EBF 301
Global Finance for the Earth, Energy, and Materials Industries

Price Signals

PrintPrint

As with trend analysis and market indicators, there are several types of price signals. We will deal with a few of the ones that are more common and easy to use.

1) Support & Resistance: As prices move up-and-down, Traders make decisions as to when to continue to buy in an uptrend and when to sell in a downtrend; that is, they try to determine when the current trend will exhaust itself and change direction. One way to do this is to look at the “Support” and “Resistance” price levels. Support represents a price level at which Buyers will step back into the market after a period of selling. This interest establishes a “floor” price. Traders find value at this level and start to buy-up the contracts again. In some cases, Traders who have been selling contracts during the downtrend may be buying them back to take some profits. Resistance is the price level at which the market is no longer interested in buying contracts. The price is deemed to be too high and Sellers re-enter the market, thus establishing a "ceiling" price.

So, how do we establish these pricing points? As the chart below shows, when we draw upper and lower trendlines, the lines continue through price points on the right, vertical axis. Where the upper trendline crosses the right axis is the Resistance point while the price where the lower trendline crosses the right axis is the Support point. Theoretically, then, these represent both the maximum the market is willing to pay as well as the minimum at which is it willing to sell.

Support and Resistance - Price Signals. Described in text above

This chart indicates that Resistance is about $97.20 and, Support is about $95.00. Traders will now look to see if prices can trade above, or below, these levels. If they do, there will be a flurry of activity in the direction of the move.

2) “Tops & Bottoms.” Since we are on the subject of Support and Resistance, we can discuss price signals related to those concepts. As we have said, Traders are interested solely in price movement. And Support and Resistance levels represent buying and selling interest. So what happens when the Buyers or Sellers step-in to halt the moves higher or lower? They are testing the points of Support and Resistance. If the Sellers can’t break-through Support, it is a result of Buyers stepping-in. As mentioned above, that sets a “floor” or “bottom” price on that day. Likewise, if Buyers test the Resistance price and Sellers step in to prevent a breach of that level, a “ceiling” or “top” is established.

While a one-day occurrence of these events is not a very strong indicator of a change in direction, the more a “bottom” or “top” is tested and holds, the more significant that price level becomes. Think about it this way. Let’s say crude oil Traders are trying to sell September contracts and push the price down to the $95.00 Support level on the chart above. Buyers step in at that price and the sell-off fails. The next day, Sellers again attempt to push prices down to $95.00, and again, the move fails. The market now begins to see $95.00 as a stronger Support price. We refer to this as a “double-bottom.” While this is still a good indicator of price levels, a third day, or “triple-bottom” is a very strong indicator that prices will rally higher. Traders have no choice but to recognize the buying interest at $95.00 and thus will buy contracts until the Resistance, or “top” is tested. The same holds true for Resistance levels, but in reverse. The more “tops” are established, the stronger the level at which Sellers will step-in and sell contracts.

The September, 2012, natural gas chart below clearly illustrates this point. On August 15th, prices reached a High of $2.84. The next day, this level was tested by Buyers and "held," resulting in a “double-top” at $2.84. After that, the market reversed direction and tested new Lows. But, $2.68 held for 3-consecutive days, forming a "triple-bottom." This caused prices to rally the next day.

Tops and Bottoms - Price Signals. Described in text above

3) “Head-and-shoulders” reversal patterns: These are identifiable, 3-day price patterns that signal a change in direction and can be used for long-term or short-term trend analysis. This consists of three consecutive trading days where the middle day’s High, or Low, is higher or lower than that of the other two days. The first day then represents the “left shoulder,” the second day is the “head,” and the third day is the “right shoulder.” Using the chart below without all the trendlines, we can see that on July 31st, the High for the day was higher than the 30th. We are now looking for the completion of the pattern the next day. And on August 1st, the High for the day was lower than the prior day. Now you can see the pattern whereby the 30th is the “left shoulder,” the 31st is the “head,” and the 1st is the “right shoulder.” The right shoulder “leans” in the direction of the price change. In this case, prices reversed from an uptrend to a downtrend. There are also “reverse” head-and-shoulders patterns. These occur in an upside-down fashion and signal a move from a downtrend to an uptrend. Looking at August 6th, we see that the day’s Low was lower than that on the 3rd. Then on the 7th, the pattern was completed as that day’s Low was higher than the 6th. Since the “right shoulder” is leaning upward, the trend is now upwards.

Head and Shoulders - Price Signals. Described in text above

4) “Consolidation” patterns: when upper and lower trendlines are drawn and are parallel to one another and perpendicular to the Y axis, they form a rectangular shape. The upper trendline does represent Resistance, with the lower trendline indicating Support. In this pattern, prices will move up-and-down within the rectangle. This “consolidation” is indicative of market indecision. Traders are not really sure what direction prices should take. It is a battle between Buyers and Sellers. The key here is the number of days this pattern continues to exist. The longer Traders battle, the more momentum builds-up for when prices break-out of this range. Think of it as a spring that winds tighter and tighter for each day prices stay within the consolidation range. That means a very large price movement will occur in the direction of the breakout. A good illustration of this is the September, 2012 natural gas contract, shown below. Starting on June 25th, the contract bounded by a Low of $2.70 for sixteen straight days. The High was $2.91 with the exception of three attempted "break-outs" that failed as prices returned to the Channel. But on July 18th, prices broke-out to the upside with good momentum and hit a 6-month High.

Consolidation - Price Signals. Described in text above

These are but a few of the methods in Technical Analysis used to try to determine when a greater probability exists of prices moving in one direction vs. another. Once determined, Traders enter or exit the market at those price levels.