading.com.
Founded in 1807, John Wiley & Sons is the oldest independent publishing com-
pany in the United States. With offices in North America, Europe, Australia and
Asia, Wiley is globally committed to developing and marketing print and electronic
products and services for our customers’ professional and personal knowledge
and understanding.
A Complete Guide
to the
Futures mArket
Technical Analysis and Trading Systems,
Fundamental Analysis, Options, Spreads, and
Trading Principles
seCond edition
Jack d. schwager
mark etzkorn
Cover images: Stock Chart © Adam Kazmierski/iStockphoto; Abstract Background © Olga Altunina/ iStockphoto
Cover design: Wiley
Copyright © 2017 by Jack D. Schwager. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
The first edition of A Complete Guide to the Futures Market was published by John Wiley & Sons in 1984.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form
or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as
permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior
written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the
Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-
8600, or on the W eb at www .copyright.com. Requests to the Publisher for permission should be addressed to
the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011,
fax (201) 748-6008, or online at www .wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in
preparing this book, they make no representations or warranties with respect to the accuracy or completeness
of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness
for a particular purpose. No warranty may be created or extended by sales representatives or written sales
materials. The advice and strategies contained herein may not be suitable for your situation. Y ou should consult
with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit
or any other commercial damages, including but not limited to special, incidental, consequential, or other
damages.
For general information on our other products and services or for technical support, please contact our
Customer Care Department within the United States at (800) 762-2974, outside the United States at (317)
572-3993, or fax (317) 572-4002.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included
with standard print versions of this book may not be included in e-books or in print-on-demand. If this book
refers to media such as a CD or DVD that is not included in the version you purchased, you may download this
material at http://booksupport.wiley.com. For more information about Wiley products, visit www .wiley.com.
Library of Congress Cataloging-in-Publication Data:
Names: Schwager, Jack D., 1948- author.
Title: A complete guide to the futures market : fundamental analysis,
 technical analysis, trading, spreads and options / Jack D. Schwager.
Description: Second edition. | Hoboken, New Jersey : John Wiley & Sons, Inc.,
 [2017] | Series: Wiley trading series | Includes index.
Identifiers: LCCN 2016034802 (print) | LCCN 2016047999 (ebook) | ISBN
 9781118853757 (pbk.) | ISBN 9781118859599 (pdf) | ISBN 9781118859544 (epub)
Subjects: LCSH: Futures market. | Commodity exchanges. | Hedging (Finance)
Classification: LCC HG6046 .S39 2017 (print) | LCC HG6046 (ebook) | DDC
 332.64/52-dc23
LC record available at https://lccn.loc.gov/2016034802
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
In memory of Stephen Chronowitz, my mentor and friend.

vii
Contents
About the Authors xv
PArt I PrelImInArIes
ChAPter 1 For Beginners only 3
Purpose of This Chapter 3
The Nature of Futures Markets 3
Delivery 4
Contract Specifications 5
V olume and Open Interest 9
Hedging 11
Trading 15
Types of Orders 16
Commissions and Margins 19
Tax Considerations 19
ChAPter 2 the Great Fundamental versus technical Analysis Debate 21
PArt II ChArt AnAlysIs AnD teChnICAl InDICAtors
ChAPter 3 Charts: Forecasting tool or Folklore? 27
ChAPter 4 types of Charts 35
Bar Charts 35
Linked Contract Series: Nearest Futures versus Continuous Futures 39
Close-Only (“Line”) Charts 40
viii
Contents
Point-and-Figure Charts 42
Candlestick Charts 43
ChAPter 5 linking Contracts for long-term Chart Analysis:
nearest versus Continuous Futures 45
The Necessity of Linked-Contract Charts 45
Methods of Creating Linked-Contract Charts 46
Nearest versus Continuous Futures in Chart Analysis 48
Conclusion 51
ChAPter 6 trends 57
Defining Trends by Highs and Lows 57
TD Lines 66
Internal Trend Lines 73
Moving Averages 78
ChAPter 7 trading ranges 83
Trading Ranges: Trading Considerations 83
Trading Range Breakouts 86
ChAPter 8 support and resistance 91
Nearest Futures or Continuous Futures? 91
Trading Ranges 92
Prior Major Highs and Lows 94
Concentrations of Relative Highs and Relative Lows 101
Trend Lines, Channels, and Internal Trend Lines 106
Price Envelope Bands 107
ChAPter 9 Chart Patterns 109
One-Day Patterns 109
Continuation Patterns 122
T op and Bottom Formations 134
ChA

eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf


s 83
Trading Range Breakouts 86
ChAPter 8 support and resistance 91
Nearest Futures or Continuous Futures? 91
Trading Ranges 92
Prior Major Highs and Lows 94
Concentrations of Relative Highs and Relative Lows 101
Trend Lines, Channels, and Internal Trend Lines 106
Price Envelope Bands 107
ChAPter 9 Chart Patterns 109
One-Day Patterns 109
Continuation Patterns 122
T op and Bottom Formations 134
ChAPter 10 Is Chart Analysis still Valid? 149
ChAPter 11 technical Indicators 155
What Is an Indicator? 155
The Basic Indicator Calculations 157
Comparing Indicators 157
Moving Average Types 165
Oscillators and Trading Signals 167
Indicator Myths 170
Indicator “Types” 172
Conclusion 173
ixCONTENTS
PArt III APPlyInG ChArt AnAlysIs to trADInG
ChAPter 12 midtrend entry and Pyramiding 177
ChAPter 13 Choosing stop-loss Points 183
ChAPter 14 setting objectives and other Position exit Criteria 189
Chart-Based Objectives 189
Measured Move 190
Rule of Seven 194
Support and Resistance Levels 196
Overbought/Oversold Indicators 198
DeMark Sequential 199
Contrary Opinion 203
Trailing Stops 204
Change of Market Opinion 204
ChAPter 15 the most Important rule in Chart Analysis 205
Failed Signals 205
Bull and Bear Traps 205
False Trend Line Breakouts 211
Return to Spike Extremes 213
Return to Wide-Ranging Day Extremes 216
Counter-to-Anticipated Breakout of Flag or Pennant 219
Opposite Direction Breakout of Flag or Pennant Following a Normal Breakout 222
Penetration of T op and Bottom Formations 225
Breaking of Curvature 229
The Future Reliability of Failed Signals 229
Conclusion 231
PArt IV t rADInG systems AnD PerFormAnCe meAsurement
ChAPter 16 technical trading systems: structure and Design 235
The Benefits of a Mechanical Trading System 236
Three Basic Types of Systems 236
Trend-Following Systems 237
T en Common Problems with Standard Trend-Following Systems 244
Possible Modifications for Basic Trend-Following Systems 247
Countertrend Systems 254
Diversification 256
T en Common Problems with Trend-Following Systems Revisited 259
x
Contents
ChAPter 17 examples of original trading systems 261
Wide-Ranging-Day System 261
Run-Day Breakout System 268
Run-Day Consecutive Count System 273
Conclusion 278
ChAPter 18 selecting the Best Futures Price series for system testing 279
Actual Contract Series 279
Nearest Futures 280
Constant-Forward (“Perpetual”) Series 281
Continuous (Spread-Adjusted) Price Series 282
Comparing the Series 285
Conclusion 287
ChAPter 19 testing and optimizing trading systems 289
The W ell-Chosen Example 289
Basic Concepts and Definitions 291
Choosing the Price Series 293
Choosing the Time Period 293
Realistic Assumptions 295
Optimizing Systems 297
The Optimization Myth 298
T esting versus Fitting 310
The Truth about Simulated Results 312
Multimarket System T esting 313
Negative Results 314
T en Steps in Constructing and T esting a Trading System 315
Observations about Trading Systems 316
ChAPter 20 how to evaluate Past Performance 319
Why Return Alone Is Meaningless 319
Risk-Adjusted Return Measures 323
Visual Performance Evaluation 335
Investment Insights 343
PArt V FunDAmentAl AnAlysIs
ChAPter 21 Fourteen Popular Fallacies, or What not to Do Wrong 347
Five Short Scenes 347
The Fourteen Fallacies 349
xiCONTENTS
ChAPter 22 supply-Demand Analysis: Basic economic theory 359
Supply and Demand Defined 359
The Problem of Quantifying Demand 362
Understanding the Difference between Consumption and Demand 363
The Need to Incorporate Demand 366
Possible Methods for Incorporating Demand 368
Why Traditional Fundamental Analysis Doesn’t W ork in the Gold Market 371
ChAPter 23 types of Fundamental Analysis 373
The “Old Hand” Approach 373
The Balance Table 373
The Analogous Season Method 374
Regression Analysis 375
Index Models 376
ChAPter 24 the role of expectations 379
Using Prior- Y ear Estimates Rather Than Revised Statistics 379
Adding Expectations as a Variable in the Price-Forecasting Model 380
The Influence of Expectations on Actual Statistics 380
Defining New-Crop Expectations 381
ChAPter 25 Incorporating Inflation 383
ChAPter 26 seasonal Analysis 389
The Concept of Seasonal Trading 389
Cash versus Futures Price Seasonality 389
The Role of Expectations 390
Is It Real or Is It Probability? 390
Calculating a Seasonal Index 391
ChAPter 27 Analyzing market response 403
Evaluating Market Response for Repetitive Events 403
ChAPter 28 Building a Forecasting model: A step-by-step Approach 413
ChAPter 29 Fundamental Analysis and trading 417
Fundamental versus T echnical Analysis: A Greater Need for Caution 417
Three Major Pitfalls in Fundamental Analysis 418
Combining Fundamental Analysis with T echnical Analysis and Money Management 426
Why Bother with Fundamentals? 427
Are Fundamentals Instantaneously Discounted? 428
xii
Contents
Fitting the News to Price Moves 431
Fundamental Developments: Long- T erm Implications versus Short- T erm Response 432
Summary 435
PArt VI Futures sPreADs AnD oPtIons
ChAPter 30 the Concepts and mechanics of spread trading 439
Introduction 439
Spreads—Definition and Basic Concepts 440
Why Trade Spreads? 440
Types of Spreads 441
The General Rule 443
The General Rule—Applicability and Nonapplicability 443
Spread Rather Than Outright—An Example 445
The Limited-Risk Spread 446
The Spread Trade—Analysis and Approach 448
Pitfalls and Points of Caution 449
ChAPter 31 Intercommodity spreads: Determining Contract ratios 453
ChAPter 32 spread trading in stock Index Futures 461
Intramarket Stock Index Spreads 461
Intermarket Stock Index Spreads 462
ChAPter 33 spread trading in Currency Futures 471
Intercurrency Spreads 471
Intracurrency Spreads 473
ChAPter 34 An Introduction to options on Futures 477
Preliminaries 477
Factors That Determine Option Premiums 480
Theoretical versus Actual Option Premiums 483
Delta (the Neutral Hedge Ratio) 484
ChAPter 35 option trading strategies 487
Comparing Trading Strategies 487
Profit/Loss Profiles for Key Trading Strategies 489
PArt VII PrACtICAl trADInG Gu


ercurrency Spreads 471
Intracurrency Spreads 473
ChAPter 34 An Introduction to options on Futures 477
Preliminaries 477
Factors That Determine Option Premiums 480
Theoretical versus Actual Option Premiums 483
Delta (the Neutral Hedge Ratio) 484
ChAPter 35 option trading strategies 487
Comparing Trading Strategies 487
Profit/Loss Profiles for Key Trading Strategies 489
PArt VII PrACtICAl trADInG GuIDelInes
ChAPter 36 the Planned trading Approach 559
Step 1: Define a Trading Philosophy 559
Step 2: Choose Markets to Be Traded 560
xiii
CONTENTS
Step 3: Specify Risk Control Plan 560
Step 4: Establish a Planning Time Routine 563
Step 5: Maintain a Trader’s Spreadsheet 563
Step 6: Maintain a Trader’s Diary 565
Step 7: Analyze Personal Trading 565
ChAPter 37 seventy-Five trading rules and market observations 567
Entering Trades 568
Exiting Trades and Risk Control (Money Management) 569
Other Risk-Control (Money Management) Rules 570
Holding and Exiting Winning Trades 570
Miscellaneous Principles and Rules 571
Market Patterns 572
Analysis and Review 573
ChAPter 38 50 market Wizard lessons 575
APPenDIx A Introduction to regression Analysis 589
Basics 589
Meaning of Best Fit 591
A Practical Example 593
Reliability of the Regression Forecast 593
APPenDIx B A review of elementary statistics 597
Measures of Dispersion 597
Probability Distributions 599
Reading the Normal Curve (Z) Table 604
Populations and Samples 606
Estimating the Population Mean and Standard Deviation from the Sample Statistics 607
Sampling Distribution 608
Central Limit Theorem 609
Standard Error of the Mean 612
Confidence Intervals 612
The t- T est 614
APPenDIx C Checking the significance of the regression equation 619
The Population Regression Line 619
Basic Assumptions of Regression Analysis 620
T esting the Significance of the Regression Coefficients 620
Standard Error of the Regression 627
Confidence Interval for an Individual Forecast 627
Extrapolation 630
Coefficient of Determination (r2) 630
Spurious (“Nonsense”) Correlations 634
xiv
Contents
APPenDIx D the multiple regression model 637
Basics of Multiple Regression 637
Applying the t- T est in the Multiple Regression Model 640
Standard Error of the Regression 641
Confidence Intervals for an Individual Forecast 642
R2 and Corrected R2 642
F- T est 643
Analyzing a Regression Run 644
APPenDIx e Analyzing the regression equation 649
Outliers 649
The Residual Plot 650
Autocorrelation Defined 651
The Durbin-Watson Statistic as a Measure of Autocorrelation 651
The Implications of Autocorrelation 654
Missing Variables and Time Trend 655
Dummy Variables 658
Multicollinearity 663
Addendum: Advanced T opics 666
APPenDIx F Practical Considerations in Applying regression Analysis 673
Determining the Dependent Variable 673
Selecting the Independent Variables 675
Should the Preforecast Period Price Be Included? 675
Choosing the Length of the Survey Period 676
Sources of Forecast Error 677
Simulation 678
Stepwise Regression 679
Sample Step-by-Step Regression Procedure 680
Summary 681
references and recommended readings 683
Index 685
xv
About the A utho RS
Jack Schwager is a co-founder and Chief Research Officer of FundSeeder, a firm that seeks to find
undiscovered trading talent worldwide via its trader platform (FundSeeder.com), and a co-founder
of FundSeeder Investments (FundSeederinvest.com), which seeks to connect properly regulated
traders with sources of investment capital. Mr. Schwager is a recognized industry expert in futures
and hedge funds and the author of a number of widely acclaimed financial books. Previously,
Mr. Schwager was a partner in the Fortune Group (2001–2010), a London-based hedge fund advisory
firm. His prior experience also includes 22 years as Director of Futures research for some of Wall
Street’s leading firms, most recently Prudential Securities.
Mr. Schwager has written extensively on the futures industry and great traders in all financial mar-
kets. He is perhaps best known for his best-selling series of interviews with the greatest hedge fund
managers of the last three decades: Market Wizards (1989), The New Market Wizards (1992), Stock
Market Wizards (2001), Hedge Fund Market Wizards (2012), and The Little Book of Market Wizards (2014).
His other books include Market Sense and Nonsense (2012), a compendium of investment miscon-
ceptions, and the three-volume series Schwager on Futures, consisting of Fundamental Analysis (1995),
T echnical Analysis (1996), and Managed T rading (1996). He is also the author of Getting Started in T echnical
Analysis (1999), part of Wiley’s popular Getting Started series.
Mr. Schwager is a frequent seminar speaker and has lectured on a range of analytical topics includ-
ing the characteristics of great traders, investment fallacies, hedge fund portfolios, managed accounts,
technical analysis, and trading system evaluation. He holds a BA in Economics from Brooklyn College
(1970) and an MA in Economics from Brown University (1971).
Mark
etzkorn is founder of FinCom Media. He was formerly Editor-in-Chief of Active T rader maga-
zine, editor at Futures magazine, and a member of the Chicago Mercantile Exchange. He has authored,
edited, and contributed to more than 10 books on the financial markets.

PreliMinaries
Part I

3
Cha P ter 1
If a little knowledge is dangerous, where is the man who has so much as to be out of danger?
—Thomas Henry Huxley
 ■ Purpose of This Chapter
The focus of this book is on analysis and trading. although these subjects are explored in far greater
depth than in most general commodity texts, the presentation in the following chapters does not
assume any prior knowledge except for a familiarity with the basic concepts of futures markets. This
chapter is intended to provide a sketch of the background information necessary to make this book
accessible to the novice reader. The title of this chapter should be taken literally. Traders who are
already familiar with futures markets should pr


presentation in the following chapters does not
assume any prior knowledge except for a familiarity with the basic concepts of futures markets. This
chapter is intended to provide a sketch of the background information necessary to make this book
accessible to the novice reader. The title of this chapter should be taken literally. Traders who are
already familiar with futures markets should proceed directly to Chapter 2.
The introductory discussion provided by this chapter is deliberately brief and does not purport
to cover all background subjects. T opics such as the history of exchanges, choosing a broker, and
operation of the clearinghouse are not covered because a familiarity with these subjects is unnecessary
for the analysis and trading of futures markets.
readers who desire a more detailed discussion of com-
modity market basics can refer to a wide range of introductory commodity texts.
 ■ The Nature of Futures Markets
a futures contract is a commitment to deliver or receive a standardized quantity and quality of a com-
modity or financial instrument at a specified future date. The price associated with this commitment
is the trade entry level.
For Beginners Only
4
A Complete Guide to the Futures mArket
The essence of a futures market is in its name: Trading involves a commodity or financial
instrument for a future delivery date, as opposed to the present time. Thus, if a cotton farmer
wished to make a current sale, he would sell his crop in the local cash market. However, if the
same farmer wanted to lock in a price for an anticipated future sale (e.g., the marketing of a still
unharvested crop), he would have two options: He could locate an interested buyer and negotiate
a contract specifying the price and other details (quantity, quality, delivery time, location, etc.).
alternatively, he could sell futures. some of the major advantages of the latter approach are the
following:
 1. The futures contract is standardized; hence, the farmer does not have to find a specific buyer.
 2. The transaction can be executed virtually instantaneously online.
 3. The cost of the trade (commissions) is minimal compared with the cost of an individualized
forward contract.
 4. The farmer can offset his sale at any time between the original transaction date and the final
trading day of the contract. The reasons this may be desirable are discussed later in this chapter.
 5. The futures contract is guaranteed by the exchange.
Until the early 1970s, futures markets were restricted to commodities (e.g., wheat, sugar,
copper, cattle). since that time, the futures area has expanded to incorporate additional market sec-
tors, most significantly stock indexes, interest rates, and currencies (foreign exchange). The same
basic principles apply to these financial futures markets. Trading quotes represent prices for a future
expiration date rather than current market prices. For example, the quote for December 10-year
T -note futures implies a specific price for a $100,000, 10-year U.
s. Treasury note to be delivered
in December. Financial markets have experienced spectacular growth since their introduction, and
today trading volume in these contracts dwarfs that in commodities.
nevertheless, futures markets
are still commonly, albeit erroneously, referred to as commodity markets, and these terms are
synonymous.
 ■ Delivery
shorts who maintain their positions in deliverable futures contracts after the last trading day
are obligated to deliver the given commodity or financial instrument against the contract. similarly,
longs who maintain their positions after the last trading day must accept delivery. in the com-
modity markets, the number of open long contracts is always equal to the number of open short
contracts (see section V olume and Open
interest). Most traders have no intention of making
or accepting delivery, and hence will offset their positions before the last trading day. (The
long offsets his position by entering a sell order, the short by entering a buy order.)
it has been
estimated that fewer than 3 percent of open contracts actually result in delivery. some futures
contracts (e.g., stock indexes, eurodollar) use a cash settlement process whereby outstanding long
and short positions are offset at the prevailing price level at expiration instead of being physically
delivered.
5FOr Beginners Only
 ■ Contract Specifications
Futures contracts are traded for a wide variety of markets on a number of exchanges both in the
United states and abroad. The specifications for these contracts, especially details such as daily price
limits, trading hours, and ticker symbols, can change over time; exchange web sites should be con-
sulted for up-to-date information. Table 1.1 provides the following representative trading details for
six futures markets (
e-mini s&P 500, 10-year T -note, euro, Brent crude oil, corn, and gold):
 1. exchange. note that some markets are traded on more than one exchange. in some cases,
different contracts for the same commodity (or financial instrument) may even be traded on the
same exchange.
 2. ticker symbol. The quote symbol is the letter code that identifies each market (e.g., es for
the e-mini s&P 500, C for corn, eC for the euro), combined with an alphanumeric suffix to
represent the month and year.
 3. Contract size. The specification of a uniform quantity per contract is one of the key ways in
which a futures contract is standardized. By multiplying the contract size by the price, the trader
can determine the dollar value of a contract. For example, if corn is trading at $4.00/bushel (bu),
the contract value equals $20,000 ($4 × 5,000 bu per contract).
if Brent crude oil is trading at
$48.30, the contract value is $48,300 ($48.30 × 1,000 barrels). although there are many impor-
tant exceptions, very roughly speaking, higher per-contract dollar values will imply a greater
potential/risk level. (The concept of contract value


. For example, if corn is trading at $4.00/bushel (bu),
the contract value equals $20,000 ($4 × 5,000 bu per contract).
if Brent crude oil is trading at
$48.30, the contract value is $48,300 ($48.30 × 1,000 barrels). although there are many impor-
tant exceptions, very roughly speaking, higher per-contract dollar values will imply a greater
potential/risk level. (The concept of contract value has no meaning for interest rate contracts.)
 4. Price quoted in. This row indicates the relevant unit of measure for the given market.
 5. Minimum price fluctuation (“tick”) size and value. This row indicates the minimum
increment in which prices can trade, and the dollar value of that move. For example, the mini-
mum fluctuation for the
e-mini s&P 500 contract is 0.25 index points. Thus, you can enter an
order to buy December e-mini s&P futures at 1,870.25 or 1,870.50, but not 1,870.30. The
minimum fluctuation for corn is 1
4 ¢/bu, which means you can enter an order to buy December
corn at $4.01 1
2 or $4.01 3
4 , but not $4.01 5
8 per bushel. The tick value is obtained by multiply-
ing the minimum fluctuation by the contract size. For example, for Brent crude oil, one cent
($0.01) per barrel × 1,000 barrels = $10. For corn,
1
4 50 00 12 50¢/bu ×=,$ ..
 6. Contract months. each market is traded for specific months. For example, the e-mini s&P
500 futures contract is traded for March, June, september, and December. Corn is traded for
March, May, July, september, and December. Table 1.2 shows the letter designations for each
month of the year, which are added (along with the contract year) to a market’s base ticker
symbol to create a contract-specific ticker symbol. For example, December 2017
e-mini s&P
500 futures have a ticker symbol of esZ17, while the symbol for the March 2018 contract is
esH18. The symbol for May 2017 corn is CK17. The last trading day for a contract typically
occurs on a specified date in the contract month, although in some markets (such as crude oil),
the last trading day falls in the month preceding the contract month. For most markets, futures
are listed for contract months at least one year forward from the current date. However, trading
activity is normally heavily concentrated in the nearest two contracts.
6
A Complete Guide to the Futures mArket
table 1.1 Sample Futures Contract Specifications
e-Mini S&P 500 10-Y ear t-Note euro FX brent Crude Oil Corn Gold
exchange CMe group CM e group/CBOT CM e group intercontinental
exchange (iCe Futures
europe)
CMe group/CBOT CM e group/nyMeX
ticker Symbol es Ty eC B C gC
Contract Size $50 × s&P 500 index U.s. Treasury note with a
face value at maturity of
$100,000.
125,000 euros 1,000 barrels 5,000 bushels (∼ 127
metric tons)
100 troy ounces
Price Quoted In
index points Points ($1,000) and halves of
1/32 of a point (e.g., 126-16
represents 126 16/32 and
126-165 represents 126
16.5/32).
U.
s. dollars per
euro
U.s. dollars and cents Cents per bushel U. s. dollars and cents per
troy ounce
Minimum Price
Fluctuation
(“tick”) Size
and Value
0.25 index points =
$12.50
One-half of 1/32 of one
point ($15.625, rounded
to the nearest cent per
contract).
$0.00005 per
euro increments
($6.25/contract)
One cent ($0.01) per
barrel = $10
1/4 cent per bushel =
$12.50
$0.10 per troy ounce = $10
Contract Months Mar, Jun,
sep, Dec Mar, Jun, sep, Dec Mar, Jun, sep, Dec all months of the year Mar, May, Jul, sep, Dec The current month; the next
two months; any Feb, apr,
aug, and Oct within a 23-
month period; and any June
and Dec within a 72-month
period beginning with the
current month.
trading hours Mon–Fri, 5:00 p.m.
previous day to 4:15
p.m.; trading halt
from 3:15 p.m. to
3:30 p.m.
5:00 p.m. to 4:00 p.m.,
sun–Fri.
sun–Fri. 5 p.m. to
4 p.m. CT with a
60-min. break each
day beginning at
4:00 p.m.
1 a.m. to 11 p.m.
london time
sun–Fri, 7:00 p.m.
to 7:45 a.m. CT and
Mon–Fri, 8:30 a.m. to
1:20 p.m. CT .
sun–Fri, 6:00 p.m. to 5:00
p.m. (5:00 p.m. to 4:00 p.m.
Chicago time/CT) with a
60-minute break each day
beginning at 5:00 p.m. (4:00
p.m. CT).
6
7FOr Beginners Only
Daily Price limit 7%, 13%, and 20%
limits are applied
to the futures fixing
price, effective 8:30
a.m. to 3 p.m. CT ,
Mon–Fri.
7%, 13%, and 20% limits are
applied to the futures fixing
price, effective 8:30 a.m. to
3 p.m. CT , Mon–Fri. (
see
exchange for specifics.)
n/a n/a $0.25 n/a
Settlement type Cash settlement Deliverable Deliverable Physical delivery based
on eFP delivery, with
an option to cash settle
against the
iCe Brent
index price for the
last trading day of the
futures contract.
Deliverable Deliverable
First Notice Day
n/a Final business day of the
month preceding the
contract month.
n/a n/a last business day of
month preceding
contract month.
The last business day of the
month preceding the delivery
month.
last Notice Day n/a Final business day of the
contract month.
n/a n/a The business day after
the last contract’s last
trading day.
The second-to-last business
day of the delivery month.
last trading Day Until 8:30 a.m. on
the 3rd Friday of the
contract month.
12:01 p.m. on the 7th
business day preceding
the last business day of the
delivery month.
9:16 a.m. CT on
the second business
day immediately
preceding the
third W ed of the
contract month.
The last business day
of the second month
preceding the relevant
contract month.
Business day prior to
the 15th calendar day of
the contract month.
The third-to-last business day
of the delivery month.
Deliverable
Grade
n/a U.s. T -notes with a remaining
term to maturity of 6.5 to 10
years from the first day of the
delivery month.
n/a n/a #2 yellow at contract
price, #1 yellow at
a 1.5 cent/bushel
premium, #3
yellow
at a 1.5 cent/bushel
discount.
gold delivered under this
contract shall assay to a
minimum of 995 fineness.
7
8
A Complete Guide to the Futures mArket
 7. trading hours. Trading hours are listed in terms


es with a remaining
term to maturity of 6.5 to 10
years from the first day of the
delivery month.
n/a n/a #2 yellow at contract
price, #1 yellow at
a 1.5 cent/bushel
premium, #3
yellow
at a 1.5 cent/bushel
discount.
gold delivered under this
contract shall assay to a
minimum of 995 fineness.
7
8
A Complete Guide to the Futures mArket
 7. trading hours. Trading hours are listed in terms of the local times for the given exchange.
(all U.s. exchanges are currently located in either the eastern or Central time zones.)
 8. Daily price limit. exchanges normally specify a maximum amount by which the contract
price can change on a given day. For example, if the December corn contract closed at $4.10 on
the previous day, and the daily price limit is 25¢/bu, corn cannot trade above $4.35 or below
$3.85.
some markets employ formulas for increasing the daily limit after a specified number of
consecutive limit days.
in cases in which free market forces would normally seek an equilibrium price outside the
range boundaries implied by the limit, the market will simply move to the limit and virtually
cease to trade. For example, if after the market close the U.
s. Department of agriculture (UsDa)
releases a very bullish corn crop production estimate, which hypothetically would result in an
immediate 30¢/bu price rise in an unrestricted market, prices will be locked limit up (25¢/bu) the
next day. This means that the market will open and stay at the limit, with virtually no trading tak-
ing place. The reason for the absence of trading activity is that the limit rule restriction maintains
an artificially low price, leading to a deluge of buy orders at that price but few if any sell orders.
in the case of a very severe surprise event (e.g., sudden major crop damage), a market
could move several limits in succession, although such moves are less common than in the days
before near-24-hour electronic trading.
in such situations, traders on the wrong side of the
fence might not be able to liquidate their positions until the market trades freely. The new trader
should be aware of, but not be overly frightened by, this possibility, since such events of extreme
volatility rarely come as a complete surprise.
in most cases, markets vulnerable to such volatile
price action can be identified. some examples of such markets would include commodities in
which the UsDa is scheduled to release a major report, coffee or frozen concentrated orange
juice during their respective freeze seasons, and markets that have exhibited recent extreme
trading volatility. For some markets, the limit on the nearby contract is removed at some point
table 1.2 Contract Month Designations
Month ticker Designation
January F
February g
March H
april J
May K
June M
July n
august Q
september U
October V
november X
December Z
9FOr Beginners Only
approaching expiration (frequently first notice day—see item 10). Daily price limits can change
frequently, so traders should consult the exchange on which their products trade to ensure they
are aware of current thresholds.
 9. Settlement type. Markets are designated either as physically deliverable or cash settled. in
Table 1.1, the e-mini s&P 500 futures are cash settled, while all the other markets can be physi-
cally delivered.
 10. First notice day. This is the first day on which a long can receive a delivery notice. First notice
day presents no problem for shorts, since they are not obligated to issue a notice until after the
last trading day. Furthermore, in some markets, first notice day occurs after last trading day,
presenting no problem to the long either, since all remaining longs at that point presumably
wish to take delivery. However, in markets in which first notice day precedes last trading day,
longs who do not wish to take delivery should be sure to offset their positions in time to avoid
receiving a delivery notice. (Brokerage firms routinely supply their clients with a list of these
important dates.)
although longs can pass on an undesired delivery notice by liquidating their
position, this transaction will incur extra transaction costs and should be avoided. Last notice
day is the final day a long can receive a delivery notice.
 11. last trading day. This is the last day on which positions can be offset before delivery becomes
obligatory for shorts and the acceptance of delivery obligatory for longs. as indicated previously,
the vast majority of traders will liquidate their positions before this day.
 12. Deliverable grade. This is the specific quality and type of the underlying commodity or finan-
cial instrument that is acceptable for delivery.
 ■ Volume and Open Interest
V olume is the total number of contracts traded on a given day. V olume figures are available for each
traded month in a market, but most traders focus on the total volume of all traded months.
Open interest is the total number of outstanding long contracts, or equivalently, the total number
of outstanding short contracts—in futures, the two are always the same. When a new contract begins
trading (typically about 12 to 18 months before its expiration date), its open interest is equal to zero.
if a buy order and sell order are matched, then the open interest increases to 1. Basically, open interest
increases when a new buyer purchases from a new seller and decreases when an existing long sells to
an existing short. The open interest will remain unchanged if a new buyer purchases from an existing
long or a new seller sells to an existing short.
V olume and open interest are very useful as indicators of a market’s liquidity.
not all listed futures mar-
kets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading
activity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the
trader will often have to accept very poor trade execution prices if he wants to get in or out o


t are very useful as indicators of a market’s liquidity.
not all listed futures mar-
kets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading
activity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the
trader will often have to accept very poor trade execution prices if he wants to get in or out of a position.
generally speaking, markets with open interest levels below 5,000 contracts, or average daily
volume levels below 1,000 contracts, should be avoided, or at least approached very cautiously.
new markets will usually exhibit volume and open interest figures below these levels during their
10a COMPleTe gUiDe TO THe FUTUres MarKeT
initial months (and sometimes even years) of trading. By monitoring the volume and open interest
fi gures, a trader can determine when the market’s level of liquidity is suffi cient to warrant participa-
tion. Figure 1.1 shows February 2016 gold (top) and april 2016 gold (bottom) prices, along with
their respective daily volume fi gures. February gold’s volume is negligible until november 2015,
at which point it increases rapidly into December and maintains a high level through January (the
February contract expires in late February). Meanwhile, april gold’s volume is minimal until Janu-
ary, at which point it increases steadily and becomes the more actively traded contract in the last
two days of January—even though the February gold contract is still a month from expiration at
that point.
 The breakdown of volume and open interest fi gures by contract month can be very useful in
determining whether a specifi c month is suffi ciently liquid. For example, a trader who prefers to
initiate a long position in a nine-month forward futures contract rather than in more nearby con-
tracts because of an assessment that it is relatively underpriced may be concerned whether its level
of trading activity is suffi cient to avoid liquidity problems. in this case, the breakdown of volume and
open interest fi gures by contract month can help the trader decide whether it is reasonable to enter
the position in the more forward contract or whether it is better to restrict trading to the nearby
contracts.
 Traders with short-term time horizons (e.g., intraday to a few days) should limit trading to the
most liquid contract, which is usually the nearby contract month.
 FIGURE  1.1 V olume shift in gold Futures
Chart created using Tradestation. ©Tradestation T echnologies, inc. all rights reserved.

11FOr Beginners Only
 ■ Hedging
a sell hedge is the sale of a futures contract as a temporary substitute for an anticipated future sale
of the cash commodity.1 similarly, a buy hedge is a temporary substitute for an anticipated forward
purchase of the cash commodity. in essence, the goal of the hedger is to lock in an approximate future
price in order to eliminate exposure to interim price fluctuations. The concept of hedging is perhaps
best explained through illustration. let’s look at several examples of hedging.
hedging examples for a Commodity
Cotton Producer Sell Hedge The date is april 1. a cotton farmer estimates his potential
production at approximately 200,000 lbs, assuming average yields. The current cash price is 95¢/
lb—an extremely attractive price, but one the producer cannot take advantage of, since his crop will
not be harvested until
november. December futures are trading at 85¢/lb, reflecting market expecta-
tions for an interim price decline. The producer believes the December price may actually be overly
optimistic. He expects that a large increase in U.
s. production, in response to high prices, will result
in a major price collapse by the time the new crop is harvested. given his bearish expectations, the
producer is eager to lock in a price on his anticipated production.
Historical comparisons indicate the november–December cash prices in the producer’s region
tend to average approximately 2–4¢ below the December futures price. (The difference between cash
and futures is called the basis.
in this case, the november–December basis is said to be “2–4¢ under.”)
Thus, by selling December futures at the current price of 85¢/lb, the farmer can lock in an approxi-
mate cash price of 81–83¢. Because the producer believes prices will be significantly below 80¢/lb by
harvest time, he decides to sell three December futures contracts against the expected post-harvest
sale of his crop. This is called a sell hedge.
note that three contracts represent 150,000 lbs of cotton, an amount equivalent to three-quarters
of the producer’s anticipated crop. The farmer does not hedge his entire crop, because his eventual
output is still open to considerable uncertainty.
if weather conditions are extremely poor, his yields
could be reduced by more than 25 percent. Consequently, to avoid the possibility of overhedging his
crop, an action that would leave him with a net short position, he prudently decides to sell only three
contracts.
Table 1.3 illustrates two hypothetical outcomes of this hedge.
in case 1, the producer is entirely
correct in his expectations, and cash prices decline to 72¢/lb by December 1. in line with the normal
historical basis relationship, December futures are simultaneously trading at 75¢/lb. The producer
sells his cash crop at 72¢/lb, but also realizes a profit of 10¢/lb on his futures position. Thus, on the
150,000 lbs of crop that he has hedged, his effective price is 82¢/lb. (Commissions have not been
included in this or the following illustrations in order to keep exposition as simple as possible. The
adjustment for commissions would not meaningfully alter the results.)
as a result of hedging, the
1 The sell hedge may also be used as a proxy for temporary inventory reduction (see example of stock portfolio
manager later in this section).
12
A Complete Guide to the Futures mArket
table 1.3 Cotton Producer Sell h


e following illustrations in order to keep exposition as simple as possible. The
adjustment for commissions would not meaningfully alter the results.)
as a result of hedging, the
1 The sell hedge may also be used as a proxy for temporary inventory reduction (see example of stock portfolio
manager later in this section).
12
A Complete Guide to the Futures mArket
table 1.3 Cotton Producer Sell hedge
Case 1: Severely W eakening Cash Price Case 2: relatively Firm Cash Price
apr. 1 Dec. 1 apr. 1 Dec. 1
Cash price 95¢ 72¢ Cash price 95¢ 92¢
Futures price 85¢ 75¢ Futures price 85¢ 95¢
results: results:
Cash sale price: 72¢ Cash sale price: 92¢
Profit on futures: 10¢ loss on futures: 10¢
effective sale price: 82¢ effective sale price: 82¢
farmer has locked in a much better price than he would have realized had he waited until his crop
was harvested before taking any marketing action. in dollar terms, the producer’s income is $15,000
higher than it would have been without the hedge:
31 05 00 00 15 000×× =¢/lb lbs,$ ,
a hedge will not always be profitable. in the situation illustrated by case 2, Table 1.3, the producer’s
projections proved wrong as cash prices remained firm, declining a mere 3¢/lb from their lofty april
1 levels. in this case, the farmer is able to sell his crop at a much better than expected 92¢/lb, but he
experiences a loss of 10¢/lb on his futures position. His effective sales price is once again 82¢/lb. Of
course, in this instance, with the benefit of hindsight, the producer would have been much better off
had he had not hedged.
nonetheless, note that even though he has sacrificed the opportunity for a
windfall profit by hedging, he still realizes his target sales price of 82¢/lb.
The value of hedging is that it provides the producer with a much wider range of marketing strate-
gies. remember, if he prefers to take his chances and wait until after the harvest to market his crop,
he can do so. Futures widen the range of possibilities by allowing the producer to lock in any futures-
implied price during the interim. Thus, although he will not always make the right choice, presumably,
over the long run, the increased marketing flexibility provided by futures should prove advantageous.
Cotton Mill Buy Hedge The date is June 1. a cotton mill has forward contracted to supply a
fabric order for the following March. T o meet this production order, the mill will need 1 million lbs
of cotton on hand by December.
The current cash price is 77¢/lb, and December futures are trading at 80¢/lb.
assuming the same
−3¢/lb basis established in the aforementioned cotton producer example, the December futures
price quote implies cash prices will be unchanged in December relative to their current levels.
although the mill has plenty of time to purchase the actual cotton, it is concerned that cash prices
will rise significantly in the coming months. since the end-product sales price has already been nego-
tiated, the company must lock in its input price in order to guarantee a satisfactory profit margin.
given this scenario, the mill has two choices:
 1. i ncrease its inventory sufficiently to cover its anticipated December–March requirements.
 2. Hedge its forward requirements by buying December cotton futures.
13FOr Beginners Only
given the price structure in this example, the mill will be much better off buying futures. Why?
Because the purchase of futures covers the forward commitment without incurring any storage costs.
(This is true since the December futures price implies an unchanged cash price relative to current
levels.)
in contrast, the purchase of actual cotton would incur storage-related costs for the six-month
period. The most important of these expenses would be borrowing costs, or lost interest, if the firm
was using its own funds.
Table 1.4 illustrates two alternative outcomes for this hedge.
in both cases, it is assumed the
firm purchases the actual cotton on December 1, simultaneously offsetting its long hedge position in
futures.
in the first situation, cash prices increase between June and December, and the actual cash
market purchase price on December 1 is 87¢/lb. However, as a result of a 10¢/lb profit on the futures
hedge, the effective price to the firm is 77¢ (the cash price on June 1).
in the second illustration, cash
prices decline, and the firm’s actual purchase price is 67¢/lb. However, as a result of a 10¢/lb loss in
futures, the effective price is once again 77¢/lb.
although in this case the mill would have been better
off not hedging, it is still purchasing the cotton at the previously desired locked-in price.
since most companies will be more concerned about locking in adequate profit margins than
about giving up windfall profits, hedging should provide a useful tool for business management.
Furthermore, it should be emphasized that the firm always has the option not to hedge if, for any
reason, the price implied by futures is not considered attractive.
in short, users of commodities who
incorporate hedging should have an advantage over their competitors, because they have a much
wider range of purchasing strategies.
hedging in Financial Futures
The previous examples illustrate the buy-and-sell hedge for a commodity. The same basic principles
apply to the financial markets, as shown by the following examples.
a corporation expecting the need for a loan in six months and concerned about rising borrowing
costs in the interim could lock in an approximate fixed rate by selling short-term interest rate futures
(e.g., eurodollars). (
an increase in interest rates will cause the price of interest rate instruments to
decline.)
table 1.4 Cotton Mill buy hedge
Case 1: rising Cash Price Case 2: Declining Cash Price
June 1 Dec. 1 June 1 Dec. 1
Cash price 77¢ 87¢ Cash price 77¢ 67¢
Futures price 80¢ 90¢ Futures price 80¢ 70¢
results: results:
Cash purchase price: 87¢ Cash purchase price: 67¢
Profit on futures: 10¢ loss on futures:


an increase in interest rates will cause the price of interest rate instruments to
decline.)
table 1.4 Cotton Mill buy hedge
Case 1: rising Cash Price Case 2: Declining Cash Price
June 1 Dec. 1 June 1 Dec. 1
Cash price 77¢ 87¢ Cash price 77¢ 67¢
Futures price 80¢ 90¢ Futures price 80¢ 70¢
results: results:
Cash purchase price: 87¢ Cash purchase price: 67¢
Profit on futures: 10¢ loss on futures: 10¢
effective purchase price: 77¢ effective purchase price: 77¢
14
A Complete Guide to the Futures mArket
a bond fund manager anticipating a cash influx in three months and an imminent decline in interest
rates could lock in a rate of return by going long T -note futures.
a stock portfolio manager concerned about the possibility of a sharp, temporary break in stock
prices could reduce market exposure by selling stock index futures (e-mini s&P 500, e-mini nasdaq
100, russell 2000 index Mini). such action would be far more cost effective (i.e., would incur much
lower commission costs) than liquidating part or all of his portfolio and reinstating the position at a
later date.
a U.s. company that knew it would require 10 million euros in three months to pay for an import
transaction could lock in the exchange rate by purchasing euro futures.
General Observations regarding hedging
 1. i n all the preceding examples, the hedger offsets either an anticipated future transaction in the
actual market or a current position with an equal but opposite transaction in futures. Thus, for
the hedger, participation in futures can reduce risks associated with price changes.
in effect, the
true speculators among producers and users of commodities (or the financial markets) are those
who do not hedge. For example, the farmer who does not hedge is speculating on the direction
of prices during the interim before his crop is harvested.
 2. s ome written discussions of hedging almost seem to imply that producers and users of
exchange-traded commodities should automatically hedge. This is ridiculous—hedging should
be considered only if the futures-implied price is desirable. Otherwise, one is merely exchang-
ing the futures-implied price for the subsequent actual cash price. Over the long run, this type
of hedging should be a break-even process in terms of trades and a net loss generator because of
commissions.
 3. Hedging should be viewed as an important marketing tool, because it provides the producer
and user with a wide range of purchase and sale strategies. Hedgers can always choose not
to hedge, but nonhedgers eliminate the possibility of enhancing their profits through futures-
related opportunities.
 4. The hedger need not wait until the time of the actual transaction to lift the hedge. For example,
reconsider the case of the cotton producer who sells December futures at 85¢/lb.
if by October,
futures have declined to 70¢/lb, the hedger might very well decide to cover his short hedge
position.
although at a price of 85¢/lb the farmer was eager to protect against the possibility
of declining prices, at a price of 70¢/lb he might well prefer to take his chances. if prices were
subsequently to rally, the producer might decide to reinstate his hedge. in fact, sophisticated
hedgers will often use such a trading approach in hedging. The key point is that, contrary to
most textbook illustrations, a hedge should be maintained only as long as the implied price
protection is deemed desirable.
 5. i t is important to keep the time differential and expectations in mind when comparing a current
cash price with the cash price implied by futures. For example, in the hedge illustrated in case
1, Table 1.3, the futures-implied cash price is 13¢/lb below the current cash price.
yet, despite
15FOr Beginners Only
this wide discount, the hedge is still very profitable because the price differential is ultimately
far outweighed by the intervening price decline. Thus, the relevant question is not whether the
futures-implied cash price is attractive relative to the current cash price, but rather whether it is
attractive relative to the expected future cash price.
 6. The hedger does not precisely lock in a transaction price. His effective price will depend on
the basis. For example, if the cotton producer sells futures at 85¢/lb, assuming a −3¢ basis, his
effective sales price will be 80¢/lb, rather than the anticipated 82¢/lb, if the actual basis at the
time of offset is −5¢. However, it should be emphasized that this basis-price uncertainty is far
smaller than the outright price uncertainty in an unhedged position. Furthermore, by using
reasonably conservative basis assumptions the hedger can increase the likelihood of achieving,
or bettering, the assumed locked-in price.
 7. a lthough a hedger plans to buy or sell the actual commodity, it will usually be far more efficient
to offset the futures position and use the local cash market for the actual transaction. Futures
should be viewed as a pricing tool, not as a vehicle for making or taking delivery.
 8. Most standard discussions of hedging make no mention whatsoever of price forecasting.
This omission seems to imply that hedgers need not be concerned about the direction of
prices.
although this conclusion may be valid for some hedgers (e.g., a middleman seek-
ing to lock in a profit margin between the purchase and sales price), it is erroneous for
most hedgers. There is little sense in following an automatic hedging program.
rather,
the hedger should evaluate the relative attractiveness of the price protection offered by
futures. Price forecasting would be a key element in making such an evaluation.
in this
respect, it can easily be argued that price forecasting is as important to many hedgers as it
is to speculators.
 ■ Trading
The trader seeks to profit by anticipating price changes. For example, if the price of December gold
is $1,150/oz, a trader who expects the price to rise above $1,250/oz will go long. The trader has
no i


asting would be a key element in making such an evaluation.
in this
respect, it can easily be argued that price forecasting is as important to many hedgers as it
is to speculators.
 ■ Trading
The trader seeks to profit by anticipating price changes. For example, if the price of December gold
is $1,150/oz, a trader who expects the price to rise above $1,250/oz will go long. The trader has
no intention of actually taking delivery of the gold in December.
right or wrong, the trader will
offset the position sometime before expiration. For example, if the price rises to $1,275 and the
trader decides to take profits, the gain on the trade will be $12,500 per contract (100 oz × $125/
oz).
if, on the other hand, the trader’s forecast is wrong and prices decline to $1,075/oz, with the
expiration date drawing near, the trader has little choice but to liquidate. in this situation, the loss
would be equal to $7,500 per contract. note that the trader would not take delivery even given
a desire to maintain the long gold position. in this case, the trader would liquidate the December
contract and simultaneously go long in a more forward contract. (This type of transaction is called
a rollover and would be implemented with a spread order—defined in the next section.) Traders
should avoid taking delivery, since it can often result in substantial extra costs without any com-
pensating benefits.
16
A Complete Guide to the Futures mArket
novice traders should caution against the securities-based bias of trading only from the long side.
in futures trading, there is no distinction between going short and going long. 2 since prices can go
down as well as up, the trader who takes only long positions will eliminate approximately half the
potential trading opportunities. also, it should be noted that futures frequently command a premium
to current prices; consequently, the inflation argument for a long-side bias is frequently erroneous.
The successful trader must employ some method for forecasting prices. The two basic analytical
approaches are:
 1. technical analysis. The technical analyst bases projections on non-economic data. Price data
are by far the most important—and often only—input in technical analysis. The basic assump-
tion of technical analysis is that prices exhibit repetitive patterns and that the recognition of
these patterns can be used to identify trading opportunities. T echnical analysis can also include
other data, such as volume, open interest, and sentiment measures.
 2. Fundamental analysis. The fundamental analyst uses economic data (e.g., production,
consumption, exports) to forecast prices.
in essence, the fundamentalist seeks to uncover trad-
ing opportunities by identifying potential transitions to significantly more ample or tighter
supply-demand balances.
as discussed in Chapter 2, technical and fundamental analysis are not mutually exclusive
approaches. Many traders use both in the decision-making process or as components of automated
trading systems.
 ■ Types of Orders
Day versus Good till Canceled (GtC)
Unless specified otherwise, orders are assumed to be good only for the day of entry. if the trader wants
the order to remain open until canceled, he must specify that it is a good-till-canceled (gTC) order.
Market
This instruction directs the broker to execute the order upon receipt at the prevailing price level.
Market orders are used when the trader is more concerned with initiating or liquidating a position
immediately than with trying to achieve a specific execution price. Market orders ensure the trade
will be executed unless prices are locked in at the daily limit or the order is entered too close to the
end of the trading session.
2 some beginners are confused about how it is possible for a trader to sell a commodity he does not own. The
key to the answer lies in the fact that the trader is selling a futures contract, not the cash commodity. even though
the trader who stays short past the last trading day must acquire the actual commodity to fulfill his contractual
obligation, there is no need for him to own the commodity before that time. The short sale is simply a bet that
prices will go down before the last trading day.
right or wrong, the trader will offset his short position before
the last trading day, eliminating any need for actual ownership of the commodity.
17FOr Beginners Only
limit
The limit order, also called an or-better order, is used when the trader wants to ensure that the execu-
tion price will be no worse than a certain level. For example, an order to buy December gold at a
$1,150/ounce limit can only be executed at a price equal to or below $1,150.
if the market is trading higher than that level when the brokerage receives the order, it must wait
for the price to decline to $1,150 before it can execute the trade. if the price fails to return to that
level, the brokerage is unable to fill the order. similarly, an order to sell December gold at a $1,190/
ounce limit would indicate that the order can only be filled at a price equal to or above $1,190. limit
orders will normally provide better fills than will market orders, but the trade-off is that they may not
be executed.
a trader whose primary concern is to get the order filled, particularly if it is an order to
liquidate a losing position, should not use a limit order.
Stop
a stop order is not executed until the market reaches the given price level. The indicated price on
a buy stop must always be above the market, while the indicated price on a sell stop must always be
below the market.
in effect, a stop order will always be filled at a price worse than the market price. Why then would
a trader use a stop order? There are two very important reasons: First, stop orders are used to limit
losses or protect open profits. For example, a trader who buys March sugar at 14.50¢/lb might place
an order to sell March sugar at 13.50¢/lb stop,
gTC. if the market s


ys be
below the market.
in effect, a stop order will always be filled at a price worse than the market price. Why then would
a trader use a stop order? There are two very important reasons: First, stop orders are used to limit
losses or protect open profits. For example, a trader who buys March sugar at 14.50¢/lb might place
an order to sell March sugar at 13.50¢/lb stop,
gTC. if the market subsequently declines to 13.50¢/lb
or lower, the stop order becomes a market order. in this way, the trader limits his risk on the trade to
approximately 100 points. The reason for the word approximately is that markets often move beyond
the stop price before the order can be executed.
in the case of a short position, the protective stop order
would be placed at a higher price. For example, if the trader went short March sugar at 14.50¢/lb, an
order might be placed to buy March sugar at 15.50¢/lb stop,
gTC.
second, a stop order may be used if a trader views the market’s ability to reach a certain level as a
price signal. For example, if March sugar has been trading between 12.00¢ and 15.00¢/lb for several
months, a trader might believe that the ability of the market to significantly penetrate the high of this
range would be a sign of strength, suggesting a potential bull move.
in this case, the trader might enter
an order to buy March sugar at 15.50¢/lb stop. Thus, even though March sugar can be purchased
more cheaply at the current price, the trader prefers to use the stop order because he only wants to
be long if the market is able to demonstrate a specified degree of strength.
Stop-limit
a stop-limit order is a stop order in which the actual execution price is limited. For example, an
order to “buy March 10-year T -notes at 124'16 stop, 124'24 limit, gTC” means that if March 10-year
T -note futures advance to 124'16, the buy order is activated but cannot be executed at a price above
124'24.
similarly, an order to “sell March T -notes at 122 stop, 121'22 limit, gTC” is a sell stop that is
activated if the market declines to 122, but which cannot be filled at a price below 121'22. The stop
and limit portions of the order need not necessarily be at different prices.
18
A Complete Guide to the Futures mArket
Stop Close-Only
a stop close-only is a stop order that is activated only if any portion of the closing price range is
beyond the indicated price. (This type of order is not accepted on all exchanges.)
Market If touched
a market-if-touched (M iT) order is similar to a limit order except that it becomes a market order
anytime the limit price is reached. For example, given the following sequence of prices—79.40,
79.35, 79.25, 79.20, 79.25, 79.30, 79.40, 79.50 . . .—a 79.20 M iT buy order would become a
market order once 79.20 was reached, but a 79.20 limit order could be filled only at a price of
79.20 or better.
in this illustration, the market decline to 79.20 is so fleeting that the limit order
might very well not be filled, while the M iT order would be executed (probably at some price
above 79.20). The MiT is a hairsplitting type of order that is largely superfluous. Over the long run,
a trader will achieve equivalent results by using slightly higher buy limits (lower sell limits) instead
of M
iT orders.
Fill or Kill
as the name implies, a fill-or-kill (FOK) order is a limit order that must be filled immediately or
canceled.
Scale
a scale order is used for multicontract positions in which the trader wants to enter different contracts
at different prices. For example, if June British pound futures are trading at 153.00, a trader who
wants to sell 10 contracts on a possible rally to the 155.00–157.00 zone might enter a scale order to
sell 10 June British pound contracts, one at 155.20 limit and one contract every 0.20 points higher,
with the last contract having a limit price of 157.00.
One Cancels Other
The one-cancels-other (OCO) order is a two-sided order in which the execution of one side cancels
the other. For example, a trader who is long February live cattle at 117.00, with an objective of
125.00 and a stop point at 109.00, might enter the following order: sell 1 February cattle 125.00
limit/109.00 stop, OCO,
gTC.
Contingent
in this type of order the execution instruction for one contract is contingent on another contract. an
example would be: sell October sugar at the market if March sugar trades at 13.00 or lower. (This
type of order is not accepted on all exchanges.)
19FOr Beginners Only
Spread
a spread involves the simultaneous purchase of one futures contract against the sale of another futures
contract, either in the same market or in a related market. in essence, a spread trader is primarily
concerned with the difference between prices rather than the direction of price. an example of a spread
trade would be: Buy 1 July cotton/sell 1 December cotton, July 200 points premium December.
This order would be executed if July could be bought at a price 200 points or less above the level at
which December is sold.
such an order would be placed if the trader expected July cotton to widen
its premium relative to December cotton.
not all brokerages will accept all the order types in this section (and may offer others not listed here).
Traders should consult with their brokerage to determine which types of orders are available to them.
 ■ Commissions and Margins
in futures trading, commissions are typically charged on a per-contract basis. in most cases, large
traders will be able to negotiate a reduced commission rate. although commodity commissions are
relatively moderate, commission costs can prove substantial for the active trader—an important rea-
son why position trading is preferable unless one has developed a very effective short-term trading
method.
Futures margins are basically good-faith deposits and represent only a small percentage of the con-
tract value (roughly 5 percent with some significant variability around this level).


s are
relatively moderate, commission costs can prove substantial for the active trader—an important rea-
son why position trading is preferable unless one has developed a very effective short-term trading
method.
Futures margins are basically good-faith deposits and represent only a small percentage of the con-
tract value (roughly 5 percent with some significant variability around this level). Futures exchanges
will set minimum margin requirements for each of their contracts, but many brokerage houses will
frequently require higher margin deposits.
since the initial margin represents only a small portion of
the contract value, traders will be required to provide additional margin funds if the market moves
against their positions. These additional margin payments are referred to as maintenance.
Many traders tend to be overly concerned with the minimum margin rate charged by a broker-
age house.
if a trader is adhering to prudent money management principles, the actual margin level
should be all but irrelevant. as a general rule, the trader should allocate at least three to five times
the minimum margin requirement to each trade. Trading an account anywhere near the full margin
allowance greatly increases the chances of experiencing a severe loss. Traders who do not maintain at
least several multiples of margin requirements in their accounts are clearly overtrading.
 ■ Tax Considerations
 Tax laws change over time, but for the average speculator in the United states, the essential elements
of the futures contract tax regulations can be summarized in three basic points:
 1. There is no holding period for futures trades (i.e., all trades are treated equally, regardless of the
length of time a position is held, or whether a position is long or short).
20
A Complete Guide to the Futures mArket
 2. s ixty percent of futures trading gains are treated as long-term capital gains, and the remaining
40 percent are treated as short-term capital gains. since current maximum tax rates on long-
and short-term capital gains are 20 percent and 50 percent, respectively, this formula suggests
a maximum tax rate of 32 percent on futures trades.
 3. g ain (loss) in a given year is calculated as the total of realized gain (loss) plus unrealized gain
(loss) as of December 31.
21
Chapter 2
The Great
Fundamental
versus T echnical
Analysis Debate
Curiously, however, the broken technician is never apologetic about his method. If anything, he
is more enthusiastic than ever. If you commit the social error of asking him why he is broke, he
will tell you quite ingeniously that he made the all-too-human error of not believing his own
charts. T o my great embarrassment, I once choked conspicuously at the dinner table of a chartist
friend of mine when he made such a comment. I have since made it a rule never to eat with a
chartist. It’s bad for digestion.
—Burton G. Malkiel
One evening, while having dinner with a fundamentalist, I accidentally knocked a sharp knife
off the edge of the table. He watched the knife twirl through the air, as it came to rest with the
pointed end sticking into his shoe. “Why didn’t you move your foot?” I exclaimed. “I was waiting
for it to come back up, ” he replied.
—Ed Seykota (an avowed technician)
F
undamental analysis involves the use of economic data (e.g., production, consumption, disposable
income) to forecast prices, whereas technical analysis is based primarily (and often solely) on the
study of patterns in the price data itself. Which method is better? This question is the subject of great
22
A Complete Guide to the Futures mArket
debate. Interestingly, the experts are no less divided on this matter than are novices. In a series of
books in which I interviewed some of the world’s best traders,1 I was struck by the sharply divergent
views on this issue.
Jim Rogers was characteristic of one extreme of the spectrum. During the 1970s, Jim Rogers and
George Soros were the two principals of the Quantum Fund, perhaps the most successful Wall Street
fund of its day. In 1980, Rogers left the fund to escape managerial responsibilities and devote all his
time to managing his own investments—an endeavor at which he again proved spectacularly success-
ful. (The Quantum Fund maintained its excellent performance in the ensuing years under George
Soros’s directorship.) Over the years, Rogers has been on record with a high percentage of accurate
market forecasts. As but one example, in my 1988 interview with him, Rogers correctly predicted
both the massive collapse in the Japanese stock market and the continued multiyear downtrend in
gold prices. Clearly, Jim Rogers is a man whose opinion merits serious attention.
When I queried Rogers about his opinion on chart reading (the classic method of technical analy-
sis), he replied: “I haven’t met a rich technician. Excluding, of course, the technicians who sell their
services and make a lot of money.”
 That cynical response succinctly summarized Rogers’s views about
technical analysis.
Marty Schwartz is a trader whose opinion lies at the other extreme. At the time of our interview ,
Schwartz, an independent stock index futures trader, was considering managing outside money. In
conjunction with this undertaking, he had just had his personal track record audited, and he allowed
me to view the results. During the prior 10-year period, he had achieved an average return of
25 percent—monthly! Equally impressive, during this 120-month period, he witnessed only two
losing months—minuscule declines of 2 percent and 3 percent. Again, here was an individual whose
opinion on the market warranted serious respect.
Although I did not mention Rogers’s comments to Schwartz, when I asked Schwartz whether
he had made a complete transition from fundamental to technical analysis (Schwartz had started his
financial career as a stock analyst), his response almost sounded like a direct rebuttal to Jim Rogers:
“Absolutely. I


cent. Again, here was an individual whose
opinion on the market warranted serious respect.
Although I did not mention Rogers’s comments to Schwartz, when I asked Schwartz whether
he had made a complete transition from fundamental to technical analysis (Schwartz had started his
financial career as a stock analyst), his response almost sounded like a direct rebuttal to Jim Rogers:
“Absolutely. I always laugh at people who say, ‘I’ve never met a rich technician. ’ I love that! It is such
an arrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician.”
There you have it. Two extraordinarily successful market participants holding polar-opposite
views regarding the efficacy of fundamental versus technical analysis. Whom do you believe?
In my own assessment, both Rogers’s and Schwartz’s viewpoints contain elements of truth. It is
possible to succeed as a trader by being a pure fundamentalist, a pure technician, or a hybrid of the
two. The two methods are certainly not mutually exclusive. In fact, many of the world’s most suc-
cessful traders use fundamental analysis to determine the direction to trade a market and technical
analysis to time the entry and exit of such trades.
One virtually universal trait I found among successful traders was that they had gravitated to an
approach that best fit their personality. Some traders prefer very long-term approaches, while others
1 Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012 [orig. pub. 1989]); The New Market Wizards (Hoboken,
NJ: John Wiley & Sons, 2008); Stock Market Wizards (New Y ork, NY: HarperBusiness, 2003); and Hedge Fund
 Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012).
23THE GREAT FuNDAMENTAl vERSuS TECHNICAl ANAlYSIS DEBATE
are inclined toward day trading; some traders feel comfortable only when following signals gener-
ated by an automated system, while others find such a mechanical method anathema; some traders
thrive in the near-bedlam atmosphere of a trading room, while others succeed only if their decisions
are made in the calm of a quiet office; and some traders find fundamental analysis a natural approach,
while others instinctively lean to technical methods, and still others a blend of the two.
Essentially, then, there is no universal answer to the question, which is better, fundamental analy-
sis or technical analysis? Quite simply, it depends on the individual, who must determine his or her
natural approach.
The relative popularity of fundamental analysis versus technical analysis tends to wax and wane in
broad cyclical fashion. When I first became a market analyst in the 1970s, fundamental analysis was
considered a solid approach, while technical analysis was regarded by most as some sort of hocus-pocus
or black magic.
The situation changed, however, because the huge price trends that developed during the com-
modity inflation period of the 1970s were ideally suited to the trend-following techniques widely
favored by technical analysts. Even the simplest trend-following strategies tended to perform
extremely well during this period, while sophisticated fundamental methodologies often proved to
be highly misleading. In this environment, the popularity of technical analysis grew enormously, while
fundamental analysis declined in favor. This basic trend extended into the 1980s, as technical analysis
became the primary method of choice and fundamental analysis a minority technique. By the end of
the 1980s, a significant majority of money managers in the futures industry (known as commodity
trading advisors, or CTAs) employed technical analysis exclusively or at least for the bulk of their
trading decisions. Thus, whereas at the beginning of the 1970s few market participants would even
consider technical analysis, by the late 1980s few would consider fundamental analysis.
By this time, however, general market behavior had become increasingly erratic, with fewer sus-
tained trends and an increasing percentage of false price breakouts (i.e., price moves above or below
trading ranges that are followed by price reversals rather than price extensions). Simultaneously, the
spectacular performance of some technical trend followers deteriorated substantially, or at the very
least their results exhibited periodic deep equity retracements. At the same time, it appeared that
many of the traders and money managers with the best performance were those who were primar-
ily fundamentally oriented, or at least relied on fundamentals as a significant input in their trading
decisions.
T o summarize, there is no “right” side to the great fundamental versus technical debate: the appro-
priate method depends on the individual. Moreover, even for individual traders, the perceived answer
may change dramatically, or even completely reverse, over the years. Also, combining fundamental
analysis with technical analysis can provide a particularly effective approach and is indeed descriptive
of the general methodology used by some of the world’s most successful traders. The bottom line is
that each trader must explore both approaches and select the methodology or blend that feels the
most comfortable and appropriate.
The relative pros and cons of using fundamental and technical analysis for trading, as well
as practical considerations about combining the two methods, are examined in greater detail in
Chapter 29.

Chart aNalysis aNd
teChNiCal iNdiCators
Part II

27
Cha P ter 3
Charts: Forecasting
tool or Folklore?
Common sense is not so common.
—V oltaire
t
here is a story about a speculator whose desire to be a winner was intensified by each successive
failure. initially he tried basing his trading decisions on fundamental analysis. he constructed
intricate models that provided price forecasts based on an array of supply/demand statistics. Unfor-
tunately, his models’ predictions were invariably upset by some unexpected event, such as a drought
or a surprise export sale


speculator whose desire to be a winner was intensified by each successive
failure. initially he tried basing his trading decisions on fundamental analysis. he constructed
intricate models that provided price forecasts based on an array of supply/demand statistics. Unfor-
tunately, his models’ predictions were invariably upset by some unexpected event, such as a drought
or a surprise export sale.
Ultimately, in exasperation, he gave up on the fundamental approach and turned to chart analysis.
he scrutinized price charts, searching for patterns that would reveal the secrets of trading success.
he was the first to discover such unusual formations as shark-tooth bottoms and Grand teton tops.
But alas, the patterns always seemed reliable until he started basing his trades on them. When he went
short, top formations proved to be nothing more than pauses in towering bull markets.
equally dis-
tressing, steady uptrends had an uncanny tendency to reverse course abruptly soon after he went long.
“the problem,” he reasoned, “is that chart analysis is too inexact. What i need is a computerized trad-
ing system.” so he began testing various schemes to see if any would have been profitable as a trading sys-
tem in the past. after exhaustive research, he found that buying cattle, cocoa, and eurodollars on the first
tuesday of months with an odd number of days and then liquidating these positions on the third thursday
of the month would have yielded extremely profitable results during the preceding five years. inexpli-
cably, this carefully researched pattern failed to hold once he began trading. another stroke of bad luck.
the speculator tried many other approaches— elliott waves, Fibonacci numbers, Gann squares,
the phases of the moon—but all proved equally unsuccessful. it was at this point that he heard of a
famous guru who lived on a remote mountain in the himalayas and who answered the questions of
all pilgrims who sought him out. the trader boarded a plane to Nepal, hired guides, and set out on a
two-month trek. Finally, completely exhausted, he reached the famous guru.
28
A Complete Guide to the Futures mArket
“oh, Wise one,” he said, “i am a frustrated man. For many years i have sought the key to successful
trading, but everything i have tried has failed. What is the secret?”
the guru paused for only a moment, and, staring at his visitor intently, answered, “B lash.” he
said no more.
“Blash?” the trader did not understand the answer. it filled his mind every waking moment, but
he could not fathom its meaning. he repeated the story to many, until finally one listener interpreted
the guru’s response.
“it’s quite simple,” he said. “Buy low and sell high.”
the guru’s message is apt to be disappointing to readers seeking the profound key to trading wis-
dom. Blash does not satisfy our concept of an insight because it appears to be a matter of common
sense. however, if, as V oltaire suggested, “Common sense is not so common,” neither is it obvious.
For example, consider the following question: What are the trading implications of a market reaching
new highs? the “common-sense” Blash theory would unambiguously indicate that subsequent trad-
ing activity should be confined to the short side.
V ery likely, a large percentage of speculators would be comfortable with this interpretation. Per-
haps the appeal of the B lash approach is tied to the desire of most traders to demonstrate their
brilliance. after all, any fool can buy the market after a long uptrend, but it takes genius to fade the
trend and pick a top. in any case, few trading responses are as instinctive as the bias toward buying
when prices are low and selling when prices are high.
as a result, many speculators have a strong predilection toward favoring the short side when
a market trades in new high ground. there is only one thing wrong with this approach: it doesn’t
work. a plausible explanation is readily available. a market’s ability to reach and sustain new highs is
usually evidence of powerful underlying forces that often push prices much higher. Common sense?
Certainly. But note that the trading implications are exactly opposite to those of the “common-sense”
B
lash approach.
the key point of all of this is that many of our common-sense instincts about market behavior are
wrong. Chart analysis provides a means of acquiring common sense in trading—a goal far more elu-
sive than it sounds. For example, if prior to beginning trading an individual exhaustively researched
historical price charts to determine the consequences of a market’s reaching new highs, he would
have a strong advantage in avoiding one of the common pitfalls that await the novice trader.
similarly,
other market truths can be gleaned through a careful study of historical price patterns.
it must be acknowledged, however, that the usefulness of charts as an indicator of future price
direction is a fiercely contested subject. rather than list the pros and cons of this argument, we
found an episode of a financial markets tV series that was very popular in the 1980s and 1990s,
which succinctly highlighted some of the key issues in this debate. the transcript from this program
is presented:
Moderator: hello, i’m louis Puneyser of Wallet Street Week. tonight we will depart from our
normal interview format to provide a forum for a debate on the usefulness of commodity
price charts. Can all those wiggly lines and patterns really predict the future?
or is shake-
speare’s description of life also appropriate to chart analysis: “. . . a tale told by an idiot, full of
29
Charts: ForeCasting tool or Folklore?
sound and fury, signifying nothing”? our guests tonight are Faith N. trend, a renowned techni-
cal analyst with the Wall street firm of Churnum & Burnum, and Phillip a. Coin, a professor
at ivory tower University and the author of The Only Way to Beat the Market—Become a Broker.
Mr. Coin, you belong to a group called the random Walkers.


an idiot, full of
29
Charts: ForeCasting tool or Folklore?
sound and fury, signifying nothing”? our guests tonight are Faith N. trend, a renowned techni-
cal analyst with the Wall street firm of Churnum & Burnum, and Phillip a. Coin, a professor
at ivory tower University and the author of The Only Way to Beat the Market—Become a Broker.
Mr. Coin, you belong to a group called the random Walkers. is that some sort of hiking club
that decides its destinations by throwing darts at a trail map? (He smiles smugly into the camera.)
ProFessor CoiN: W ell, no, Mr. Puneyser. the random Walkers are a group of economists who
believe that market price movements are random. that is, one can no more devise a system
to predict market prices than one can devise a system to predict the sequence of colors that
will turn up on a roulette wheel. Both events are strictly a matter of chance. Prices have no
memory, and what happened yesterday has nothing to do with what will happen tomorrow .
in other words, charts can only tell you what has happened in the past; they are useless in
predicting the future.
Ms. treNd: Professor, you overlook a very important fact: daily prices are not drawn out of a bowl,
but rather are the consequence of the collective activity of all market participants. human be-
havior may not be as predictable as the motion of planets as governed by the laws of physics, but
neither is it totally random.
if this is not the case, your profession—economics—is doomed to
the same fate as alchemy. (Professor Coin squirms uncomfortably in his seat upon this reference.) Charts
reveal basic behavioral patterns.
insofar as similar interactions between buyers and sellers will
result in similar price patterns, the past can indeed be used as a guideline for the future.
ProFessor CoiN: if past prices can be used to predict future prices, why have a myriad of
academic studies concluded that tested technical rules failed to outperform a simple buy-
and-hold policy once commissions were taken into account?
M
s. treNd: the rules used in those studies are generally oversimplified. the studies demonstrate
that those particular rules don’t work. they don’t prove that a richer synthesis of price infor-
mation, such as chart analysis, or a more complex technical system, cannot be successfully
exploited for making trading decisions.
P
roFessor CoiN: Why then are there no studies that conclusively demonstrate the viability of
chart analysis as a forecasting tool?
Ms. treNd: your argument merely reflects the difficulties of quantifying chart theories rather
than the deficiencies of the chartist approach. one man’s top formation is another man’s
congestion area. an attempt to define anything but the simplest chart pattern mathematically
will be unavoidably arbitrary. the problems become even more tangled when one realizes
that at any given time, the chart picture may exhibit conflicting patterns. thus, in a sense, it
is not really possible to test many chart theories objectively.
ProFessor CoiN: that’s rather convenient for you, isn’t it? if these theories can’t be rigorously
tested, of what use are they? how do you know that trading on charts will lead to better than
a 50/50 success rate—that is, before commissions?
30
A Complete Guide to the Futures mArket
Ms. treNd: if you mean that blindly following every chart signal will only make your broker
rich, i don’t disagree. however, my point is that chart analysis is an art, not a science. a
familiarity with basic chart theories is only the starting point. the true usefulness of charts
depends on the individual trader’s ability to synthesize successfully his own experience with
standard concepts. in the right hands, charts can be extremely valuable in anticipating ma-
jor market trends. there are many successful traders who base their decisions primarily on
charts. What would you attribute their success to—a lucky streak?
ProFessor CoiN: yes. exactly that, a lucky streak. if there are enough traders, some of them
will be winners, whether they reach their decisions by reading charts or throwing darts at
the commodity price page.
it’s not the method, just the laws of probability. even in a casino,
some percentage of the people are winners. you wouldn’t say that their success is due to any
insights or system.
Ms. treNd: all that proves is that superior performance by some chartists could be due to chance. it
doesn’t disprove the contention that the skillful chartist is onto something that gives him an edge.
Moderator: i sense a lot of resistance here, and i think we could use some more support. have
either of you brought any evidence along that would tend to substantiate your positions?
ProFessor CoiN: yes! (At this point, Professor Coin pulls a thick manuscript from his briefcase and
thrusts it into Mr. Puneyser’s hands. The moderator flips through the pages and shakes his head as he
notices a profusion of funny little Greek letters.)
M
oderator: i had something a little less mathematical in mind. even educational tV is not
ready for this.
ProFessor CoiN: W ell, i also have this. (He pulls out a sheet of paper and hands it to Ms. T rend.)
how would you interpret this chart, Ms. trend? (He unsuccessfully attempts to suppress a smirk.)
Ms. treNd: i’ d say this looks like a chart based on a series of coin tosses. you know , heads one
box up, tails one box down.
ProFessor CoiN: (Whose smirk has turned into a very visible frown.) how did you know that?
Ms. treNd: lucky guess.
ProFessor CoiN: W ell, anyway, that doesn’t affect my argument. look at this chart. here’s a
trend. and this here—isn’t that what you people call a head-and-shoulders formation?
Moderator: speaking of head and shoulders, do either of you have an opinion on Procter &
Gamble?
ProFessor CoiN: (Continuing.) the same chart patterns you are so quick to point to on your
price charts also show up in obviously random series.
Ms. treNd: yes, but that line of reasoning


ook at this chart. here’s a
trend. and this here—isn’t that what you people call a head-and-shoulders formation?
Moderator: speaking of head and shoulders, do either of you have an opinion on Procter &
Gamble?
ProFessor CoiN: (Continuing.) the same chart patterns you are so quick to point to on your
price charts also show up in obviously random series.
Ms. treNd: yes, but that line of reasoning can lead to some odd conclusions. For instance, would
you agree that the fact that working economists tend to have advanced degrees is not a chance
occurrence?
31Charts: ForeCastiNG tool or FolKlore?
 ProFessor CoiN: of course.
 Ms. treNd: W ell then, a random sample of the population is also likely to turn up some people
with advanced degrees. do you then conclude that the fact that an economist has an advanced
degree is a coincidence?
 ProFessor CoiN: i still don’t see any diff erence between price charts and my randomly gener-
ated chart.
 Ms. treNd: y ou don’t? does this look like a randomly generated chart? (Ms. T rend holds up a July
1980 silver chart—see Figure 3.1 .)
 ProFessor CoiN: W ell, not exactly, but . . .
 Ms. treNd: ( On the attack .) or this. ( She holds up the December 1994 coﬀ ee chart—see Figure 3.2 .)
i could go on.
 Moderator: ( T o Professor Coin .) Ms. trend really seems to be percolating. are there any grounds
for dismissing her examples?
 ProFessor CoiN: W ell, i admit those examples are pretty extreme, but they still don’t prove
that past prices can predict future prices.
 Moderator: Before our time reaches limit-up, so to speak, i would like to rechart our course.
i wonder what your opinions are about fundamental analysts?
 FIGURE /uni00A03.1 July 1980 silver
Chart created using tradestation. ©tradestation t echnologies, inc. all rights reserved.

32a CoMPlete GUide to the FUtUres MarKet
 FIGURE /uni00A03.2 december 1994 Coff ee
Chart created using tradestation. ©tradestation t echnologies, inc. all rights reserved.
 ProFessor CoiN: W ell, they’re better than chartists since they can at least explain price moves.
But i’m afraid their attempts to forecast prices are equally futile. y ou see, at any given moment,
the market discounts all known information, so there is no way they can project prices unless
they can anticipate unforeseen future developments such as droughts or export embargoes.
 Ms. treNd: W ell, fi rst i would like to address the implication that chart analysts ignore funda-
mentals. actually we believe that the price chart provides an unambiguous and immediate
summary of the net impact of all fundamental and psychological factors. in contrast, accurate
fundamental models, if they could be constructed at all, would be extremely complex. Fur-
thermore, the fundamental data for the forecast period would have to be estimated, thereby
making the price projections extremely vulnerable to error.
 Moderator: then you might say you both agree with the statement that fundamentalists end
up with holes in their shoes.
 Ms. treNd: y es.
 ProFessor CoiN: y es.
 Moderator: W ell, on that upbeat note of agreement, we end tonight’s program.
 in a sense, the argument between the “random walkers” and the chartists can never be clearly
resolved. it must be understood that it is impossible to prove randomness; all that one can prove is
33
Charts: ForeCasting tool or Folklore?
that a given pattern does not exist. since there is no consensus as to the precise mathematical defini-
tion of many chart patterns, the viability of these patterns as price indicators can be neither proven
nor disproven.
For example, if one wanted to test the contention that breakouts from trading ranges represent
valid trade signals, the first requirement would be to formulate concise definitions of a trading range
and a breakout.
assume that the following definitions are adopted: (1) that the trading range is a price
band that completely encloses all daily price changes during the past six-week period and that is no
wider than 5 percent of the median price during that period,
1 and (2) that a breakout is a closing price
above or below the six-week trading range. although the validity of breakouts as trading signals could
be tested for these specific definitions, the definitions themselves will be challenged by many. some
of the objections might be the following:
 1. t he price band is too narrow .
 2. t he price band is too wide.
 3. t he six-week period is too long.
 4. t he six-week period is too short.
 5. No allowance is made for isolated days beyond the confines of the range—an event that most
chart analysts would agree does not disturb the basic pattern.
 6. t he direction of the trend prior to the trading range is not considered—a factor many chartists
would view as a critical input in interpreting the reliability of a breakout.
 7. t he breakout should be required to exceed the boundary of the trading range by a minimum
amount (e.g., 1 percent of the price level) in order to be viewed as valid.
 8. s everal closes above the trading range should be required to indicate a breakout.
 9. a time lag should be used to test the validity of the breakout; for example, are prices still
beyond the trading range one week after the initial penetration of the range?
the preceding list represents only a partial itemization of the possible objections to our hypotheti-
cal definitions of a trading range and breakout, and all of this for one of the most basic chart patterns.
imagine the ambiguities and complications in specifically defining a pattern such as a confirmed head
and shoulders.
For their part, the chartists cannot win the argument, either. although chart analysis is based on gen-
eral principles, its application depends on individual interpretation. the successful chart-oriented trader
might not have any doubts about the viability of chart analysis, but the “random walk” theoreticians
would dismiss his success as a consequence of the laws of pr