A Complete Guide to the Futures Market

JACK D. SCHWAGER is a co-founder of FundSeeder, a web-based technology and investment business designed to connect undiscovered trading talent with sources of investment capital. He is the author of numerous acclaimed financial books, including the Market Wizards series and Market Sense and Nonsense. MARK ETZKORN is founder of FinCom Media. He was formerly Editor-in-Chief of Active Trader magazine, 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.

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

Volume 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

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

Top 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

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 Top and Bottom Formations 225

Breaking of Curvature 229

The Future Reliability of Failed Signals 229

Conclusion 231

Part IV Trading 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

Ten Common Problems with Standard Trend-Following Systems 244

Possible Modifications for Basic Trend-Following Systems 247

Countertrend Systems 254

Diversification 256

Ten Common Problems with Trend-Following Systems Revisited 259

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 Well-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

Testing versus Fitting 310

The Truth about Simulated Results 312

Multimarket System Testing 313

Negative Results 314

Ten Steps in Constructing and Testing 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

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 Work 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-Year 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 Technical Analysis: A Greater Need for Caution 417

Three Major Pitfalls in Fundamental Analysis 418

Combining Fundamental Analysis with Technical Analysis and Money Management 426

Why Bother with Fundamentals? 427

Are Fundamentals Instantaneously Discounted? 428

Fitting the News to Price Moves 431

Fundamental Developments: Long-Term Implications versus Short-Term 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 Guidelines

Chapter 36 The Planned Trading Approach 559

Step 1: Define a Trading Philosophy 559

Step 2: Choose Markets to Be Traded 560

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-Test 614

Appendix C Checking the Significance of the Regression Equation 619

The Population Regression Line 619

Basic Assumptions of Regression Analysis 620

Testing 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

Appendix D The Multiple Regression Model 637

Basics of Multiple Regression 637

Applying the t-Test 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-Test 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 Topics 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