Introduction: Long Range Price Charts

INTRODUCTION

Of all the charts utilized by the market technician for forecasting and trading the financial markets, the daily bar chart is by far the most popular. The daily bar chart usually covers a period of only six to nine months. However, because most traders confine their inter­est to relatively short term market action, daily bar charts have gained wide acceptance as the primary working tool of the chartist.

The average trader's dependence on these daily charts, however, and the preoccupation with short term market behavior, cause many to overlook a very useful and rewarding area of price charting—the use of weekly and monthly charts for longer range trend analysis and forecasting.

The daily bar chart covers a relatively short period of time in the life of any market. A thorough trend analysis of a market, however, should include some consideration of how the daily market price is moving in relation to its long range trend struc­ture. To accomplish that task, longer range charts must be employed. Whereas on the daily bar chart each bar represents one day's price action, on the weekly and monthly charts each price bar repre­sents one week's and one month's price action, respectively. The purpose of weekly and monthly charts is to compress price action in such a way that the time horizon can be greatly expanded and much longer time periods can be studied.

THE IMPORTANCE OF LONGER RANGE PERSPECTIVE

Long range price charts provide a perspective on the market trend that is impossible to achieve with the use of daily charts alone. During our introduction to the technical philosophy in Chapter 1, it was pointed out that one of the greatest advantages of chart analysis is the application of its principles to virtually any time dimension, including long range forecasting. We also addressed the fallacy, espoused by some, that technical analysis should be limited to short term "timing" with longer range forecasting left to the fun­damental analyst.

The accompanying charts will demonstrate that the prin­ciples of technical analysis—including trend analysis, support and resistance levels, trendlines, percentage retracements, and price patterns—lend themselves quite well to the analysis of long range price movements. Anyone who is not consulting these longer range charts is missing an enormous amount of valuable price information.

CONSTRUCTION OF CONTINUATION CHARTS FOR FUTURES

The average futures contract has a trading life of about a year and a half before expiration. This limited life feature poses some obvi­ous problems for the technician interested in constructing a long range chart going back several years. Stock market technicians don't have this problem. Charts are readily available for individ­ual common stocks and the market averages from the inception of trading. How then does the futures technician construct longer range charts for contracts that are constantly expiring?

The answer is the continuation chart. Notice the emphasis on the word "continuation." The technique most commonly employed is simply to link a number of contracts together to provide continuity. When one contract expires, another one is used. In order to accomplish this, the simplest method, and the one used by most chart services, is to always use the price of the nearest expiring contract. When that nearest expiring contract stops trading, the next in line becomes the nearest contract and is the one plotted.

Other Ways to Construct Continuation Charts

The technique of linking prices of the nearest expiring contracts is relatively simple and does solve the problem of providing price continuity. However, there are some problems with that method. Sometimes the expiring contract may be trading at a significant premium or discount to the next contract, and the changeover to the new contract may cause a sudden price drop or jump on the chart. Another potential distortion is the extreme volatility expe­rienced by some spot contracts just before expiration.

Futures technicians have devised many ways to deal with these occasional distortions. Some will stop plotting the nearest contract a month or two before it expires to avoid the volatility in the spot month. Others will avoid using the nearest contract alto­gether and will instead chart the second or third contract. Another method is to chart the contract with the highest open interest on the theory that that delivery month is the truest rep­resentation of market value.

Continuation charts can also be constructed by linking specific calendar months. For example, a November soybean continuation chart would combine only the historic data pro­vided by each successive year's November soybean contract. (This technique of linking specific delivery months was favored by W.D. Gann.) Some chartists go even further by averaging the prices of several contracts, or constructing indices that attempt to smooth the changeover by making adjustments in the price premium or discount.

THE PERPETUAL CONTRACT™

An innovative solution to the problem of price continuity was developed by Robert Pelletier, president of Commodity Systems, Inc., a commodity and stock data service (CSI. 200 W. Palmetto Park Road, Boca Raton, FL 33422), called the Perpetual Contract.™ ("Perpetual Contract™ " is a registered trademark of that firm.)

The purpose of the Perpetual Contract™ is to provide years of futures price history in one continuous time series. That is accomplished by constructing a time series based on a constant forward time period. For example, the series would determine a value three months or six months into the future. The time peri­od varies and can be chosen by the user. The Perpetual Contract™ is constructed by taking a weighted average of two futures con­tracts that surround the time period desired.

The value for the Perpetual Contract™ is not an actual price, but a weighted average of two other prices. The main advan­tage of the Perpetual Contract™ is that it eliminates the need for using only the nearest expiring contract and smoothes out the price series by eliminating the distortions that can take place dur­ing the transition between delivery months. For chart analysis pur­poses, the nearest-month continuation charts published by chart services are more than adequate. A continuous price series, how­ever, is more useful for back-testing trading systems and indicators. A more complete explanation of ways to construct continuous futures contracts is provided by Greg Morris in Appendix D.

LONG TERM TRENDS DISPUTE RANDOMNESS

The most striking features of long range charts is that not only are trends very clearly defined, but that long range trends often last for years. Imagine making a forecast based on one of these long range trends, and not having to change that forecast for several years!

The persistence of long range trends raises another inter­esting question that should be mentioned—the question of ran­domness. While technical analysts do not subscribe to the theory that market action is random and unpredictable, it seems safe to observe that whatever randomness does exist in price action is probably a phenomenon of the very short term. The persistence of existing trends over long periods of time, in many cases for years, is a compelling argument against the claims of Random Walk Theorists that prices are serially independent and that past price action has no effect on future price action.

PATTERNS ON CHARTS: WEEKLY AND MONTHLY REVERSALS

Price patterns appear on the long range charts, which are inter­preted in the same way as on the daily charts. Double tops and bot­toms are very prominent on these charts, as are head and shoul­der reversals. Triangles, which are usually continuation patterns, are frequently seen.

Another pattern that occurs quite frequently on these charts is the weekly and monthly reversal. For example, on the monthly chart, a new monthly high followed by a close below the previous month's close often represents a significant turning point, especially if it occurs near a major support or resistance area. Weekly reversals are quite frequent on the weekly charts. These patterns are the equivalent of the key reversal day on the daily charts, except that on the long range charts these reversals carry a great deal more significance.

LONG-TERM TO SHORT-TERM CHARTS

It's especially important to appreciate the order in which price charts should be studied in performing a thorough trend analysis. The proper order to follow in chart analysis is to begin with the long-range and gradually work to the near term. The reason for this should become apparent as one works with different time dimensions. If the analyst begins with only the near-term picture, he or she is forced to constantly revise conclusions as more price data is considered. A thorough analysis of a daily chart may have to be completely redone after looking at the long-range charts. By starting with the big picture, going back as far as 20 years, all data to be con­sidered are already included in the chart and a proper perspective is achieved. Once the analyst knows where the market is from a longer range perspective, he or she gradually "zeros in" on the shorter term.

The first chart to be considered is the 20 year monthly chart. The analyst looks for the more obvious chart patterns, major trend­lines, or the proximity of major support or resistance levels. He or she then consults the most recent five years on the weekly chart, repeat­ing the same process. Having done that, the analyst narrows his or her focus to the last six to nine months of market action on the daily bar chart, thus going from the "macro" to the "micro" approach. If the trader wants to proceed further, intraday charts can then be con­sulted for an even more microscopic study of recent action.

WHY SHOULD LONG RANGE CHARTS BE ADJUSTED FOR INFLATION?

A question often raised concerning long term charts is whether or not historic price levels seen on the charts should be adjusted for inflation. After all, the argument goes, do these long range peaks and troughs have any validity if not adjusted to reflect the changes in the value of the U.S. dollar? This is a point of some controversy among analysts.

I do not believe that any adjustment is necessary on these long range charts for a number of reasons. The main reason is my belief that the markets themselves have already made the necessary adjustments. A currency declining in value causes commodities quoted in that currency to increase in value. The declining value of the dollar, therefore, would contribute to rising commodity prices. A rising dollar would cause the price of most commodities to fall.

The tremendous price gains in commodity markets during the 1970s and declining prices in the 1980s and 1990s are classic examples of inflation at work. To have suggested during the 1970s that commodity price levels that had doubled and tripled in price should then be adjusted to reflect rising inflation would make no sense at all. The rising commodity markets already were a mani­festation of that inflation. Declining commodity markets since the 1980s reflect a long period of disinflation. Should we take the price of gold, which is now worth less than half of its value in 1980, and adjust it to reflect the lower inflation rate? The market has already taken care of that.

The final point in this debate goes to the heart of the tech­nical theory, which states that price action discounts everything, even inflation. All financial markets adjust to periods of inflation and deflation and to changes in currency values. The real answer to whether long range charts should be adjusted for inflation lies in the charts themselves. Many markets fail at historic resistance levels set several years earlier and then bounce off support levels not seen in several years. It's also clear that falling inflation since the early 1980s has helped support bull markets in bonds and stocks. It would seem that those markets have already made their own inflation adjustment. (See Figure 8.1.)

Figure 8.1 The gold price peak in 1980 ushered in two decades of low inflation. Low inflation normally causes falling gold prices and rising stock prices as this chart shows. Why adjust the charts again for inflation? It’s already been done.