Lecture Notes Compilation

Futures Markets
By M. Metghalchi
Introduction
Agricultural futures contracts were introduced on the Chicago Board of Trade (CBOT) during
the 1860s. After the Collapse of the Bretton Woods Agreement in 1971, Chicago Mercantile
Exchange (CME), Another Chicago Futures Exchange, began trading currency futures contracts
in 1972. The CME introduced in 70’s the interest rate future and then in early 1980s the stock
index future. The following are major world's futures and options exchanges:
1. The International Monetary Market (IMM), a subsidiary of CME

2. The Philadelphia Board of Trade (PBOT)
3. The Bolsa Mercadorias & de Futuros in Brazil
4. The London International Financial Futures Exchanges (LIFFE)
5. The Marche a Term des Instruments Financiers (MATIF)
6. The Singapore International Monetary Exchange (SIMEX)
7. The Tokyo International Financial Futures Exchange (TIFFE)
In summer of 2007 the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange
(CME) merged to form CME Group Inc. (the world’s largest futures exchange).
Futures
Futures are all about future prices. People who trade futures essentially trade agreements
(obligations) about how much they will buy or sell something (Underlying Product) for a
specific price at a specific date in the future – most contracts have an expiration date in March,
June, September and December, although oil contracts have monthly expiration dates. These
agreements are contracts that also specify the quantity and other details of the commodity being
traded.
Underlying Product: initially were created for agricultural products, however, today almost
everything has a future contract.
Therefore futures contracts are worldwide meeting places of buyers and sellers of an ever-
expanding list of products that includes financial instruments such as U.S.Treasury notes, bonds,
stock indexes (S&P500, Dow, Nasdaq), and foreign currencies (Euro, Yen,) as well as traditional
agricultural commodities (Corn, Wheat, soybeans), metals(Gold, Silver, Copper), and petroleum
products (Crude, Rbob, Gasoline, Heating oil, Natural gas).There is also active trading in options
on futures contracts allowing option buyers to participate in futures markets with known risk.
Futures contracts can be traded either in a pit (open outcry) or electronically. Generally, only
one type of contract is traded in each pit. For example, there's a T-bond pit, a Nasdaq 100 pit, an
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S&P 500 pit, and many others. Whether trades are executed in the pits or matched
electronically, the trading process in both cases consists of an "auction" in which all bids and
offers on each of the contracts are made known to the public and traders can see that the market's
best price prevails. Futures prices, whether arrived at either through open outcry or by electronic
matching of bids and offers, are immediately and continuously relayed around the world.
Electronic order placement is increasingly being used in many markets. Most futures traders now
can trade electronically from their home 24 hours a day.
We have two types of futures contracts:
1. Contracts that require physical delivery of a particular commodity. The commodity is
specifically defined, as is the month when delivery is to occur.
2. Contracts that call for an eventual cash settlement. This means that contracts are settled in
cash rather than by delivery at the time the contract expires. For example Stock index futures
contracts are settled in cash on the basis of the index number at the close of the final day of
trading. Delivery of the actual shares of stock that comprise the index is not required.
Most futures contract will be closed before expiration, in other words, futures markets are rarely
used to actually buy or sell the physical commodity or financial instrument being traded; they're
used for risk management, and for some people, investment and profit.
Raison d’etre of futures markets (Primary purpose):

The primary purpose of the futures markets is to provide an efficient and effective mechanism
for RISK MANAGEMENT. By going long or short a futures contract that establish a known
price now for a purchase or sale that will take place at a later time, individuals and businesses are
able to achieve protection against adverse price changes. This is called hedging. Simultaneously,
other futures market participants are speculators
Therefore, we have two major types of players: "hedgers" (those seeking to minimize and
manage price risk) and "speculators" (those willing to take on risk in the hope of making a
profit). If you trade for your own financial benefit, you are a speculator. If you have risk
associated with the underlying commodity and trade futures to manage this risk, then you are a
hedger. This interaction between hedgers and speculators, each pursuing their own goals, helps
to provide active, liquid, and competitive markets.
A speculator job is to buy low and sell high, or sell high and buy low in order to make profits.
Speculators include:
Small investors. A person like you, who would like to make a killing in the futures
markets. They trade part time in various market by buying and selling various futures
contracts.
Professional traders. Many individuals devote 100 % of their time in speculation of

various markets. The use heavily futures markets.
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Hedge fund managers. Many hedge funds speculate on some specific market and use
heavily futures contracts.
Some speculators use the services of a professional trading advisor by establishing a fully
managed trading account or by participating in a commodity pool that is similar in
concept to a mutual fund.
Speculation in futures contracts is very risky and not appropriate for everyone. Although
it is possible to realize a very high return in a short period of time, it is also possible to
loose losses almost all of your capital in a short period of time. The reason for possibility
of high profits or losses in relation to the initial commitment of capital is the fact that
futures trading are highly leveraged form of speculation. Only a relatively small amount
of money is required to participate in the price movements of assets having a much
greater value. Anybody can open a future account by initial capital of $5,000 and start
trading.
On the other hand, hedgers trade futures to manage cash market risk. Therefore for hedger,
making a futures trading decision also involves cash market decision. For example if Continental
Airline buys jet fuel futures as a hedge, the Company has concluded that cash jet fuel prices will
be higher when the Company has to buy jet fuel later on. Or if a wheat producer sells wheat
future as a hedge, this producer has decided that cash wheat prices will be lower down the road.
Or hedgers may use futures to lock in an acceptable margin between their purchase cost and their
selling price.
Example of Hedge:
Houston jewelry manufactures Gold Bracelet and need to buy additional gold from his supplier
in nine months. During this coming 9 months, he fears the price of gold may increase and given
his published price, he could be hurt. Today’s cash price is $530 per ounce. He goes to future
market and buys Gold future, delivery 9-month, he buys one future contract at a price of, say,
$550 an ounce.
If, nine months later, the cash market price of gold has risen to $600, he will have to pay his
supplier that amount to acquire gold. However, the extra $70 an ounce cost will be offset by a
$50 an ounce profit when the futures contract bought at $550 is sold for $600. So the Jeweler
some hedged himself. Had the price of gold declined instead of risen, he would have incurred a
loss on his futures position but this would have been offset by the lower cost of acquiring gold in
the cash market.
Other example of hedging: A cattle feeder can hedge against a decline in livestock prices buy
buying future cattle feeder. Borrowers can hedge against higher interest rates, and lenders
against lower interest rates buy selling and buying bonds. Investors can hedge against an overall
decline in stock prices buy selling stock index future. And the list goes on.
Whatever the hedging strategy, the common denominator is that hedgers willingly give up the
opportunity to benefit from favorable price changes in order to achieve protection against
unfavorable price
What Futures Are Not:
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Futures are not Stocks. Futures are agreements (not ownership) that will end at the expiration
date whereas stocks are assets that one can keep forever.
Futures are contracts, not shares. The supply of futures contracts is unlimited. Every time a buyer
and a seller make a trade, a contract has been created.
The word margin in stock trading means that you are borrowing money and paying interest,
however in futures accounts, the margin is the amount of money that you need to have in your
account to trade a future contract, it is really a GOOD-FAITH deposit.
Futures are different than options in that, options give the owner the RIGHT, not the
OBLIGATION, like futures contract.
OPENING AN ACCOUNT:
A lot of paperwork is involved to open a future account. You will open an account with a
brokerage firm, also known as a future commission merchant, FCM, (Or Introducing
Broker). In these paper works you will disclose:
Your financial position
Your level of knowledge and experience in future trading

Your broker will:
Disclose risk associated with futures trading.
Describe the right and responsibility of the client and the broker
Type of account:
You may open an individual account, joint account, corporate account, trust account, limited
partnership account, and requirement account.
Since September 11, 2001, the accounts are screened much more closely.
Once an account has been approved, the customer must fund the account from a bank account
with the same title as the futures trading account. FMCs usually don’t accept third party checks,
or funds originating from a source different than the account owner.
Although futures accounts with FCMs are not insured, FMCs must segregate customer
funds from the rest of the firm’s money. FMCs are limited in how they may invest those
extra funds (above margin requirement) to earn interest.
Unlike securities industry, FMCs cannot require customers to binding arbitration.
Customers may go to Commodity Futures Trading Commission, CFTC or National
Futures Association or bring a lawsuit.
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The Future Contracts Versus Forward Contracts
Forward Contracts and forward rates:
It is possible for economic agents to agree today to exchange currencies at some specified
time in the future, (1 month, 3 months, 6 months, 9 months, 1 year the most common). The rate
of exchange at which such a purchase or sale can be made is known as forward exchange rate.
Nonstandardized maturities (such as 40day, 70 days) are available, but transaction costs
make them more expensive.
No cash change hand when a forward contract is arranged or at any time until the settlement
date. Corporate customers gain access to the forward market on the basis of credit standing;
typically, there are no margin or collateral requirements.
Futures contract and forward contract are very similar but there are differences. As with a
forward contract, a foreign currency futures contract is a commitment to exchange a specified
amount of one currency for a specified amount of another currency at a specified time in the
future. However, the followings are important differences between the two transactions:
Dispersed versus Central Trading-- Whereas forward contracts are traded in an interbank
market (commercial banks, investment banks, dealers) which is geographically dispersed and
open 24 hours a day, futures contracts are mostly traded on centralized exchanges in a pit. Pit
traders use a system called open outcry to communicate (hand signals) and execute trades with
one another. The exchanges have their own hours, for example, currency futures on the IMM
trades between 7:20 AM to 2.00 PM Chicago time.
Customized versus Standardized Transactions-- whereas forward contracts are customized to

fit the particular needs of each client, futures contracts are highly standardized. The exchange
designs the contract and the regulatory authority approves it and the trade begins. Each futures
contract specifies a contract size of the underlying assets. Contract expiration dates are also
standardized, generally currency futures and bond futures expiration months are March, June,
September, and December. Also the exchange standardize the daily price limit, minimum tick,
delivery terms and trading days and hours. Since all futures contracts are identical (in the sense
that March 2003 yen is the same for all traders, in contrast to forward contract), therefore, futures
are more liquid than forwards.
Variable Counterparty Risk versus the Clearinghouse:
In the forward market each counterparty assumes the credit risk of other counterparty. In
contrast, all futures contract traded on an organized exchange has the clearinghouse as one of
the two counterparties. The clearinghouse may be a separate chartered corporation or a
division of the futures exchange. So the clearinghouse is the legal entity on one side of every
future contract (short or long) and stand ready to meet the obligations of the futures contract vis a
vis every customer of the exchange. Clearinghouses are backed by substantial reserves and, in
the US a clearinghouse of a major Exchange has never defaulted on an obligation.
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Cash settlement and delivery versus the Marking to Market convention
In the forward contract transactions no cash flows take place until the final maturity of the
contract. In contrast the futures contracts are marked to market daily at the closing price. An
Initial margin should be deposited into your account to establish a futures position
(approximately 4% of contract size). Your position is marked to market every day, if the market
is moving in your favor the value of your account goes up, on the other hand, if the market is
going against you, when your position is market to market every day, the value of your account
keeps going down, if the value of your account falls below 75% of the initial margin,
maintenance margin, most broker will issue you a margin call and demand that you restore
your margin account to the level of the initial margin.
You can get forward rates from: http://www.fxstreet.com/rates-charts/forward-rates
Participants in the Futures Markets
Speculators and hedgers:

Speculators are: Trader who accepts risk by going long or short to bet on the future direction of
prices. (Long = you are bullish, therefore you buy the future contract. Short = you are bearish,
you have shorted the future contract).
Hedgers: Trader who seeks to transfer risk by taking a futures position opposite to an existing
position in the underlying commodity or financial instrument.
Most trades are reversed before the maturity of contract

Futures market is a zero-sum game, (stock market in not a zero-sum game)
Round trip commission between $15 at the discount broker and up to $100 at a full brokerage
houses.
Futures Margin: Required funds in your futures trading account in order to cover potential
losses from your open futures position.
Initial Margin: each future contract has an initial margin requirement set by the exchanges.
Initial margin varies with the type and size of a contract, for volatile contracts like S&P500 the
initial margin is high, for gold it is much lower. The initial margin is the same for long and short
futures positions. Usually initial margin for future contracts are between 5-10 percent of the
value of the contract (Highly leveraged).
Initial margin is therefore the the amount of funds that must be deposited by a customer when the
positions are initially taken in the future contract (Open position). On any day that profits or
losses accrue to your open positions, the profits will be added to the balance, and the losses will
be subtracted to the balance in your margin account. This process whereby gains and losses on
your open futures positions are recognized on a daily basis is called Marking-to-Market.
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Marking-to-Market: the process whereby gains and losses on your open futures positions are
recognized on a daily basis.
Maintenance Margin: The minimum margin level your broker requires in a futures trading
account at all times. It is different from broker to broker. For example a broker may requires
$20,000 initial margin for trading S&P500. Assume this broker’s maintenance margin is
$12,000. It means you can deposit $20,000 to trade S&P500. Assume you trade S&P500 and the
market goes against you and you loose, but if your loss is less that $8,000 then your account
value will not go under $12,000 maintenance margin and you will not get a margin call. But if
you loose more that $8,000, then the value of your account will go below $12,000 the
maintenance margin and you will get a margin call from your broker to deposit funds in your
account. If you don’t deposit additional funds in your account the broker will close your position.
Are the Margin Requirements for Futures Similar to Those for Stocks?
No, margin means something different in futures than it does in stocks. In stocks it means that
you're borrowing money for the purchase of stocks and paying interest. In futures it simply refers
to the amount of money that you need to have in your account in order to trade.
Margin Call: Notification to deposit funds in your account to increase the margin level in your
trading account.
Reverse Trade: A trade that closes out a previously established futures position by taking the
opposite position.
Cash Price or Spot price: Price of a commodity or financial instrument for current delivery.
Cash-Futures Arbitrage: Strategy for earning risk-free profits from a mismatch (large difference
that is not justified ) between cash and futures prices. Example, if cash gold price is $400 (per
once) in April and August gold future price is $500, many will buy cash gold and sell August
future contract. The cost of storage is much lower than the $100 difference.
Carrying-Charge Market: In most situation the futures price is greater than the cash price; we
say this is the carrying-charge market
Inverted Market: is the opposite of carrying-charge market, in an inverted market the futures
price is less than the cash price. Does not happen too often.
Open Interest: is a measure of how many futures contract for a commodity exist at a point in
time. Every time two opening transactions are matched, the open interest increases by one, every
time two closing trades are matched, then the open interest decreases by one. If a trade involves
an opening transaction and a closing transaction, the open interest stays the same.
Triple witching: Four times a year (On the third Friday of the following months: March, June,
September, December) when S&P 500 futures contracts, options on the S&P index, and various
stock options (individual stocks) all expire at the same time.
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Counterparty: you can have confidence that the other side of your trade will be made good. In
fact, the clearing member firms, and ultimately the futures exchanges themselves, guarantee that
each trade will be honored. So as a trader, you need never give thought to the guy on the other
side of your trade.
Are your funds protected?
Funds in your futures account are required to be segregated (held separately) from any of the
brokerage firm's own funds. That should provide some level of safety; however, your account is
not insured.
Spot-Futures Parity
It is a relationship between cash or spot prices and futures prices that theoretically holds.
The futures price (assuming no dividend payments) is simply the future value of the spot price,
compounded at the risk-free rate.
F = S(1 + r)T
Fair future premium value = S(1 + r)T - S
Example:
Assume spot gold price is $640 and risk free rate is 5 percent. What should be a future contract
on gold that expires in three months?
F = S(1 + r)T = 640 * ( 1 + .05)3/12 = 640 * 1.012272 = $647.85
If we consider that the underlying asset pays dividend, then the Spot-Future Parity becomes:
F = S(1 + r - d)T
Where d is the dividend yield of the underlying asset.
Example:
Assume spot (cash) S&P500 price is 1320 and risk free rate is 5 percent. What should be a future
contract price for S&P500 that expires in three months? Assume the dividend yield for S&P
500 is 1.8 percent per year.
F = S(1 + r - d)T
F = 1320 * (1+ .05 - .018)3/12 = 1320* 1.007906 = 1330.44
Therefore 3-month future S&P500 should be 1330.44. If future price is quiet different than
1330.44, then program trading will bring the future and cash price in line with the Spot-Future
Parity.
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Index Arbitrage: If the future price of a stock index (S&P500, CAC40, Nasdaq 100, …) is quiet
different than its spot price, one can make riskless profits by exploiting this unusual difference. It
is done mostly by computer (program trading).
Program Trading: If there is a temporary discrepancy between future and spot prices, some
institutions have developed a coordinated trading program that could buys and sell an entire
portfolio of stocks.
Triple witching: Four times a year (On the third Friday of the following months: March, June,
September, December) when S&P 500 futures contracts, options on the S&P index, and various
stock options (individual stocks) all expire at the same time.
Trading in the futures market:
We have two types of futures contract:

i. those that provide for physical delivery of a particular commodity (Example, Crude oil,
Corn, Currencies, Ext.).
ii. those that call for an eventual cash settlement.
The commodity is defined in contract specification, as is the month when delivery or settlement
is to occur. A June futures contract, for example, provides for delivery or settlement in June.
More detail can be find in the contract specification.
Please note that even in the case of delivery-type futures contracts, very few actually result in
delivery. Not many speculators want to take or make delivery of 5,000 bushels of wheat or
1,000 barrel of oil. Rather, the majority of both speculators and hedgers choose to realize their
gains or losses by buying or selling an offsetting futures contract prior to the delivery date.
Cash settlement futures contracts are settled in cash rather than by delivery at the time the
contract expires. For example, all stock index futures contracts are settled in cash on the basis of
the index number at the close of the final day of trading. There is no delivery of actual stock
shares comprising the index.
When you buy or sell (Short) a future contract you are making a bit on the direction of the
security that the future contract represent. You don’t pay any money nor do you pay a down
payment, rather than providing a down payment, you need to have a deposit with your broker as
your margin requirement, therefore, for the futures contract a deposit of good faith money is
needed to buy or sell the future contract. This deposit with your broker is adjusted everyday to
reflect the gain or loss of your future contract on the daily basis.
One of the most important features of futures market is that they are highly leveraged. If the
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price moves in the direction that you have bit on the future contract your profits will be very
large, on the other hand if the price moves against you, then your loss will be very large.
How do you determine your profits and losses? As we said, you bit on a future at a specific
point of time, say, 1/8/2010 at 3.00 PM central time. Let’s take S&P 500 index, at that specific
point of time S&P 500 is 1141.60. So, let’s say you think the market will go up, so therefore
you buy (bit) the future S&P 500 at 1141.60. Your bit is done, you don’t pay any down payment
but in your account you have to have at least an amount to initial margin requirement for S&P
500. If the S&P 500 goes up then you make money on your bit, on the other hand if the S&P
500 goes down you lose money on your bit. How do we determine our profits? It is easy, we
need to look at CONTRACT SPECIFICATION (CS) for that future. Once we know the price
and contract specification, then we can easily determine our profits and losses.
Major categories of future contracts:
Agricultural
Metals
Foreign Currency
Interest rate futures
Energy
Equity Indexes
Examples of futures trading.
As we said above, to determine our profits and losses, we need to know about contract
specification. (You can get contract specification of any future from the Exchange site that has
created the future contract). A lot of futures contracts are traded at the Chicago Mercantile
Exchange (http://www.cmegroup.com) and you can go to their site and get contract specification.
Below I took the contract specification for S&P 500 from CME in 2006 as follow:
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SP500 futures: contract specification

Ticker Symbol SP
Contract Size $250 times S&P 500 futures price
Price Limits 5%, 10%, 15% and 20%
For more details see Price Limits
Minimum Price .10 index points = $25 per contract
Fluctuation (Tick)
Contract Months Mar, Jun, Sep, Dec
Regular Trading Hours 8:30 a.m. - 3:15 p.m.
(Central Time)
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GLOBEX Trading Hours 3:45 p.m. - 8:15 a.m.
Last Trading Day The Thursday prior to the third Friday of the contract month
Final Settlement Date The third Friday of the contract month
Position Limits 20,000 net long or short in all contract months combined
Examples of trading SP500 future:

Example 1:
Assume that on October 10, 2002 you bought one S&P500 future (December 02 contract, as you
can see from CS, the S&P 500 has for future contract, March, June, September, and December)
at 800.25. On October 11, 2002 the market opened very strongly, at 9:52 am the S&P 500 was
trading around 828.00, you decide to take your profit and run and call your future broker or if
you trade on a platform, you can go to your computer and close your long position on the
S&P500 (market order). Assume you are filled (sold the SP500) at 827.95.
Estimate your profit?
As you can see, the price quote is based on two decimal. Minimum price fluctuation, or last
decimal (Last decimal is also called a pip) is $25 according to contract specification. If the last
decimal on a two decimal quote is $25, then one point in S&P500 move is therefore worth $250.
Given this, we can estimate our profits and losses as follow:
Profits = (827.95 – 800.25) * $250 = $6,925
Another way is as follow:
Contract size * Net gain on the number you have bit, or:
Profits = 250 * ((827.95 – 800.25) = $6,925
Example 2:
Assume that on October 10 you were bearish and sell (short) the S&P500 (December contract) at
800.25. However, you want to limit your losses and at the same time put a stop-loss order at
810.05. On October 11, 2002, the SP500 opened at 803.10 and kept going up as the price
registered 810.10 you are filled for sure, and your broker will call you and tell you that your
stop-loss order is filled at the 810.05 level, estimate your losses?
Loss = (810.05 – 800.25) * $250 = $2,450
Note: S&P500 has a mini sized contract called mini S&P , for mini-S&P each point of index
change is $50 and not $250. Most individual traders trade the mini-SP. Calculate the above
profit and loss assuming that you used mini-S&P contracts?
Example 1:
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Profits = (827.95 – 800.25) * $50 = $1,385.00
Example 2:
Loss = (810.05 – 800.25) * $50 = $490.00
Contract Specification on Mini Nasdaq, (From:www.cme.com)

futures
Ticker Symbol NQ
AON: NV
Contract Size $20 times E-mini Nasdaq-100 futures price
Price Limits 5%, 10%, 15% and 20%
For more details see Price Limits
Minimum Price .50 index points = $10 per contract
Fluctuation (Tick)
Contract Months Mar, Jun, Sep, Dec
Regular Trading Hours Virtually 24 hours per day (from 5:30 p.m. Sunday to 3:15 p.m. Friday)
(Central Time)
Last Trading Day Trading can occur up to 8:30 a.m. (Chicago Time) on the third Friday of the
contract month
Final Settlement Date The third Friday of the contract month
Position Limits Position limits work in conjunction with existing Nasdaq-100 position limits
Examples of trading Mini-NASDAQ 100 future:
Assume on October 10th, 2002 you buy one contact of mini Nasdaq future (December 02
contract) at a price of 840.35 and as the market opens very strongly on October 11, 2002, you
sell it at 881.40. Estimate your profits:
Profits = (881.40 – 840.35) * 20 = $821
NASDAQ 100 has a large contract where each point is worth $100. So if you had bought
the large NASDAQ100 (Symbol ND) at 840.35 and sold it at 881.40, then your profits
would be:
Profits = (881.40 – 840.35) * 100 = $4,105.00
Note: If you had shorted and then covered your shorts at the above prices, then your profits
become your losses.
You can use both the S&P500 and NASDAQ100 futures to hedge or insure your portfolio.
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Contract Specification on Currency Futures
Again for a lots of futures, please go to: http://www.cmegroup.com/.
Euro FX futures and options on futures contracts traded at CME are designed to reflect changes
in the U.S. dollar value of the Euro. Futures contracts are quoted in U.S dollars per foreign
currency, and call for physical delivery at expiration.
Understanding Foreign currency quotes:
Reading a foreign exchange quote is simple if you remember two things:

1. The first currency listed is the base currency
2. The value of the base currency is always 1. (In case of yen, it is 100)
For most futures contracts, the foreign currency is the base currency. When the bas currency is a
foreign currency, think of the quote as telling you what the foreign currency is worth in US
dollar.
When the foreign currency is the base and the quote goes up, that means USD has weakened in
value and the other currency has strengthened in value. Rising quotes means the foreign currency
in question now buys more USD than before.
Examples: EUR/USD
The first currency is the base (Euro). The March 2010 EUR/USD closed on 1/17/10 at 1.4325
and it closed at 1.4415 on 1/8/2010.
As we said above, a rising quote means the foreign currency (Euro) is strengthening. Here the
Euro has become stronger; on 1/7/10 1.4325 dollars would buy one Euro but on 1/18/10 more
dollars, 1.4425 dollars buys one Euro. Therefore, Euro is stronger or USD is weaker.
Example: YEN/USD
The first currency is the base (Yen). The March 2010 Yen/USD closed on 1/17/10 at 1.0740 and
it closed at 1.0800 on 1/8/2010.
As we said above, a rising quote means the foreign currency (yen) is strengthening. Here the Yen
has become stronger; on 1/7/10 1.0740 dollars would buy 100 yen (Remember only Yen is based
on 100) but on 1/18/10 more dollars, 1.0800 dollars buys 100 yen. Therefore, Yen is stronger or
USD is weaker.
Major futures contracts that have a lot of liquidity (Easy to trade):
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Euro/USD, Pound/USD, Australian $/USD, JY/USD, Canadian $/USD, Swiss Franc/UDS
For all of the above contracts, please go to http://www.cmegroup.com and get the specification
for each.
Futures prices are often so liquid that they're quoted in tiny increments called pips, or
"percentage in point". A pip refers to the last decimal point in the quotation.
Here is the contract specification for Euro (Taken in 2006, now the format is different)
Example of Euro Future:

Assume you buy 1 March 10 Euro on 1/17/10 at 1.4325 and sell your position at 1.4415 on
1/8/2010. Estimate your profits and losses?
Contract Specification on the Euro, (http://www.cmegroup.com)
EUR/USD Futures
Contract Size 125,000 euro

Contract
Month Six months in the March quarterly cycle (Mar, Jun, Sep, Dec)
Listings
Settlement
Physical Delivery
Procedure
Position
10,000 contracts
Accountability
CME Globex Electronic Markets: 6E
Open Outcry (All-or-None only): EC
Ticker
AON Code: UG
Symbol
View product and vendor codes
Minimum $.0001 per euro increments ($12.50/contract). $.00005 per euro increments
Price ($6.25/contract) for EUR/USD futures intra-currency spreads executed on
Increment the trading floor and electronically, and for AON transactions.
OPEN OUTCRY (RTH)
7:20 a.m.-2:00 p.m.
Trading GLOBEX (ETH)
Hours Sundays: 5:00 p.m. – 4:00 p.m. Central Time (CT) next day. Monday – Friday:
5:00 p.m. – 4:00 p.m. CT the next day, except on Friday - closes at 4:00 p.m.
and reopens Sunday at 5:00 p.m. CT.
Last Trade
Date / Time 9:16 a.m. Central Time (CT) on the second business day immediately
View preceding the third Wednesday of the contract month (usually Monday).
calendar
Exchange These contracts are listed with, and subject to, the rules and regulations of
Rule CME.
14
One tick or minimum tick, the fourth decimal = $12.50
Profits = 90 Ticks * $12.50 = $1,125
90 ticks are number of ticks from 1.4325 to 1.4415.
Another way of estimation your profits:
125000 * (1.4415 – 1.4325) = $1,125

Example of Yen future
Assume on December 31th of 2009, you buy one contract March 2010 yen future. The price you
paid was 1.0740 for 100 Yen (Sometimes it is quoted as 10740), or 100 yen will buy 1.0740
dollar. This is the way it is quoted in the futures market, 100Yen/USD. If that quote goes up, it
means the USD is weakening. Assume you closed your position on 1/4/2010 at a price of
1.08040. Estimate your profits and loss.
Here is the contract specification for JY/USD taken from CME.com.

JPY/USD Futures
Contract Size 12,500,000 Japanese yen

Contract
Month Six months in the March quarterly cycle (Mar, Jun, Sep, Dec)
Listings
Settlement
Physical delivery
Procedure
Position
10,000 contracts
Accountability
CME Globex Electronic Markets: 6J
Open Outcry: JY
Ticker
AON Code: LJ
Symbol
View product and vendor codes
$.000001 per Japanese yen increments ($12.50/contract). $.0000005 per
Minimum
Japanese yen increments ($6.25/contract) for JPY/USD futures intra-
Price
currency spreads executed on the trading floor and electronically, and for
Increment
AON transactions.
OPEN OUTCRY (RTH)
7:20 a.m.-2:00 p.m.
Trading GLOBEX (ETH)
Hours Sundays: 5:00 p.m. – 4:00 p.m. Central Time (CT) next day. Monday – Friday:
5:00 p.m. – 4:00 p.m. CT the next day, except on Friday - closes at 4:00 p.m.
and reopens Sunday at 5:00 p.m. CT.
Last Trade
Date / Time 9:16 a.m. Central Time (CT) on the second business day immediately
View preceding the third Wednesday of the contract month (usually Monday).
calendar
The way I estimate profits and loss is as follow:
15
Although as the contract says $.000001 per Japanese yen increments ($12.50/contract), since the quote is
100 Yen/USD, then $.000001 will be in reality $.0001, which means the fourth decimal is equal
to a pip = $12.50 and here is my profit estimation:
(1.08040 – 1.0740) = 64 pips
Profits = 64 * 12.5 = $800
Another way of estimating profits:
12,500,000 /100 * (1.08040 -1.0740) = $800
Note: I have divided the contract size by 100, since the quotation is USD per 100 Yen.
Eurodollar Interest Rate Futures Contract
Trading in interest rate futures (short term interest or long term interest) is wide spread across
major world futures exchanges (Chicago, London, Paris, Tokyo,....). In the following table we
list some of interest rate futures traded in various exchanges:
Selected Interest Rate Futures Contract

Exchange Underlying Assets: Contract Size Minimum tick Value of a
Interest Rate futures on or Price change tick
CME 3 month Euro $ $1,000,000 $.01 $25
CBOT US treasury bond $ 100,000 $1/64 $15.625
LIFFE UK government bond Pond 50,000 p 1/64 p7.8125
The 3 month Eurodollar interest rate future of the CME has become the most widely used futures
contract for hedging short-term US dollar interest risk.
16
The basics: Getting
All CME interest rate futures contracts are traded using a price index, which Started
is derived by subtracting the futures' interest rate from 100.00. For instance, Trading CME
an interest rate of 5.00 percent translates to an index price of 95.00 (100.00 - Interest Rates
5.00 = 95.00). Given this price index construction, if interest rates rise, the
CME Interest
price of the contract falls and vice versa. Therefore, to profit from declining
interest rates, you would buy the futures contract (go long); to profit from a
Rate Products
rise in interest rates, you would sell the contract (go short). In either case, if
CME Interest
your view turns out to be correct, you will be able to liquidate or offset your
original position and realize a gain. If you are wrong, however, your trade Rate Futures
will result in a loss.” Options on
The design of most CME interest rate futures contracts features a baseline Interest Rates
price move, of 0.01. Gains or losses, therefore, are calculated simply by The Trading
determining the number of ticks moved, multiplied by the value of the tick. Process
For all Eurodollar and LIBOR contracts, the minimum tick is typically .005,
(for the nearest contract) or $12.50 (Other contracts). Thus a price move How To Get
of from 95.00 to 95.01 for example, would mean a $25 gain for the long Started
position, and a $25 loss for the short position. The above quote is taken from
cme.com.
Example of Treasury Bill Future:
The following is the contract specification for 13-week Treasury Bill Future taken from CME:
13-Week U.S. Treasury Bill Futures
Underlying One three-month (13-week) U.S. Treasury bill having a face value at maturity
Unit of $1,000,000.
100 minus the Treasury bill discount rate for the delivery month (e.g., a 5.25
Price Quote
percent rate equals 94.75).
Tick Size
(minimum One-half of one basis point (0.005), or $12.50 per contract.
fluctuation)
Contract Three serial expirations plus four quarterly expirations in the March, June,
Months September, and December quarterly cycle.
The business day of the 91-day U.S. Treasury bill auction in the week of the
Last Trading
third Wednesday of the delivery month. Trading in expiring contracts closes at
Day
12:00 p.m. on the last trading day.
Expiring contracts are cash settled against the highest discount rate accepted
Final
in the U.S. Treasury Department's 91-day U.S. Treasury bill auction in the
Settlement
week of the third Wednesday of the contract month.
Position
Current Position Limits
Limits
Block
Block Trade Minimums
Minimum
All or None
All or None Minimums
Minimum
17
Rulebook
CBOT Chapter 451
Chapter
Trading
OPEN OUTCRY
Hours
MON - FRI: 7:20 a.m. - 2:00 p.m.
(All times
CME GLOBEX
listed are
SUN - FRI: 5:00 p.m. - 4:00 p.m.
Central Time)
OPEN OUTCRY
Ticker TB
Symbol CME GLOBEX
GTB
Rule CME.
Below please find the 3-months Treasury bill future contract (December) prices:
Open High Low Close

10/10/02 98.600 98.600 98.580 98.580
10/11/02 98.570 98.570 98.530 98.580
Suppose you shorted the T-Bill December future at the open on 10/10/02 and covered your short
on the open on 10/11/02. Estimate your profits?
As we saw above, minimum tick=.005 = $12.5 or .01 point (1 basis) = $25
Profits = 98.600 – 98.570 = .03 or 3 basis * $25 = $75 per contract (Commission is not
included).
Interest future contracts are cash settlement, that is the delivery of underlying assets is not made
or received, instead, final settlement is made through realizing profits or loss.
The price quotation establishes an inverse relationship between the futures price and the
underlying interest rate.
Treasury Bond Future Contract: Trades on CBOT
Contract Specification:
30-Year U.S. Treasury Bond Futures
Underlying
One U.S. Treasury bond having a face value at maturity of $100,000.
Unit
Deliverable U.S. Treasury bonds that, if callable, are not callable for at least 15 years
Grades from the first day of the delivery month or, if not callable, have a remaining
term to maturity of at least 15 years from the first day of the delivery month.
The invoice price equals the futures settlement price times a conversion
factor, plus accrued interest. The conversion factor is the price of the
delivered bond ($1 par value) to yield 6 percent.
Price Quote Points ($1,000) and 1/32 of a point. For example, 134-16 represents 134
16/32. Par is on the basis of 100 points.
18
Tick Size One thirty-second (1/32) of one point ($31.25), except for intermonth
(minimum spreads, where the minimum price fluctuation shall be one-quarter of one
fluctuation) thirty-second of one point ($7.8125 per contract).
Contract The first three consecutive contracts in the March, June, September, and
Months December quarterly cycle.
Last Trading Seventh business day preceding the last business day of the delivery
Day month. Trading in expiring contracts closes at 12:01 p.m. on the last trading
day.
Last Delivery
Last business day of the delivery month.
Day
Delivery
Federal Reserve book-entry wire-transfer system.
Method
Settlement U.S. Treasury Futures Settlement Procedures
Position
Limits
Block
Minimum
All or None
Minimum
Rulebook
CBOT Chapter 18
Chapter
Trading
OPEN OUTCRY
Hours
MON - FRI: 7:20 a.m. - 2:00 p.m.
(All times
CME GLOBEX
listed are
SUN - FRI: 5:30 p.m. - 4:00 p.m.
Central Time)
OPEN OUTCRY
Ticker US
Symbol CME GLOBEX
ZB
Rule CBOT.
Size: $100,000 face value U.S. Treasury bonds

Price Quotation: In points ($1,000) and thirty-seconds of a point; for example 98.18
equals to: 98-18/32. Or 112.14 equals to: 112-14/32.
Minimum Price fluctuation = tick= One thirty-second of a point, or $31.25

Expiration: March, June, September and December.
Ticker Symbol = US= pit symbol, ZB = Globex symbol
Last Trading day: Seven business days prior to the last business day of the month.
Delivery: Cash settlement
Example of 30-year Treasury Bond Future:
On October 10 2002 the interest rate is so low and you think that it should not go lower, so you
short one December Treasury bond future contract at 113.18. On October 11, 2002 the stock
19
market opens strong and some people switch from bond to stock, bond prices fall (interest rate
goes up) and you cover (buy back) your short position at 112.10. Estimate your profits:
Profits = (113.18-112.10) =1 points + 8 basis = $1,000 + 8(31.25) = $1,250.00 (Commission

not included)
. 10 Year U.S. Treasury Notes Futures

10-Year U.S. Treasury Note Futures
Underlying
One U.S. Treasury note having a face value at maturity of $100,000.
Unit
U.S. Treasury notes with a remaining term to maturity of at least six and a
half years, but not more than 10 years, from the first day of the delivery
Deliverable
month. The invoice price equals the futures settlement price times a
Grades
conversion factor, plus accrued interest. The conversion factor is the price of
the delivered note ($1 par value) to yield 6 percent.
Points ($1,000) and halves of 1/32 of a point. For example, 126-16
Price Quote represents 126 16/32 and 126-165 represents 126 16.5/32. Par is on the
basis of 100 points.
One-half of one thirty-second (1/32) of one point ($15.625, rounded up to
Tick Size
the nearest cent per contract), except for intermonth spreads, where the
(minimum
minimum price fluctuation shall be one-quarter of one thirty-second of one
fluctuation)
point ($7.8125 per contract).
Contract The first five consecutive contracts in the March, June, September, and
Months December quarterly cycle.
Seventh business day preceding the last business day of the delivery
Last Trading
month. Trading in expiring contracts closes at 12:01 p.m. on the last trading
Day
day.
Last Delivery
Last business day of the delivery month.
Day
Delivery
Federal Reserve book-entry wire-transfer system.
Method
Settlement U.S. Treasury Futures Settlement Procedures
Position
Limits
Block
Minimum
All or None
Minimum
Rulebook
CBOT Chapter 19
Chapter
Trading
OPEN OUTCRY
Hours
MON - FRI: 7:20 a.m. - 2:00 p.m.
(All times
CME GLOBEX
listed are
SUN - FRI: 5:30 p.m. - 4:00 p.m.
Central Time)
OPEN OUTCRY
Ticker TY
Symbol CME GLOBEX
ZN
20
Example of Treasury Notes Future.
On October 10 2006 the interest rate is so low and you think that it should not go lower, so you
short one December Treasury note future contract at 108-050. On October 16, 2006 the stock
market opens strong and some people switch from bond to stock, bond prices fall (interest rate
goes up) and you cover (buy back) your short position at 106-145. Estimate your profits or
losses.
Each point = $1,000

1/32 of a point = 1000/32 = $31.25
Minimum tick = .5 * (1/32) = $15.625
108-050 = 108 + 5/32 = 108.1563

106-145 = 106+14.5/32 = 106.4531
Loss = (108.1563 – 106.4531)*1000 = 1.703125 * 1000 = $1703.125
Another way of estimation:
Loss = 1 point plus 22.5 ticks = $1,000 + 22.5* 31.25 = $1,703.125
For Agricultural and Energy futures contracts example, please see contract specifications file.
Futures Order Types:

Market Order: You will be filled at the best possible price obtainable at the time the order
reaches the trading pit.
Limit Order
Buy Limit: An order to buy a futures contract (Or any security) at or below a specified price
(called the limit price). Or to sell it at or above a specified price (Sell limit). The limit order is an
order to buy or sell at a designated price. Since the market may never get high enough or low
enough to trigger a limit order, a customer may miss the market if he or she uses a limit order.
(Even though you may see the market touch a limit price several times, this does not guarantee a
fill at that price, it has to go above or below the limit for guaranteed fill).
Example:
o With the Dec. DOW trading at 13,100 on December 1st, Buy 1 Dec DJIA 13,005
on a Limit. Order can only be filled at the stated price 13,005 or lower (better).
o With the market trading at 13,100, Sell 1 Dec DJIA at 13,195 on a Limit (or
better…fill at 13,195 or higher). Can only be filled at the stated price of 13,195 or
higher (better).
Stop Order
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Buy stop: Buy stop is placed above the market. When the stop price is touched, then the order is
treated like a market order and will be filled at the best possible price. (Note: buy limit is placed
below market).
Sell Stop: Sell stop is placed below the market. Buy stop order is placed above the market and a
sell stop order is placed below the market. When the stop price is touched, then the order is
treated like a market order and will be filled at the best possible price. (Note: sell limit is placed
above the market).
Example Buy Stop.
o with the market trading at 13,100, Buy 1 Dec DJIA 13,200 Stop. Can only be
filled at the Market, after the Market trades (or is "offered") at 13,200 or higher.
Example of Sell Stop.
o With the market trading at 13,100, Sell 1 Dec DJIA 13,000 Stop. Can only be
filled at the Market, after the Market trades (or is "bid") at 13,000 or lower.
Stop Limit Order

A stop limit order is the combination of stop and limit order. The first part is written like the
above stop order. The second part of the order specifies a limit price. This means that once your
stop is triggered, you do not want to be filled beyond the limit price. Stop limit orders should
usually not be used when trying to exit a position. If a customer does not mention a limit price,
then the stop price and the limit price are the same.
Stop Close Order (SCO)

The stop price on a stop close only will only be triggered if the market touches the stop during
the close of trading. This could protect the trader from getting filled during adverse price
fluctuations during the course of the day.
Market If Touched Order (MIT)

An order which becomes a market order if and when the specified price is touched. The order is
carried out at the first available price after the specified price has been reached, which is not
always equal to the specified price. An MIT order is similar to a limit order in that a specific
price is placed on the order. But, an MIT order becomes a market order once the limit price is
touched or passed through. An execution may be at, above, or below the originally specified
price.
Good Until Canceled Order (GTC)

Good Till Canceled (or Open Order). Used in conjunction with a Limit or Stop order. Order will
remain valid and worked until client cancels order, or it is filled, or contract expires.
One Cancels the Other Order (OCO)

One (order) Cancels (the) Other.
22
Enter a pair of orders and link them together. When one order has been executed, our system will
automatically attempt to cancel the other.
As an example, with the DOW trading at 13,100 with support at 13,000 and resistance at
13,200. You want to buy at 13,000 Limit (lower), or on an upside breakout at 13,210
Stop (higher), Buy 1 Dec DJIA 13,000 on a Limit, OCO Buy 1 Dec DJIA 13,210 Stop.
When one order is executed, the other is automatically canceled.
Market on Close (MOC)

Your order will be filled during the final seconds of trading at whatever price is available.
Market on Opening (MOO)

You will be filled at the opening range of trading at the best possible price obtainable within the
opening range.
Spread Order
A spread can be established between different months of the same commodity, between related
commodities or between the same or related commodities traded on two different exchanges. A
spread order can be entered at the market or you can designate that you wish to be filled when
the price difference between the commodities reaches a certain point (or premium)
Fill or Kill Order (FOK)

The fill or kill order is used by customers wishing an immediate fill, but at a specified price. The
floor broker will bid or offer the order three times and immediately return either a fill or an
unable.
One Triggers the other (OTO)
Place a primary order and up to two contingent orders at the same time. When the primary
order's executed, your contingents are automatically activated! OTOs are perfect when you'd like
to place a limit order at your profit objective, as well as a stop order for protection.
Please go to http://www.cmegroup.com for the list of more than 100s futures and commodities
that you can trade.
Copy right M. Metghalchi, 2010, all rights reserved.
23
Fin 6361
By M. Metghalchi
EQUITY OPTIONS: options on the common stock of individual company trades on many
exchanges, they started on the CBOE (Chicago Board Options Exchange) in 1973.
Options and futures are Derivative Security: derivative Securities’ values are derived from the
value of another security. For example, the value of a call option on IBM is derived from the value
of IBM stock price.
Call option gives the buyer the right to purchase underlying asset at striking (or exercise) price on
or before expiration date.
Put option gives the buyer of the put the right to sell underlying asset at striking price on of before
expiration date.
Writer (seller) of call option has commitment to sell underlying asset at striking price on or before
expiration date.
Writer of put option has the commitment to buy underlying asset at striking price on or before
expiration date.
Writing a covered call refers to owning the underlying stock; writing a naked call refers to not
owning the underlying stock but selling the call on the stock.
Buyer has right to exercise; writer has commitment to deliver.
Buyer and seller have opposite price expectations.
Premium is the price of the contract.
Options may be:

Exercised
Traded in the open market
Allowed to expire worthless.
Profit and Loss on Call Option on IBM
If you buy a call option on IBM:
Exercise Price = $90;

Premium = $7;
If Market Price of IBM = $100 at expiration
Proceeds = Stock Price - Exercise Price;
1
Proceeds = $100 - $90 = $10.
Profit = Proceeds - Premium;
Profit = $10 -- $7 = $3.
If Market Price of IBM = $89.25; You would not exercise.
Loss = $7.
Now if you buy a put Options on IBM:
Exercise Price = $90;

Premium = $7.50;
If Market Price = $90.25 at expiration, contract not exercised.
If Market Price is $86 at expiration:
Proceeds equal: Exercise Price - Stock Price;
Proceeds = $90 -- $86 = $4.
Profit = Proceeds - Premium;
Profit = $4 -- $7.50 = -$2.50; (loss)
Option would be exercised to offset partially the Premium Cost.
For Option prices, see: www.yahoo.com
American versus European Options
1. An American Option contract allows the owner to exercise the right to buy or sell the
underlying asset on or before the expiration date.
A European Option contract allows the owner to exercise the right to buy or sell the underlying
asset on the expiration date only.
In general, American Options are more valuable, due to increased

flexibility.
Virtually all option contracts traded in the U.S. are American option contracts.
2
Payoff and Profit to Call Options at Expiration for Equity Options:
Value of the Call Option @ Expiration:
Payoff to Call Owner = St - X; If St > X.

Payoff to Call Owner = 0 ; If St < X.
St = Value of the stock @ expiration.

X = Striking Price.
Example:
Call Option on IBM; X = $90 Or striking price =90
Premium = $14. The buyer of the option will pay $14 for the right.
Value of option at different stock prices at expiration:
Stock Price at expiration $80 $90 $100 $110 $120
Option Value $0 $0 $10 $20 $30

Profit to option holder 0 0 (-$4) $6 $16
Bullish, Bearish Strategies of Puts & Calls
Buyer of Call Option expects price of underlying stock to increase, therefore, if you buy a call on
a stock, you expect the price of that stock to go up, you are bullish on the stock.
Writer of Call Option expects price of underlying stock to decrease or to remain stable. Therefore,
if you sell a call on a stock, you expect that the price of the stock to go down or stay the same. You
are bearish on the stock.
Buyer of Put Option expects price of underlying stock to decrease, therefore, if you buy a put
option on a stock, you expect the stock price to go down, you are bearish on that stock.
Writer of put option expects price of underlying stock to increase or to remain stable. If you sell a
put option, you expect the stock price to go up or stay the same, you are bullish on that stock.
Important variables that affect the value of a call option are:
1. the market stock price. (with the exercise price and everything else constant)
an increase (decrease) in the stock price will increase (decrease) the value of
a call option.
2. The exercise price (everything else the same). The higher the exercise price,
3
the lower will be the value of a call option.
3. The longer the time remaining until expiration the higher the option value
(all other things being equal).
4. The higher the level of interest rates, the higher is the call option's value (all
other things being equal).
5. The greater the volatility of the stock price, the higher is the call option value
The intrinsic value of a call option is:
Call option intrinsic value = max [0, S - K]
Where S= stock price and K= strike price.
In English, the intrinsic value of a call option is the maximum of zero or the value of the stock price
minus the strike price.
Example, if S=60 and K=53, then the intrinsic value of a call option on this stock is:
Call option intrinsic value = max [0, S - K] = max [0, 60-53] = $7
Put option intrinsic value = max [0, K - S]
Example: if S= 50 and K = 55, then

Intrinsic value of a put option = max [0, K - S] = max[0, 55-50] =$5
Put and call options are never less than their intrinsic values,or:
Call option price ≥ max [0, S - K]

Put option price ≥ max [0, K - S]
Intrinsic and time value

The premium or the option prices that you pay consist of the sum of two specific elements:
intrinsic value and time value.
Intrinsic value
The intrinsic value = if you exercise now (immediately) how much you can realize. Intrinsic value
is always positive or zero. Out-of-the-money options have zero intrinsic values. (See above)
Time value
The time value of an option = Option price – intrinsic value.
The price on this time value depends on a number of factors: time to expiration, volatility of
the underlying product price, risk free interest rates and expected dividends.
Option sensitivities
4
Option Sensitivity or the ‘Greeks’: these are defined as follow:
Delta: the change in the option price for a given change in the price of the underlying security. The
delta is between 0 and +1 for calls and between 0 and -1 for puts. If IBM has a delta of .5, it means
that if IBM stock goes up by $2, the particular option on the IBM stock will delta of .5 will go up
by $1.
Gamma: the change in delta for a given change in the underlying security. For example if a call
option on IBM has a delta of 0.5 and a gamma of 0.05, this indicates that the new delta for IBM
option will be 0.55 if the IBM price moves up by $1 and 0.45 if the IBM price moves down by $1.
Theta: shows the effect of time decay on an option. As time passes, options will lose time value
and the theta measures the extent of this decay. Both call and put options have a negative theta.
The decay of options is nonlinear in that the rate of decay will accelerate as the option approaches
the expiration date.
Vega: defines the effect that a change in implied volatility has on an option’s price.
Both calls and puts will have a positive vega.
(for more details see: http://www.euronext.com/fic/000/010/729/107297.pdf)
Option Strategies:
1. Protective put: You own a stock but in order to protect yourself from downside, you buy
the put on the same stock that you own.
Example: suppose you own the stock of IBM. Assume the IBM stock price is $83 dollars
today. You are not confident about the next 12 months, and for some reasons (tax, not
knowing the exact timing of sale, ect)you decide not to sell the stock. In order to sleep easy at
nights, you can buy one year put option on IBM with an exercise price of $80. The premium
could be $8. So if you are wrong and the IBM price goes up, you loose the $8 premium but
you gain on IBM stock price increase.
If you are correct and IBM price goes down to $50 by next year, you loose $33 on the IBM
price (83 – 50 = $33) but the value of your put option on IBM will be $30 (80-50), so your
profits on the option will be $22 (30 – 8). On the whole, you have reduced your downside risk.
The Protective put strategy can be applied to your portfolio. If your portfolio is very
diversified, then you can by a put option on the S&P 500. If your portfolio is mostly high tech
stocks, then you can buy a put option on Nasdaq 100. If your portfolio is mostly small stocks,
then you can buy a put on Russel 2000 index.
2. Covered Call: You own the stock and you think there is not much upside and downside
possibility for your stock, you sell the call option for your stock.
5
today. You are not confident about the next 12 months, and for some reasons you don’t think
the stock will go MUCH lower, as a result you decide to sell the call option on your IBM. you
can sell one year call option on IBM with an exercise price of $85. The premium could be $9.
So if you are wrong and the IBM price goes up by next year to $105, you loose $11 on your
option call (-105+85+9) but you own a stock that is worth $105 dollars. Or you could deliver
the stock at expiration and receive $85 cash and you have already pocked the $9 premium, a
total of $94 (versus $105 if you did not sell the call). However, If you are right and by next
year IBM price is $78 dollars, then the call option that you have sold will expire with a zero
value and you end up with IBM share that is worth $78 plus you have pocketed the $9
premium on the option (78+9=87).
3. Long Stradel: Buying both a call and a put option on a stock with the same exercise price
and the same expiration date. Why you would do this? Because you think that the stock will
move violently either up or down, you don’t know the direction of the move.
today and for some reasons (court case, new product, ext) you believe that within the next 6
months IBM stock will have a very strong move on either direction. So, you buy a call option
On IBM, exercise price $85, expiration 6 months for $5 and at the same time you buy a put
option on IBM, exercise price $85, expiration 6 months for $6. Your total costs on these two
options will be $11. For you to break even on this long stradel strategy, the IBM stock should
be $11 either above or below $85, or $96 and $74. If IBM stock price is $96 or $74 you just
break even. Any price above $94 or below $74 will be your profits. If the stock price in six
months ends up between $74 and $96, your strategy will be a loosing strategy. Your
maximum loss will be $11 if the stock price settles at $85 in six months.
4. Short Stradel: Selling both a call and a put option on a stock with the same exercise price
and the same expiration date. Why you would do this? Because you think that the stock will
not move violently in either direction.
5. Strips: similar to stradel, however, a strip is two puts and one call on a security with the
same exercise price and maturity date.
6. Straps: similar to stradel, however, a strap is two calls and one put on a security with the
same exercise price and maturity date.
7. Spreads: usually a combination of calls and puts. There are many ways of spread strategies
as follow:
a). Bull Spread with call (Vertical): Buying a call with strike price of $X and selling another
call with Strike price of $Y (Y must be greater than X) for the same expiration month.
Limited risk reward.
6
b) Bull Spread with put: Selling a put with strike price $U and buying a put with strik price
of $V (V must be lower than U) for the same expiration month. Limited Risk reward.
c). Bear Spread with call: It involves two call options; you would sell the call with lower
exercise price and buy the call with higher exercise price. The same expiration dates.
d). Bear Spread with put: it involves two put options; you would buy the put with higher
exercise price and sell the put with lower exercise price. The same expiration dates.
e) The Box Spread: it consist of a bull spread with call plus a bear spread with puts, with the
two spreads having the same pair of exercise prices. Example: 1 long IBM call $95, 1 short
IBM call $105 and 1 long put $105, 1 short put $95, all have same expiration.
Example of bull call spread: Assume the IBM stock price is $83. And you are mildly bullish
on IBM. What can you do? One option would be simply to buy a call option on IBM. For
example you may buy call IBM with exercise price 85 and maturity 1 year at $8. But since
you are not VERY bullish on IBM you don’t want to spend $8. So you buy a call spread on
IBM: You buy call 85 and sell call 95 both expiring in one year. This way you reduce your
cost but at the same time you limit your upside potential. Your net cost could be $5 per share
(assuming call 85 is $8 and call 95 is $3, you buy $8 call 85 and sell $3 call 95 for a net of $5.
Your maximum profit would be $5 if IBM stock closes at 95 or higher one year from today.
Your break even is $90, and below 90 you would loose and your maximum loss is $5 the net
cost of the spread. You loose this $5 net cost of the spread strategy if IBM stock closes at $90
or lower in one year.
f) The Butterfly Spread with Calls: It involves 4 calls, buy one call with low exercise price,
buy another with very high exercise price and sell 2 calls with an intermediate exercise price.
Example, long one IBM $95 call, short 2 IBM $100 call, and long 1 IBM $105 call.
g) The Butterfly Spread with Puts: It consists of 4 puts, buy one put with high exercise price,
sell 2 put with intermediate exercise price, and buy one put with low exercise price. Example:
Long put IBM $105, Short 2 puts IBM $100, Long one put IBM $95.
h) Call Calendar: example - You sell call IBM $100 March and buy call IBM $100 June.
i)Put Calendar: example – You sell Put IBM $100 March and buy Put IBM $100 June.
J). Call Diagonal: example - You sell call IBM $100 March and buy call IBM $105 June.
k) Put Diagonal: You sell Put IBM $100 March and buy Put IBM $90 June.
7
Options on Stock Index:
Call options exist for individual common stocks, but call options also exist on future contracts such
as stock Indices (SP500, NYSE, NASDAQ, DOW), Treasury bonds, foreign exchange, and many
other instruments. Most of these options on future contracts are traded on organized exchanges
such as the Chicago Board Options Exchange and the Chicago Mercantile Exchange.
WWW.CME.com
The buyer of a call option on a stock index has the right, but not the obligation, to purchase (go
long) a particular stock index contract at a specified price at any time during the life of the option.
The buyer of a put option on a stock has the right to sell (go short) a particular stock index contract
at a specified price. Put options can be purchased to profit from an anticipated price decrease.
Settlement is cash;
Payoff is difference between the Striking Price and the Value of Index at settlement.
Example Of option on stock index:
On Friday December 15, 2006 the March S&P 500, 2007 closed at 1438.20. Below please find the
March-07 option call and put prices for a few strike prices on S&P500:
Call 1440 = $31.50

Call 1450 = $26.50
Call 1460 = $20.80
Put 1440 = $32.50

Put 1435 = $30.40
Put 1425 = $26.80
Put 1415 = $23.70
Exercise 1: Assume you are bullish on the stock market and buy one March call 1440 on the March
S&P500.
Estimate your profits and losses if S&P500 at its March expiration (Third Friday of March) closes
at the following levels:
a. 1495.40
b. 1452.80
c. 1438.50
SOLUTION FOR EXCERSIE 1:
Option premium = cost of option = 31.50 * 250 (each point of S&P500 =$250)
Option costs = 31.50* 250 = $7,875
a. if the index closes at 1495.40, then the value of option at expiration is:
8
(1495.40 – 1440)* 250 = $13,850
Profits = 13,850 – 7,875 = $5,975
b. if the index closes at 1452.80, then the value of option at expiration is:
(1452.80 – 1440)*250 = $3,200
Profits = 3,200 – 7,875 = -$4,675 (There will be a loss)
c. if the index closes at 1438.50, then the value of option at expiration is zero and you would
lose $7,875.
Exercise 2: Assume you are bearish on the stock market and buy one March Put 1425 on the March
S&P500.
Estimate your profits and losses if S&P500 at its March expiration (Third Friday of March) closes
at the following levels:
a. 1398.40
b. 1418.50
c. 1428.20
SOLUTION OF EXERCISE 2:
Option cost = 26.80 * 250 = $6,700
a. if the index closes at 1398.40, then the value of option at expiration is:
(1425 – 1398.40) * 250 = $6,650
Profits = 6,650 – 6,700 = -$50 (you lose 50 dollars)
b. if the index closes at 1418.50, then the value of option at expiration is:
(1425 – 1418.50) * 250 = $1,625
Profits = 1,625 – 6,700 = -$5,075 (This would be your loss).
c. if the index closes at 1428.50, then the value of option at expiration is zero and you
would lose $6,700
Exercise 3: Assume you think the stock market will violently move one way (Up or down), but you
don’t know which way. So you go long one Stradel (Strike price 1440). Estimate your profits and
losses if S&P500 at its March expiration (Third Friday of March) closes at the following levels:
a. 1510.40
b. 1480.95
c. 1445.60
d. 1432.60
e. 1410.20
f. 1360.40
SOLUTION OF EXCERSIE 3:
9
Cost of the stradel = cost of call + cost of put
Cost of call = $7,875 (See exercise 1)
Cost of put = 32.50 * 250 = $8,125
Cost of the Stradel = 7,875 + 8,125 = $16,000
a. if the index closes at 1510.40, then the value of the call option at expiration is:
(1510.40 – 1440)* 250 = $17,600
Value of put option at the expiration is zero
Profits = 17,600– 16,000 = $1,600
b. if the index closes at 1480.95, then the value of the call option at expiration is:
(1480.95 – 1440)* 250 = $10,237.50
Profits = 10,237.50 – 16,000 = $-5,762.50 (You would lose)
c. if the index closes at 1445.60, then the value of the call option at expiration is:
(1445.60 – 1440)* 250 = $1400
Profits = 1400 – 16,000 = $-14,600 (You would lose)
d. if the index closes at 1432.60, then the value of the call option at expiration is zero.
Value of put option at the expiration is:
(1440 – 1432.60) *250 = $1,850
Profits = 1,850 – 16,000 = $-14,150 (You would lose)
e. if the index closes at 1410.20, then the value of the call option at expiration is zero.
(1440 – 1410.20) *250 = $7,450
Profits = 7,450 – 16,000 = $-8,550 (You would lose)
f. if the index closes at 1360.40, then the value of the call option at expiration is zero.
(1440 – 1360.40) *250 = $19,900
Profits = 19,900 – 16,000 = $3,900 (You would lose)
As you can see, the long Stradel strategy only works if the price has a very big move in one
direction.
Exercise 4: Assume you think the stock market will trade sideway over the next three months. So
you go short one Stradel (Strike price 1440). Estimate your profits and losses if S&P500 at its
March expiration (Third Friday of March) closes at the following levels:
g. 1510.40
h. 1480.95
i. 1445.60
j. 1432.60
10
k. 1410.20
l. 1360.40
SOLUTION OF EXCERSIE 4:
You sell both call and put March S&P500 1440.

Your account will be credited as follow:
Cost of call = $7,875 (See exercise 1)
Cost of put = 32.50 * 250 = $8,125
So, your account will be credited by $16,000, since you are now the seller of the options.
a. if the index closes at 1510.40, then the value of the call option at expiration is:
(1510.40 – 1440)* 250 = $17,600
Profits = 16,000 – 17,600 = - $1,600 (You would lose)
b. if the index closes at 1480.95, then the value of the call option at expiration is:
(1480.95 – 1440)* 250 = $10,237.50
Profits = 16,000 - 10,237.50 = $5,762.50 (Your profits)
c. if the index closes at 1445.60, then the value of the call option at expiration is:
(1445.60 – 1440)* 250 = $1400
Profits = 16,000 - 1400 = $14,600 (Your profits)
d. if the index closes at 1432.60, then the value of the call option at expiration is zero.
(1440 – 1432.60) *250 = $1,850
Profits = 16,000 - 1,850 = $14,150 (Your profits)
e. if the index closes at 1410.20, then the value of the call option at expiration is zero.
(1440 – 1410.20) *250 = $7,450
Profits = 16,000 -7,450 = $8,550 (Your profits)
f. if the index closes at 1360.40, then the value of the call option at expiration is zero.
(1440 – 1360.40) *250 = $19,900
Profits = 16,000 - 19,900 = -$3,900 (You would lose)
Options on Futures
11
The buyer of a call option has the right, but not the obligation, to purchase (go long) a particular
futures contract at a specified price at any time during the life of the option.
Example : A March -2007 Treasury Note 107 call option would convey the right to buy one
March U.S. Treasury Note futures contract at a price of $107,000 at any time during the life
of the option. The buyer may not hold the option till expiration, a profit can be realized if,
prior to expiration, the option rights can be sold for more than its cost.
The most that an option buyer can lose is the option premium plus transaction costs.
The buyer of a put option has the right to sell (go short) a particular futures contract at a specified
price. Put options can be purchased to profit from an anticipated price decrease.
Example: you pay a premium of $750 (Cost of put option) to purchase an April 620 gold
put option. The option gives you the right to sell a 100 ounce gold futures contract for $620 an
ounce.
Assume that, at expiration, the April futures price has declined to $600 an ounce. The option
giving you the right to sell at $620 can thus be sold or exercised at a gain of $20 an ounce. On
100 ounces (see contract specification file), that’s $2,000.After subtracting $750 cost of the
option, your net profit comes to $1,250. Not including the transaction cost.
Exercise 5: On Friday December 15, 2006 the March Euro, 2007 closed at 131.36. Below please
find the March-07 option call and put prices for a few strike prices on Euro currency:
Call 131.00 = 0.0193

Call 132.00 = 0.0146
Put 131.00 = 0.0157

Put 130.00 = 0.0116
Assume you think the Euro will violently move one way (Up or down), but you don’t know which
way. So you go long one Stradel (Strike price 131.00). Estimate your profits and losses if March
Euro at its March expiration (Third Friday of March) closes at the following levels:
a. 136.80
b. 132.60
c. 131.00
d. 130.20
e. 126.76
Solution of Exercise 5:
Long Stradel, Stike price 131.00:

12
As we have seen in the Future chapter, for Euro trading can occur in $.0001 per
Euro increments ($12.50/contract). So each .0001 = $12.5. Therefore a price of
.0193 implies a cost of (.0193/.0001) * 12.50 = $2,412.50. This could be also
obtained by (125,000 * .0193 = $2,412.50)
Cost of call = $2,412.5
Cost of put = 125,000 * .0157 = $1,962.50
Cost of the Stradel = 2,412.5 + 1,962.5 = $4,375
a. if the Euro closes at 138.80 at its expiration, then the call option value at the expiration is:
(138.80 – 131.00)*1,250 = $7,250
Value of put will be zero.
Profits = 7,250 – 4375 = $2,875
b. if the Euro closes at 132.60 at its expiration, then the call option value at the expiration is:
(132.60 – 131.00)*1,250 = $2,000
Profits = 2,000 – 4375 = -$2,375 (There will be a loss)
c. if the Euro closes at 131.00 at its expiration, then the call option value at the expiration is:
(131.00 – 131.00)*1,250 = $0
Value of put will also be zero.
Loss = $4,375
d. if the Euro closes at 130.20 at its expiration, then the put option value at the expiration is:
(131.00 – 130.20)*1,250 = $1,000
Value of call will also be zero.
Loss = 4,375 – 1,000 = 3,375
e. if the Euro closes at 126.76 at its expiration, then the put option value at the expiration is:
(131.00 – 126.76)*1,250 = $5,300
Profits = 5,300 - 4,375 = $925.
Exercise 6: On Friday December 15, 2006 the March Euro, 2007 closed at 131.36. Below please
find the March-07 option call and put prices for a few strike prices on Euro currency:
Call 131.00 = 0.0193

Call 132.00 = 0.0146
Put 131.00 = 0.0157

Put 130.00 = 0.0116
Assume you think the Euro will trade sideway over the next three months. So you go short one
Stradel (Strike price 131.00). Estimate your profits and losses if March Euro at its March expiration
(Third Friday of March) closes at the following levels:
13
a. 136.80
b. 132.60
c. 131.00
d. 130.20
e. 126.76
Short Stradel, Stike price 131.00:

As we have seen in the Future chapter, for Euro trading can occur in $.0001 per
Euro increments ($12.50/contract). So each .0001 = $12.5. Therefore a price of
.0193 implies a cost of (.0193/.0001) * 12.50 = $2,412.50. This could be also
obtained by (125,000 * .0193 = $2,412.50)
Cost of put = 125,000 * .0157 = $1,962.50
Cost of the Stradel = 2,412.5 + 1,962.5 = $4,375
Since you are a seller of the Stradel (Seller of both call and put), your account will be credited
$4,375.
a. if the Euro closes at 138.80 at its expiration, then the call option value at the expiration is:
(138.80 – 131.00)*1,250 = $7,250
Your Loss = 7,250 – 4375 = $2,875
b. if the Euro closes at 132.60 at its expiration, then the call option value at the expiration is:
(132.60 – 131.00)*1,250 = $2,000
Profits = 4375 -2,000 = $2,375
c. if the Euro closes at 131.00 at its expiration, then the call option value at the expiration is:
(131.00 – 131.00)*1,250 = $0
Value of put will also be zero.
Your profits = $4,375
d. if the Euro closes at 130.20 at its expiration, then the put option value at the expiration is:
(131.00 – 130.20)*1,250 = $1,000
Your profits = 4,375 – 1,000 = $3,375
e. if the Euro closes at 126.76 at its expiration, then the put option value at the expiration is:
(131.00 – 126.76)*1,250 = $5,300
Your Loss = 5,300 - 4,375 = $925.
14
Crude Oil Options
Exercise 7: On Friday December 15, 2006 the February Crude Oil, 2007 closed at 64.11. Below
please find the Feb-07 option call and put prices for a few strike prices on Crude oil:
Call 64.00 = 1.89

Call 65.00 = 1.42
Put 64.00 = 1.73
Put 63.00 = 1.33
Assume you think the crude price will violently move one way (Up or down), but you don’t know
which way. So you go long one Stradel (Strike price 64.00). Estimate your profits and losses if
February crude at its February expiration closes at the following levels:
a. 64.50
b. 72.50
c. 63.50
d. 55.50
Long Stradel, Stike price 64.00:

As we have seen in the Contract Specification file, for crude trading, each cent
is $10.t0 or a point is $1,000. Therefore a price of 1.89 implies a cost of
189*10 =$1,890 This could be also obtained by 1.89* 1000)
Cost of put = 1.73* 1000 = $1,730.00
a. if Crude closes at 64.50 at its expiration, then the call option value at the expiration is:
(64.50 – 64.00)*1,000 = $500.00
Loss = 3,620 - 500 = $3,120
b. if Crude closes at 72.50 at its expiration, then the call option value at the expiration is:
(72.50 – 64.00)*1,000 = $8,500
Profits = 8,500 – 3,620 = $4,880
c. if Crude closes at 63.50 at its expiration, then the call option value at the expiration is zero
and put value at expiration is:
(64.00 – 63.50) * 1,000 = $500
Loss = 3,620 -500 = $3,120
d. if Crude closes at 55.50 at its expiration, then the put option value at the expiration is:
15
(64.00 – 55.50)*1,000 = $8,500
Profits = 8,500 – 3,620 = $4880.00
Interest Rate Options:
Exercise 8: On Friday December 15, 2006 the March 10-year note, 2007 closed at 108.105.
Below please find the march-07 option call and put prices for a few strike prices on 10-year
Treasury note:
Call 108 = 0.58

Call 109 = 0.30
Put 108 = 0.38
Put 107 = 016
Assume you think the 10-year Treasury note will trade sideway over the next three months. So you
go short one Stradel (Strike price 108). Estimate your profits and losses if March 10-year Treasury
note at its March expiration (Third Friday of March) closes at the following levels:
a. 110.225
b. 108.145
c. 107.180
d. 106.160
Short Stradel, Stike price 108:

As we have seen in the Future chapter, for 10- year Treasury Note, trading can occur in
Minimum tick of .5 * (1/32) = $15.625 and each point = $1,000 (108 to 109).
Therefore the call option price of.58 implies a cost of .58 * 1000 = $588.00.
Cost of call = $580.00
Cost of put = $.38 * 1000 = $380
Cost of the Stradel = 580 + 380 = $960
Since you are a seller of the Stradel (Seller of both call and put options), your account will be
credited $960.00
a. if the 10-year TN closes at 110.225 at its expiration, then the call option value at the
expiration is:
110.225 = 110 + 22.5/32 = 110.703125
Value of call option = (110.703125 – 108)*1000 = $2,703.125
Value of put option =0
Loss = 2,703.125 – 960 = $1,743.125
b. b. if the 10-year TN closes at 108.145 at its expiration, then the call option value at the
expiration is:
108.145 = 108 + 14.5/32 = 108.453125
16
Value of call option = (108.453125 – 108)*1000 = $453.125
Value of put option =0
Profits = 960 – 453.125 = $506.875
c. if the 10-year Note closes at 107.180 at its expiration, then the call option value at the
expiration is zero:
Value of put will be:
107.180 = 107 + 18/32 = 107.5625
Value of put option = (108 – 107.5625)*1000 = $437.50
Profits = 960 -437.50 = $522.50
d. if the 10-year Note closes at 106.160 at its expiration, then the call option value at the
expiration is zero:
Value of put will be:
106.160 = 106 + 16/32 = 106.50
Value of put option = (108 – 106.50)*1000 = $1,500
Loss = 1,500 - 960 = $540.00
Bullish, Bearish Strategies of Puts & Calls on Stocks or Future contracts
Buyer of Call Option expects price of underlying stock or future contract to increase, therefore, if
you buy a call on a stock or on a future, you expect the price of that stock or the future to go up,
you are bullish on the stock or on the future contract.
Writer of Call Option expects price of underlying stock or future to decrease or to remain stable.
Therefore, if you sell a call on a stock or future, you expect that the price of the stock or future to
go down or stay the same. You are bearish on the stock or future contract.
Buyer of Put Option expects price of underlying stock of future contract to decrease, therefore, if
you buy a put option on a stock or future, you expect the stock or future price to go down, you are
bearish on that stock or future contract.
Writer of put option expects price of underlying stock or future to increase or to remain stable. If
you sell a put option, you expect the stock or future price to go up or stay the same, you are bullish
on that stock or future contract.
How Option Prices (Premiums) are determined:
1. The current spot price. (with the exercise price and everything else constant) an
increase (decrease) in the spot price will increase (decrease) the value of a call
option.
2. The option’s exercise price (everything else the same). The higher the
exercise price, the lower will be the value of a call option. Or the lower the
exercise price, the lower will be the value of a put option.
17
3. The longer the time remaining until expiration the higher the option value
4. The higher the level of interest rates, the higher is the call and put option
value (all other things being equal).
5. The greater the volatility of the underlying asset price, the higher is the call
and put option value (all other things being equal).
Employee Stock Option (ESO):
An employee stock option is a call option that a firm gives or sells at a very deep discount to
employees. These will supposedly bring the convergence of shareholders and management.
(Reduce the agency problem). However, because of the abuse of this practice, many corporations
are switching to Stock Grant practice to reduce the agency problem. Stock grants are stocks given
to employees that will vest over time as the employee stays with the company.
The following quote is taken from the instructor manual of your textbook:
Beginning of the quote:

“The details of ESOs vary by firm. However, there are some specifications that
are standard enough to discuss. First, the life of the ESO is generally 10
years, which is much long than an ordinary call option. Second, ESOs can only be
exercised—that is, unlike ordinary call options, ESOs cannot be sold.
ESOs have a “vesting” period of about 3 years. That is, for the first three years that the employee
owns the ESO, they cannot exercise it. Once the employee has worked for the company for the
vesting period, the employee can exercise their ESOs any time during the remaining life of the
ESO.
If an employee leaves the company before the ESOs are “vested,” the employee
loses the ESOs. If an employee leaves the company and has ESOs that are vested,
the employee has some time to exercise these ESOs.
One major feature of ESOs that is different from ordinary call options is that occasionally, their
strike price is reduced. ESOs are generally issued exactly “at the money,” i.e., with zero intrinsic
value. However, because of its ten-year life, the ESO is still valuable to the employee.
If the stock price falls after the ESO is granted, the ESO is said to be “underwater.” Occasionally,
companies will lower the strike prices of ESOs that are “underwater.” This controversial practice
is called “restriking” or “repricing”
Why is this practice controversial?
PRO: Once an ESO is “underwater,” it loses its ability to motivate employees.

Employees realize that there is only a small chance for a payoff from their ESOs.
18
Employees may leave for other companies where they get “fresh” options.
CON: Lowering a strike price is a reward for failing. After all, decisions by employees made the
stock price fall. If employees know that ESOs will be repriced, the ESOs loose their ability to
motivate employees.
Today, most companies award ESO on a regular basis (quarterly or annually).

Therefore, employees will always have some “at the money” options. In addition, regular grants of
ESOs means that employees always have some “unvested” ESOs—giving them the added incentive
to remain with the company. ” End of quote from instructor manual.
Put-Call Parity
According to Put-Call Parity, if a stock does not pay dividend, then the difference between the call
price and the put price (European options) should be equal to the difference between the stock price
and the discounted strike price.
C – P = S - Ke-rT
Where, C = the call option price today
P is the put option price today
S = the stock price today
Ke-rT = the discounted strike price (Present value of strike price) (PV=FV*e-rT this is the formula
for continuous discounting)
r is the risk-free interest rate.
T is the time remaining until option expiration.
If a stock pays dividend (D), then Put-Call parity becomes:
C – P = S - Ke-rT – D.
The Option Clearing Corporation
Here is a quote from the instructor manual of your textbook:
“Options Clearing Corporation (OCC): Private agency that guarantees that the terms of an
option contract will be fulfilled if the option is exercised; issues and clears all option
contracts trading on U.S. exchanges.The OCC is the clearing agency for all options
exchanges in the U.S. and it is subject to regulation by the SEC. Since the OCC assumes the
writer's obligation in all trades, all default risk is transferred to the OCC” End of quote.
Clearing House is the trading partner of each trader in the option market.
19
Hedging versus Speculating
Speculator uses Futures Contracts to profit from movements in Futures Prices.
Hedger uses Futures Contracts to protect against price movements.
If speculator believes prices will increase, they take long positions.
If Speculator believes prices will decrease, they take short positions.
Managers of bond portfolio (Hedger) takes short position in Bond Futures, which guarantees that
total value of bond + futures position @ maturity is the Futures Price.
A long hedge would exist if a pension fund manager enters the long side of the contract, (a
commitment to purchase @ the current Futures Price) thus locking in current prices & yields.
For a basic summary go to: http://www.angelfire.com/vt2/corpfin/.

For more detail on options, please go to: www.cboe.com and then go to learning center.
Optional for Students (Not required)
Black-Scholes Option Valuation Model
V = P[N(d1) - Xe −k RFt [N(d2)].

ln(P/X) + [k RF + (σ 2/2)]t
d1 = .
σ t
d2 = d1 - σ t .
V = CURRENT VALUE OF A CALL OPTION WITH TIME t UNTIL

EXPIRATION.
P = CURRENT PRICE OF THE UNDERLYING STOCK.
N(di) = PROBABILITY THAT A DEVIATION LESS THAN di WILL OCCUR IN
A STANDARD NORMAL DISTRIBUTION. THUS, N(d1) AND N(d2)
REPRESENT AREAS UNDER A STANDARD NORMAL DISTRIBUTION
FUNCTION.
X = EXERCISE, OR STRIKE, PRICE OF THE OPTION.
20
e ≈ 2.7183.
kRF = RISK-FREE INTEREST RATE.
t = TIME UNTIL THE OPTION EXPIRES (THE OPTION PERIOD).
ln(P/X) = NATURAL LOGARITHM OF P/X.
σ2 = VARIANCE OF THE RATE OF RETURN ON THE STOCK.
See an example of this model in the Excel file called “Black-Schole”. I have copied the Excel file
in this lecture as follow:
Assume two stocks, VI (Victoria Inc.) and H (Houston Inc.), both with call & put options
Victoria Stock Houston Stock

Call Put Call Put
Exercise price, X $80.00 $80.00 $65.00 $65.00
Cost of option $8.90 $8.90 $1.20 $1.20
Price of stock,P, at expiration $95.50 $95.50 $63.75 $63.75
We use Excel's IF function to estimate the profits and loss at expiration.
Value of option at expiration $15.50 $0.00 $0.00 -$1.25

Profit and loss $6.60 -$8.90 -$1.20 -$2.45
Although it is easy to value option at expiration date, it is not so easy before expiration.
The most important model of option value is the Black-Scholes Model.
V = P[N(d1) - Xe −k t [N(d2)].
RF
Assume Texas Inc's market price is $20, risk freeln(

rate
P/X ) + [k
=12%, RF + (σ /2)]
time to maturity
2
t for the option=3 or
d 1 =
.25 years, exercise price= $20, the annual variace of return =.16, what is the . of this option?
value
σ t
2
P $20Krf
d2 = d1 -σ12%
t s. 0.16
X $20t 0.25
We first find d1
V = CURRENT VALUE OF A CALL OPTION WITH TIME t UNTIL
EXPIRATION.
d1 = {ln(P/X) +[Krf + s2/2]t}/st1/2
=P = CURRENT0.25 PRICE OF THE UNDERLYING STOCK.
(LN(B56/B57)+(D56+(F56/2))*D57)/((F56^0.5)*(D57^0.5))
N(di) = PROBABILITY THAT A DEVIATION LESS THAN di WILL
1/2
d2 =OCCUR IN A dSTANDARD1-s(t ) NORMAL DISTRIBUTION. THUS, N(d1)
= 0.05
AND N(d2) REPRESENT AREAS UNDER A STANDARD NORMAL
C62-(F56^.5)*(D57^0.5)
DISTRIBUTION FUNCTION.
We now need N(d1)X= andEXERCISE,
N(d2) area under
ORthe normal curve,
STRIKE, PRICEwe could
OF THEuse a normal
OPTION.table.
however, Excel can also be used. Click Insert, Function, Statistical, NORMDIST to access the
e ≈ 2.7183.
kRF = RISK-FREE INTEREST RATE.
t = TIME UNTIL THE OPTION EXPIRES 21 (THE OPTION PERIOD).
ln(P/X) = NATURAL LOGARITHM OF P/X.
σ2 = VARIANCE OF THE RATE OF RETURN ON THE STOCK.
menue, then fill .25 for X, 0 for mean, 1 for ST-Dev. And true for cumulative.
N(d1) = 0.598706
N(d2) = 0.519939
e= 2.7183
Krf * t = 0.03
Krf*t
V= P(N(d1)) - Xe [N(d2)]
V= 1.258656 This is the option value of our example
Sensitivity analysis:
I change both exercise and market prices from $20 to $30, then the above model results to a
Value = $1.90 The higher, the market price, the higher option value.
I change t from 3 months to 6 months or t=.5, then the above model results to a
Value = $2.61 Longer options are more expensive than shorter options.
I change the value of stock volatility, s2, from .16 to .30 and the above model results to a
Value = $1.89 The more volatile the stock, the higher will be its option value.
I change the risk free rate from 12 % to 5 %, the above model results to a value
Value= $2.15 The lower the risk free rate, the higher will be the option value.
Multiple choice from the test bank of your textbook:
STANDARDIZED OPTION CONTRACTS

25. Standardized option contracts are for ____ share(s) of stock.
A. 1
B. 10
C. 50
D. 100
E. 1,000
OPTION PAYOFF
C 26. Ignoring the premium, the maximum loss from writing a call option is:
A. the strike price.

B. the stock price.
C. unlimited.
D. the option price.
E. Insufficient information.
22
OPTION PAYOFF
B 27. Ignoring the premium, the maximum loss from writing a put option is:
A. the strike price.

B. the stock price.
C. unlimited.
D. the option price.
E. Insufficient information.
PUT-CALL PARITY
A 30. According to put-call parity, a put option can be replicated by:
A. buying a call, selling the underlying stock, and lending at the risk-free rate.
B. selling a call, selling the underlying stock, and lending at the risk-free rate.
C. buying a call, buying the underlying stock, and borrowing at the risk-free rate.
D. selling a call, buying the underlying stock, and borrowing at the risk-free rate.
E. buying a call, selling the underlying stock, and borrowing at the risk-free rate.
PUT-CALL PARITY
D 31. According to put-call parity, a call option can be replicated by:
A. selling a put, buying the underlying stock, and borrowing at the risk-free rate.
B. buying a put, selling the underlying stock, and lending at the risk-free rate.
C. buying a put, buying the underlying stock, and lending at the risk-free rate.
D. buying a put, buying the underlying stock, and borrowing at the risk-free rate.
E. selling a put, selling the underlying stock, and lending at the risk-free rate.
OCC
45. All options traded on an exchange in the United States are originally issued, guaranteed, and
cleared by the:
A. SEC.
B. FDIC.
C. CBOE.
D. OCC.
E. NYSE.
CALL PROFIT
D 53. An investor purchases 25 call option contracts at a price of $1.86 and a strike price of $50. At
expiration, the stock price is $47.62. What is the profit on this transaction?
A. –$10,600
B. –$5,950
C. $1,300
D. –$4,650
E. $5,950
PUT PROFIT
D 57. You purchase 10 put option contracts at a price of $1.12. The strike price of the option is $35,
and the stock price at expiration is $32.18. What is the profit on your investment?
23
A. $2,820
B. $1,974
C. $2,160
D. $1,700
E. $2,432
CALL WRITING
C 61. An investor writes 20 call options at a strike price of $85 and an option premium of $4.12. If the
stock price at expiration is $83.27, what is the profit from this transaction?
A. –$3,460
B. –$4,120
C. $8,240
D. $3,460
E. –$4,780
PUT WRITING
63. You write 5 put option contracts with a premium of $4.85 and a strike price of $80. What is your
profit if the stock price at expiration is $78.13?
A. $1,490
B. $935
C. $3,860
D. –$935
E. –$1,620
SPX OPTIONS
E 77. Suppose you buy one SPX put option at a strike price of 1150 and sell one SPX put option at a
strike price of 1200. What is your payoff if the index is at 1130 at expiration?
A. –$10,000
B. –$2,000
C. –$7,000
D. $3,000
E. –$5,000
24
63. You purchased 7 put option contracts on Alto Industries. The strike price was $42.50 and the
option premium was $1.30. On the expiration date, the stock was valued at $41.40 a share. What is
the total payoff on the option contracts?
A. -$140
B. $0
C. $110
D. $360
E. $770
Payoff = 7 x 100 x ($42.50 - $41.40) = $770
70. You purchased a call option with a $22.50 strike price and a call premium of $0.30. On the
expiration date, the underlying stock was priced at $23.10 per share. What is the percentage return
on your investment?
A. -100 percent
B. 0 percent
C. 50 percent
D. 100 percent
E. 200 percent
Percentage return = ($23.10 - $22.50 - $0.30) / $0.30 = 100%
80. Rosalita purchased a put option with a strike price of $40. She paid a total of $160 for the
contract. What is the break-even stock price?
A. $38.40
B. $39.20
C. $40.00
D. $41.60
E. $42.80
Break-even stock price = $40 - ($160 / 100) = $38.40
86. A 6-month call has a strike price of $30. The underlying stock is priced at $32.80 and the option
premium on the call is $3.60. What is the per share time value of the call?
A. $0.00
B. $0.80
C. $1.40
D. $2.80
E. $3.60
Time value = $3.60 - ($32.80 - $30) = $0.80
25
87. A 3-month put has a strike price of $47.50 and an option premium of $1.40. The underlying
stock is selling for $46.70 per share. What is the time value of the put?
A. $0.00
B. $0.60
C. $0.70
D. $1.20
E. $1.40
Time value = $1.40 - ($47.50 - $46.70) = $0.60
Copy Right 2006 by Dr. M. Metghalchi. All Rights Reserved.
26
FIN 6364
Dow Theory
By M. Metghalchi
The Dow theory is the oldest and most publicized technical analysis to
identify trends. Today many still believe in the basic components of Dow
Theory. Developed by Charles Dow, refined by William Hamilton and
articulated by Robert Rhea, the Dow Theory (published in 1932), addresses
not only technical analysis, but also market philosophy. Many of the ideas
and comments put forth by Dow and Hamilton became axioms of Wall
Street. While there are those who may think that it is different this time,
according to Dow theorists the stock market behaves the same today as it did
almost 100 years ago
As Pring (p. 36) mentions, if you had invested $44 in 1897 in Dow Jones
Industrial Average (DJIA) and had followed each Dow theory signal (out of
the market on sell signals and in the market on buy signals), your original
investment of $44 would grow to $51,268 by January 1990. If, instead, you
had adapted a buy and hold strategy, your original $44 investment would
grow to $2,500 by January 1990. This example does not consider transaction
costs nor does it consider capital gain taxes.
INTERPRETATION OF THE THEORY:
There are six basic tenets of the Dow Theory:
1. The index (stock) discount everything
The stock prices reflect all possible information, private and public. Any
surprise news will be reflected in the stock price, commodity price, and
stock index very quickly.
2. There are three types of stock market movements:
a. A primary or major trend takes place over the course of years. This
could either be a bull or bear market depending to the direction of the
trend.
b. Secondary (intermediate) or correction movements, which take place
from weeks to months. These run contrary to the primary trend.
These counter trend movements generally retrace from 33 to 68 %
(occasionally 100%) of the primary price change. Figure 1 shows a
representation of primary and secondary trend for both bull and bear
market.
Figure -1
c. There are minor movement (day-to-day fluctuations) which can

move in either direction (bull or bear), and are of no particular
importance. These are part of primary or secondary movements.
3. Lines
Sometimes the secondary movement is horizontal, and this is called line.

It should last for few weeks. In a bull market, line formation implies
smart money is accumulating and in a bear market, line indicates
distribution from strong hand to week hand.
Figure 2
Figure 2 show an example of line formation in a bull market.
4. Price /Volume Relationship.
In general we should have the followings:
Generally volume should go with the trend and we have the following
relationship between volume and price:
Price Volume Interpretation

Rising Up Volume confirms price rise, bullish
Rising Down Volume indicate weak rally, correction
or reversal is possible. Bearish
Declining Up Volume confirms price fall, bearish
Declining Down Volume indicate weak price decline,
consolidation or reversal is possible.
In a rising market the volume should expand and in a declining market the
volume should expand to confirm the trend. According to Dow Theory, If in
a rising market volume contracts then this is a warning signal that the bull
market may come to an end. Also, in a bear market if prices going down and
suddenly the volume dries up, this could signal that the end of the bear
market is very near.
5. Major Trends have three phases:
Accumulation phase, public participation phase, and distribution phase.
For example if the market is in a bear market and price is going down, the
volume should increase as the market is going down, but if the volume is not
increasing and price is going down, then it is the accumulation phase
(Bottom of the market), the smart people are not selling any more.
As the bleeding stops, then prices keep going up and the bull market begins,
(Economic news are improving) the trend followers get in and the market
keeps going up.
Finally at the top prices are going up (News papers are publishing very good
stories, many cover stories), public speculation keep increasing, here the
smart money is selling. This is the distribution phase.
6. Price action determines the trend
In a bull market the peak of successive rallies should increase and also
the trough of the secondary movements should increase too. It means we
will see higher highs and higher lows in a bull market. The reverse is
correct in a bear market; we should see lower lows and lower highs in a
bear market.
Bear market example from (http://www.stockcharts.com/education)

“In a bear market the trend is down until a higher low forms and the ensuing
advance off of the higher low surpasses the previous reaction high. Below is a chart
of the Dow Jones Transportation Average in 1992. The line in figure-3 shows the
bear market trend. Since the peak in February, a series of lower lows and lower
highs formed to make a downtrend. There was a secondary rally in April and May
(green circle), but the March high was not surpassed. The DJTA continued down until
the high volume washout day (red arrow). After this high volume day, the DJTA
dipped again and then moved above 1250, creating a higher low (green arrow). Even
after the higher low is in place, it is still too early to call for a change in trend. The
change of trend is not confirmed until the previous reaction high is surpassed (blue
arrow”
Figure -3
Bull market example from (http://www.stockcharts.com/education)

“An uptrend is considered in place until a lower low forms and the ensuing decline
exceeds the previous low. Figure 4 shows a line chart of the closing prices for the
DJIA. An uptrend began with the Oct-98 lows and the DJIA formed a series of higher
highs and higher lows over the next 11 months. Twice, in Dec-98 (red circle) and
Jun-99 (blue arrows), the validity of the uptrend came into question, but the uptrend
prevailed until late September. There were lower highs in Jun-99, but there were
never any lower lows to confirm these lower highs and support held. Any bears that
jumped the gun in June were made to sit through two more all-time highs in July and
August. The change in trend occurred on September 23 when the June lows were
violated. Some traders may have concluded that the trend changed when the late
August lows were violated. This may indeed be the case, but it is worth noting that
the June lows represented a more convincing support area. Keep in mind that the
Dow theory is not a science and Hamilton points this out numerous times. The Dow
theory is meant to offer insights and guidelines from which to begin careful study of
the market movements and price action.
Figure -4
Looking at the line chart above (DJIA 1998/1999 daily close semi-log scale), it may
be difficult to distinguish between a valid change in trend and a simple correction.
For instance: Was a change in trend warranted when the December low penetrated
the November low? (red circle) After the November peak, a lower high formed in
December and then the November reaction low was broken. In order to eliminate
false signals, Hamilton suggested excluding moves of less than 3%. This was not
meant to be a hard and fast rule, but the idea is worth noting. With the increased
volatility of today's markets comes the need to smooth the daily fluctuations and
avoid false readings.”
7. The Averages Must Confirm.
One of the most important principles of the Dow Theory is that the Dow
Jones Industrial Average and the Transportation Average must corroborate
or confirm each other's direction for there to be a reliable market trend.
Confirmation example from (http://www.stockcharts.com/education)
”The Dow Theory stresses that for a primary trend buy or sell signal to be valid, both
the Industrial Average and the Rail Average must confirm each other. (Figure 5).
Figure - 5
Figure 5 above shows an array of signals that occurred

during a 7-month period in 1998.
1. In April, both the DJIA and DJTA recorded new all-time highs (blue line). The primary trend
was already bullish, but this confirmation validated the primary trend as bullish.
2. In July, trouble began to surface when the DJTA failed to confirm the new high set by the
DJIA. This served as a warning sign, but did not change the trend. Remember, the trend is
assumed to be in force until proven otherwise.
3. On July 31, the DJTA recorded a new reaction low. Two days later, the DJIA recorded a new
reaction low and confirmed a change in the primary trend from bullish to bearish (red line).
After this signal, both averages went on to record new reaction lows.
4. In October, the DJIA formed a higher low while the DJTA recorded a new low. This was
another non-confirmation and served notice to be on guard for a possible change in trend.
5. After the higher low, the DJIA followed through with a higher high later that month. This
effectively changes the trend for the average from down to up.
6. It was not until early November that the DJTA went on to better its previous reaction high.
However, at the same time the DJIA was also advancing higher and the primary trend had
changed from bearish to bullish.”
Additional Considerations:
It isn't necessary for both averages to cross at the same time. However, the
one should then follow the other not before too long. The Dow Theory does
not specify the time period. Generally, the closer the confirmation, the
following move will be stronger. As Pring points out, the 1929-32 bear
market signal the transportation confirmed Dow 1 day after. In the bull
market signal of 1962, the confirmation was made at the same day.
A criticism of the Theory is that many signals are too late, usually 20 to 25
percent after a peak or trough has occurred.
Some Dow Theorists make their move before confirmation according to

following rule of thumb:
If the dividend yield on the DJIA is getting close to 6% (prices must be very
low to that high a yield), this signals that we are close to a bottom.
The top is more difficult to pick. Some would say a dividend yield of 2-3 %
indicates that we are close to a top.
Figure 6 shows the DJIA and DJT from 1970 to November 2005. In
November 17th (when writing this lecture) the transportation has mad a new
high but the DJIA has not. It seems that the Dow will also soon make a new
high to confirm the bull market.
I am upgrading this lecture on December 30th 2006. Figure 7 presents both DJIA and DJT
from 1970 to December 30th, 2006. As you can see from figure 7, the Dow has made a
new high in December 2006, but this high is not confirmed by Transport. If within the
next two months, Transport can not make new high, according to Dow Theory A BEAR
Market will soon starts.
Figure- 6 Dow Jones Industrial Index and Dow Jones Transportation Index
Monthly Close: 1970 to November 18th, 2005.
Figure 7: Dow Jones Industrial Index and Dow Jones Transportation Index
Quarterly Close: 1970 to December 30th, 2006.
Finance 6364
Technical Analysis of Stocks and Commodities
Momentum Principles
Chapter 10
By Dr. M. Metghalchi
Oscillator indicators can provide useful insights by alerting traders of short-term market
extremes commonly referred to as overbought and oversold conditions.
Oscillators are usually constructed with lower and upper boundaries; such as 0 to 100
or -1 to +1, or -10% to +10% As Murphy (Pp. 226) points out, oscillator must be
subordinated to trend analysis.
Caution: if used as a trend following indicator, one should be careful when an oscillator
reaches extremely high or low values (relative to its historical values), you should assume
a continuation of the current trend and not that the trend will reverse. For example, if the
oscillator indicator reaches extremely high values and then turns down, you should
assume prices will probably go still higher if trend analysis indicates that the uptrend is
continuing. The best use of oscillators are in a non trending market and when the trend is
changing or reversing its direction.
Note: momentum is an application of oscillator. Please read pages 228-232 of your

textbook.
We have Price Momentum and Breath Momentum. The first type is constructed by
using price series and the second type is constructed by statistical manipulation of various
market components. In this chapter we discuss various price momentums (Oscillator) and
in chapter 18 we will discuss some Breath Momentums. For me, I use the term
momentum and oscillator interchangeably.
Rate of Change momentum
Rate of Change momentum, ROC, like the whole group of momentum oscillators
involves the analysis of the rate of price change rather than the price level. The speed of
price movement and the rate at which prices are moving up or down provide clues to the
amount of strength the bulls or bears have at a given point in time.
ROC can be calculated by dividing the day’s closing price by the closing price X number
of days or weeks ago and then multiplying the quotient by 100.
ROC = ((Today's close - Close n periods ago) / (Close n periods ago)) * 100
Some simply use difference of prices as a measure of momentum:
1
ROC = (Today's close - Close n periods ago)
Most people use the ratio version of the ROC momentum.
When ROC momentum is above the 100 reference line and rising, prices are increasing at
an increasing rate. If momentum is above the zero line but declining, prices are still
increasing but at a decreasing rate. Usually, a rising momentum is bullish and a declining
momentum is bearish. Another way of constructing ROC reference line is to subtract the
result above from 100 so that the reference line is the zero line.
Trading rules for any Oscillator or momentum indicators:
Overbought/Oversold: Using a scale for a particular indicator and defining the

overbought and oversold conditions (establish bands) for the scale, traders would sell
when the indicator is in the overbought zone and turns down and buy when the indicator
is in the oversold zone and turns up.
Trading rules for any momentum indicators:
Overbought/Oversold: Using a scale for a particular indicator and defining the

is in the oversold zone and turns up.
Example of Fedex stock taken from incrediblechart.com

Oscillator = ROC, (Rate of Change of Price) the band or overbought/oversold zone is
defined by plus or minus 10% around the zero line.
FedEx is plotted with 10 day ROC indicator and 21 day exponential moving average.
2
1. Go short [S, overbought] when ROC turns down above the overbought level.
Place a stop-loss above the recent High.
2. Go long [L, oversold] when ROC turns up from below the oversold level. Place a
stop below the latest Low.
3. Go short [S, overbought].
4. Go long [L, oversold]. This proves a false signal as price falls below the recent
Low - stopping out the position.
5. Go long [L, oversold] when ROC again turns up from below the oversold level.
6. Go short [S, overbought].
Another way of using any momentum indicator is by looking for higher lows, lower
highs, to determine positive and negative divergences.
Bearish divergence or negative divergence: when the price is making a new high but
this high is not confirmed by the momentum (Momentum is not making a new high) this
is a bearish divergence and is a signal to sell. Sometimes when the market is trending
very strongly, the first bearish divergence may not work; a conservative trader could wait
till the third bearish divergence to short the market.
3
The followings is taken from Pring.com (By permission). The concept of bearish
divergence (Or negative divergence is show in figure 3 of Pring.com)
Figure 3 shows how this works in practice. Point A marks the point of maximum
velocity, but the price continues to rally at a slower and slower pace until Point C. This
conflict between momentum and price is known as divergence, since the oscillator is out
of sync with the price. It is also called a negative divergence, because rising prices are
supported by weaker and weaker underlying momentum. The deteriorating momentum
represents an early warning sign of some underlying weakness in the price trend.
End of quote.
Example of Bearish divergence for Lucent stock in December 1999. As you

can see from figure 1 below (Generated from StockChart.com), during November,
4
Figure 1: Bearish Divergence
And December 1999 while Lucent stock price was making new highs, the 10 day ROC
momentum indicator was not confirming the highs in the stock price. This is a bearish
signal and an aggressive trader could in conjunction with other indicators or technical
analysis sell or short Lucent at that time.
Bullish divergence or positive divergence: when the price is making a new low but this
low is not confirmed by the momentum (Momentum is not making a new low) this is a
bullish divergence and is a signal to buy. Sometimes when the market is trending very
strongly, the first bullish divergence may not work, a conservative trade could wait till
the third bullish divergence to go long. In figure 2 below, we show the chart of Dow
Jones and 10 days ROC momentum indicator. As you can see in march of 2009, the Dow
made a new low but the 10-day ROC momentum did not confirm this low. This is an
example of bullish divergence that gave a buy signal on March 2009.
5
Figure 2 (Generated from advfn.com)
The concept of bullish divergence (Or positive divergence is show in figure 4 of

Pring.com)
Positive divergences, as shown in Figure 4, tell us that even though a price is

declining, it is declining at a slower and slower rate. In this instance, the technical
position is said to be improving, or getting stronger. Indeed, if you think a market is
in the process of reaching its bottom and you do not see a divergence, you may want
to reconsider your analysis, because most market bottoms are preceded by at least
one positive divergence.
Similarly, in the case of a negative-momentum divergence, a market observer

can see that the price is moving higher and higher. To him it would seem that
the trend is perfectly healthy. Indeed, the fact that prices are advancing gives a
misplaced sense of confidence. Yet, if he could see that the underlying
momentum is deteriorating, he would be far more inclined to sell. By the same
token, the driver of the car, aware from the din under the hood that some serious
trouble was developing, would be inclined to visit the repair shop or risk a
breakdown. Thus, if we accept the premise that a malfunctioning car is likely to
require more attention the longer an engine problem is ignored, then we should
6
agree that the greater the number of divergences an indicator shows, the more
serious the consequences of a reversal in trend when it inevitably takes place.
In Summary:
Bullish divergence:
Price is making a new low, but the indicators do not making new low.
(In a strong trending market, this will be repeated a few times, price
keeps making new lows but an indicator does not make new lows).
Bearish Divergence:
Price is making a new high but an indicator does not make the new
high. In a strong trending market, this will be repeated a few times,
price keeps making new highs but an indicator does not make new
highs).
7
SOME WIDLY USED OSCILLATORS:
RELATIVE STRNGTH INDEX (RSI)
The RSI indicator, one of the most popular indicators was invented by Welles Wilder, it
measures the velocity of directional movement. The name is somehow misleading, as RSI
does not compare the relative strength of different markets (Like Nasdaq versus S&P500
or Chevron versus Exxon), but rather, measures the internal strength of a single security
or future contract. The RSI indicator calculates a value based on the cumulative strength
and weakness of price, over a specific time period.
Note: RSI is a momentum indicator or an oscillator. (Oscillates around a number like 50)
RSI is an oscillator that compares magnitude of a stock's recent gains to the magnitude of
its recent losses. It is used to interpret the strength of a security or a future contract.
Calculation of RSI
RSI is a ratio of the upward price movement to the total price movement over a given
period of days (Wells Wilder suggested using 14). Suppose the number of days is N. The
calculation of RSI is described below.
AU = Average of x days’ up closes

AD = Average of x days’ down closes
AU
RS
AD
100
Then, RSI 100
1 RS
AU
Actually, RSI equals to 100 , so it is a number between 0 and 100.
AU AD
RSI ranges from 0 to 100. A security is considered overbought if the RSI approaches
above the 70 level (some people use 80 in a bull market). If it falls below 30 (or 20 in a
bear market), it is considered oversold.
8
The RSI curve of natural gas (NG) is illustrated in Figure-1 (created in www.advfn.com
on February 2005).
Figure-1: 14-day RSI of Natural Gas (NG)
Trading Rules with RSI
Overbought/Oversold: Using a scale for RSI indicator and defining the overbought and
oversold conditions (establish bands) for the scale, traders would sell when the indicator
is in the overbought zone and turns down and buy when the indicator is in the oversold
zone and turns up. Usually, in a bull market overbought is above 80 and oversold is
below 30. In a bear market, overbought is above 70 and oversold is below 20. In an up
trending market RSI stays most of the time above 50 and in a down trending market the
RSI mostly stays below 50.
Bearish divergence: when the price is making a new high but this high is not confirmed
by the RSI indicator. This is a bearish divergence and is a signal to sell. Sometimes when
the market is trending very strongly, the first bearish divergence may not work; a
conservative trader could wait till the third bearish divergence to short the market.
9
Bullish divergence: when the price is making a new low but this low is not confirmed
by the RSI. This is a bullish divergence and is a signal to buy. Sometimes when the
market is trending very strongly, the first bullish divergence may not work, a
conservative trader could wait till the third bullish divergence to go long.
It is helpful to use moving average, trendlines, support and resistance lines along with
the RSI chart. For example, one can identify the long-term trend and then use extreme
readings for entry points. An entry point is observed when the long-term trend is bullish
and the RSI is in oversold reading.
Centerline crossover is also used by many investors. The RSI centerline is the horizontal
line at 50. A RSI reading above the centerline indicates that average gains are higher than
average losses, and a reading below the centerline suggests that losses are winning the
battle. If the RSI move from below the centerline to above it, it is a bullish signal.
Similarly, a downward cross the centerline produces a bearish signal.
Using the same NG example, Figure-2 below shows multiple buy/sell signals given by
the above trading rules.
Notes on RSI
The selection of N (the number of periods used to calculate AU and AD). If a

smaller N is used, RSI will become more volatile and more often to hit extremes.
A longer term RSI fluctuates a lot less. The threshold level to use depends on the
sectors and future contract. Stocks in some industries will rise as high as 75-80
before dropping back, while others have a tough time breaking 70. A good rule is
to watch the RSI over the long term to determine at what level the historical RSI
has traded and how the stock of future reacted when it reaches those levels. For
daily data, most people use 14 days RSI. However, you make experiment 9, 18,
25 and 30 days RSI to see which one works the best for a particular market. For
weekly data, most people use 9 or 14 weeks RSI.
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Figure-2: Trading signals in 14-day RSI of NG
Big surges and drops in a security’s (future) price will dramatically affect the RSI
and can produce false buy/sell signals. Many investors agree that RSI is most
effective when it is combined with other technical indicators.
An Example for your term paper project using RSI:

You can back test the following mechanical trading system:
Buy days: you will be in the market (cover all shorts) as long as the RSI is equal or
greater than 50.
Short days: you will sell all ofyour portfolio and go short as long as the RSI remains
below 50
Moving Average Convergence Divergence (MACD)
MACD is a momentum of form of a trend deviation indicator. It is the difference between

two moving averages (MA). Usually these two moving averages are 26 and 12 days and
are calculated by using exponential moving average, however, other numbers than 26 and
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12 periods can be used. The MACD is calculated by subtracting the value of a 26-period
exponential moving average from a 12-period exponential moving average. A 9-period
simple moving average of the MACD (the signal line) is then plotted on top of the
MACD.
MACD = EMA(CLOSE, 12) - EMA(CLOSE, 26)

Signal Line = SMA(MACD, 9)
Where EMA is exponential moving average and SMA is simple moving average. The
signal line could be constructed by using EMA rather than SMA.
Trading Rules for MACD indicator.
Crossover signals. When the MACD line crosses the signal line from below that is a buy
signal, when the MACD crosses the signal line from above, it is a sell signal. Another
crossover signal occurs when MACD crosses above or below the zero line. If it move
above zero, it is a buy signal and when it moves below zero, it is a sell signal.
Overbought/Oversold: Oscillators usually oscillate around a number like zero and are
confined in the 0:1, or -1 band. But this is not true for MACD, it means that we can not
use it to find overbought or oversold conditions. However, if the shorter moving average
pulls away from the longer moving average dramatically (i.e., the MACD rises), it
indicates the market may be coming over-extended and is due for a correction to bring
the averages back together. The same can be said for the oversold condition.
Bearish divergence: when the price is making a new high but this high is not confirmed
by the MACD indicator. This is a bearish divergence and is a signal to sell. Sometimes
when the market is trending very strongly, the first bearish divergence may not work; a
conservative trader could wait till the third bearish divergence to short the market.
Bullish divergence: when the price is making a new low but this low is not confirmed
by the MACD. This is a bullish divergence and is a signal to buy. Sometimes when the
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market is trending very strongly, the first bullish divergence may not work, a
conservative trader could wait till the third bullish divergence to go long.
Example:
Figure 3 (Generated by StockChart.com) shows the buy signal for Merill Lynch chart. On top
of the chart we have MA12 and MA26. At the bottom of the chart, the bold black line is
the MACD line , the difference between MA12 and MA26, and the gray line is the signal
line (EMA(MACD, 9)). Note when the two MA crosses, the MACD line is zero.
Figure 3: MACD crossover signal
As you can see from Figure 3, when the MACD line crosses the signal line, the buy or
sell signal is generated. As usual, you should use the MACD indicators with other
technical indicators.
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Figure 3-a shows a sell signal for FedEx using MACD indicator. (Generated by
stockcharts.com). As you can see from figure 3-a, there is a bearish divergence (price is
making new high but the MACD is not making a new high) sell signal in late May/early
June. Also we see the bearish crossover at the same time and the histogram becomes
negative. In late June the indicator makes a lower low which is negative,
Figure 3-a
In both figure 3 and 3-a, the charts also show the MACD-Histogram; the MACD
Histogram plots the distance between MACD and its signal line. (The bars in figures 3&
3-a). Some day trades use the histogram signals (Buy if the bars above zero, and sell
when below zero; or go long/short as the bars turn direction), because these signals are
ahead of regular crossover or bullish/bearish divergence. When the histogram is around
zero, it means that the market is not trending and is ranging, in that case signals are not
very reliable.
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The Stochastic
Created by Dr. George Lane in late 1950s, the Stochastic Oscillator is a very popular
technical indicator that shows the location of a security’s current close price relative to its
price range over a given time period. The idea is that when a stock or future is trending
up, the price tends to close near the high of the day (on a daily chart), however, when the
trend is maturing the price closes away from the high of the day. When a stock or future
is trending down, the price tends to close near the low of the day (Daily chart), however,
when this down trend is maturing, the price tends to close away from the low of the day.
The Stochastic is shown as two lines. The main line is called %K. The second line, called
%D; the % D is a moving average of %K. The %K line is usually displayed as a solid line
and the %D line is usually displayed as a dotted line.
Calculation of the Stochastic

The basic calculation is called the raw stochastic (also known as %K) specifies the
relative position of the closing price within the range of the previous N days.
close (today ) lowest low of past N days
% K (Today ) 100
(high low) range of past N days
Where N is a given number that indicates the time period. Most people use a 14-day
stochastic, but N can be 9, 28, 33. It is tp to you what number to use. This % K is the first
line (Usually bold line).
A smoother version of the raw stochastic (%K) is known as %D, which is essentially the
moving average 3 of %K. An even smoother version is %D-slow, which is the moving
average 3 of %D. We therefore have two stochastic oscillators:
1. Fast stochastic ( %K and %D lines)

2. Slow stochastic (%K and %D-slow lines)
There are three parameters for the stochastic. The first is the number of period (N) used
in the %K calculation. The second is the number of periods of moving average used to
calculate %D, and the third is the number of period of moving average in %D-slow
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calculation. For example, a slow stochastic (14, 3, 3) is a slow stochastic that uses 14
periods to calculate %K and 3-period moving average for %D and %D-slow.
The value of the stochastic is within the range of 0 and 100. If the stochastic is above 80
(some people use 70 if it is not a strong bull market), the security is considered
overbought. If stochastic is below 20 (some people use 30 if it is not a strong bear
market), the security is considered oversold. If the market is trending up, the stochastic is
usually above 50 and when the market is trending down, the stochastic generally stays
below 50.
A slow-stochastic (14, 3, 3) chart is shown in Firgure-4 (Created in www.advfn.com).
Figure 4: Slow stochastic for S&P 500
Trading Rules with the Stochastic

.Overbought/Oversold: Using a scale for Stochastic indicator and defining the
is in the oversold zone and turns up. Usually, in a bull market overbought zone for
stochastic is above 80 and oversold is below 30. In a bear market, overbought is above 70
and oversold is below 20.
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Crossover signals. Crossovers of %K and %D generate buy/sell signals. The signal is
stronger when both %K and %D have extreme values. The rule is to buy when the %K
line rises above the %D line when they are in oversold area, and to sell when the %K line
falls below the %D line when they are both in overbought territory. However, crossover
signals occur frequently and may result in a lot of whipsaws.
Bearish divergence or negative divergence: when the price is making a new high but
this high is not confirmed by the Stochastic indicator. This is a bearish divergence and is
a signal to sell. Sometimes when the market is trending very strongly, the first bearish
divergence may not work; a conservative trader could wait till the third bearish
divergence to short the market.
Bullish divergence or positive divergence: when the price is making a new low but this
low is not confirmed by the Stochastic. This is a bullish divergence and is a signal to buy.
Sometimes when the market is trending very strongly, the first bullish divergence may
not work; a conservative trader could wait till the third bullish divergence to go long.
It is helpful to use moving average, trendlines, other indicators, support and resistance
lines along with the Stochastic indicator.
Given that crossover signals occur frequently and may result in a lot of whipsaws. Bullish
and bearish divergences provide more reliable signals. So as a trader, wait for the
oscillator to reach overbought levels, wait for a negative divergence to develop and then
go short. For a buy signal, wait for a positive divergence to develop after the indicator
moves below the oversold level. After the positive divergence forms, the second break
above the oversold level confirms the divergence and a buy signal is given.
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Figure-5: Stochastic signals
Using the same SP 500 example in Figure-4, many buy/sell signals can be found
according to the above trading rules (Figure-5).
StochRSI
In their 1994 book, “The New Technical Trader”, Tushard Chande and Stanley Kroll
explained that RSI sometimes trades between 80 and 20 for extended periods without
reaching overbought and oversold levels. Traders looking to enter a stock based on an
overbought or oversold reading in RSI might find themselves continuously on the
sidelines. To increase the sensitivity and provide a method for identifying overbought and
oversold levels in RSI, Chande and Kroll developed StochRSI that uses RSI as the
foundation and applies to it the formula behind Stochastics:
RSI (today ) lowest ow RSI of past N days
StochRSI
(highRSI lowRSI ) range of past N days
The stochRSI oscillator is between 0 and 1. The oversold level is usually set at 0.20 and
overbought level at 0.80. The trading rules used in the stochastic and RSI, such as
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overbought and oversold crossover, divergence, and centerline crossover, are used in
stochRSI.
All of the above indicators should be studied using daily, weekly, and monthly
charts. For day traders, these indicators can be used on 5, 15, 30, and 60 minutes
charts.
Average Directional Movement Index - ADX
The ADX indicator was developed by Welles Wilder in his book "New concepts in
technical trading systems". The ADX indicator helps to determine whether there is a
price trend. This indicator is based on the comparison of two directional indicators: the
14-period +DI and the 14-period -DI. The standard time period is 14 periods, although
other time span can be used. The calculations of DI’s are a bit complex, however, most
chart providers provides this indicator. Wilder suggests putting the charts of +DI and -DI
one on top of the other. Wilder recommends buying when +DI is higher than -DI, and
selling when +DI sinks lower than -DI.
There is additional indicator bases on +DI and –DI, namely, Average Directional
Movement Index (ADX). The ADX is an average of +DI and –DI over a specific period,
usually 14 periods; the ADX is constructed in such a way that it plots between 0 and 100.
A high reading of the ADX means that the stock or the future contract is in a trending
mode (Directional movement) whereas a low reading means that the stock or the future
contract are not trending (They are in trading range).
IMPORTANT NOTE: Unlike other oscillators, the ADX does not tell about the direction
of price (Up or down), it only implies whether the security is trending or not. In figure 6,
we generate the Japanese Yen chart (From Barchart.com) and the ADX indicator on
December 27, 2006. The violet colored line is +DI, the green line is –DI and the red line
is the ADX.
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Figure 6: +DI, -DI, and ADX for Japanese Yen
According to this indicator, one should go long when the violet line is above the green
line and go short when the green line is above the violet line. As you can see, the red line
(The ADX line) does not go to extreme high or low, indicating the price is not trending.
In figure 7, we generate the Euro currency chart (From Barchart.com) and the ADX
indicator on December 27, 2006. The violet colored line is +DI, the green line is –DI and
the red line is the ADX.
According to this indicator, one should go long when the violet line is above the green
line and go short when the green line is above the violet line. As you can see, the red line
(The ADX line) has gone to extreme in late November and early December of 2006,
indicating a trending price for the Euro currency.
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Figure 7: +DI, -DI, and ADX for Euro Currency
Note: some technicians believe that an extreme number for ADX line implies a change in
trend. But it is not clear whether the change in trend is from up to down or from up trend
to trading range (No trend or consolidation).
The Parabolic Indicator
Wells Wilder’s the Parabolic SAR is used to set trailing price stops. Parabolic SAR (Stop
and Reversal) Technical Indicator was developed for analyzing the trending markets. It is
a stop-loss system. The stop is continuously moved in the direction of the position. The
indicator is below the prices on the bull market (Up Trend), when it’s bearish (Down
Trend), it is above the prices. It is estimated as follow:
SAR(i) = SAR(i-1)+AF*(EPRICE(i-1)-SAR(i-1))
SAR(i-1) = value of the indicator on the previous bar;

AF = Acceleration Factor; default = .02; and is increased by 0.02 every time a new high
or a new low price is reached.
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The maximum AF value is 0.2.
EPRICE(i-1) = the highest high or the lowest low for the previous period.
(EPRICE=HIGH for long positions and EPRICE=LOW for short positions).
The Parabolic SAR is an excellent indicator for providing exit strategy. Long positions
should be closed when the price goes below the SAR line, short positions should be
closed when the price goes above the SAR line. It is often the case that the indicator
serves as a trailing stop line. Remember, a lot of money can be lost when you have a
position which is against the main trend. If you use this indicator you can avoid large
losses. Figure 8 shows the chart of crude oil (Generated by advfn.com) over the period of
March through December 2006.
Figure 8: Parabolic SAR
I would use this indicator as a stop on my position. For example, if I am long Crude oil,
as soon as this indicator tells me the trend is down (Red check mark sign) I will get out of
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my long position. On the other hand, if I am short Crude oil, as soon as this indicator tells
me that the trend may reverse (Green check mark sign) I will close my short position.
In the project icon, you can see a paper from one of my student from previous semester
who used the PSA for his mechanical trading system. He is working on the paper to
present it at a finance conference.
I could not program the PSAR in Excel, if you are expert with Excel programming and
you think you can program the PSAR formula and gets its value, I appreciate if you let
me know how to do it. You get a bonus if you do it. Other indicators beside +/-DI (RSI,
Stochastics, MACD are easy to estimate using Excel).
ON Balance Volume (OBV)

OBV was introduced by Joe Granville. This was one of the first and most popular
indicators to measure positive and negative volume flow. OBV Technical Indicator is a
momentum technical indicator that relates volume to price change.
Calculation
OBV is calculated by adding the day’s volume to a running cumulative total when the
security’s price closes up, and subtracts the volume when it closes down.
Example:
If today the closing price is greater than yesterday’s closing price, then the new
OBV = Yesterday’s OBV + Today’s Volume
If today the closing price is less than yesterday’s closing price, then the new
OBV = Yesterday’s OBV – Today’s Volume
If today the closing price is equal to yesterday’s closing price, then the new
OBV = Yesterday’s OBV
This OBV line can then be compared with the price chart of the underlying security to
look for divergences or confirmation.
How OBV is used:
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The concept is: volume precedes price. This means that a rising volume can indicate
the presence money flowing into a security. A rising (bullish) OBV line indicates that the
volume is heavier on up days. If the price is also rising, then the OBV can serve as a
confirmation of the price uptrend. We can conclude that the rising price is the result of
an increased demand for a security. However, if the prices are moving higher while the
volume is dropping, the OBV line does not confirm the new high in volume, a bearish
divergence is present, which suggests that the uptrend in price is not healthy and should
be taken as a warning signal that the trend will reverse.
Example of divergence.
Intel Corporation plotted with On Balance Volume. (Generated by exclusivechart.com)
Figure – 4
Looking at figure 4, we can observe the followings
1. Price trades in a range during March before a bearish divergence occurs. The
signal is fairly weak - price makes an equal high while On Balance Volume
makes a lower high.
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2. The signal at [1] appears to have been incorrect - price rises to a higher peak -
but a far stronger triple divergence (price makes a higher high while OBV makes
a lower high) signals weakness.
3. A further bearish divergence occurs - price makes an equal high and OBV makes
a lower high. Shortly thereafter price falls sharply.
If you can remember from previous discussions in chapter 11 on momentum indicators, I

warned you that sometimes when a market is trending very strongly, the first bullish
(bearish) divergence may not work, a conservative trader could wait till the third bullish
(bearish) divergence to go long (Short). The above example is a case in point, the first
two bearish divergences are not working, however, the third one is a good point to short
the market.
Accumulation/Distribution Line
The Accumulation/Distribution Line (ADL) was developed by Mark Chaikin. Similarly to the
OBV, ADL is another popular volume indicator using the volume-precedes-price concept. The
ADL indicator is a variant of the OBV indicator. They are both used to confirm price changes by
means of measuring the respective volume of sales.
Calculation
The value is calculated based on the location of the close, relative to the range for the
period. This value is called the “Close Location Value” or CLV. It ranges from plus one
to minus one with the center point at zero.
The CLV is then multiplied by the corresponding period's volume, and the cumulative
total forms the Accumulation/Distribution Line.
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Trading signals
The strongest signals on the Accumulation/Distribution line are based on divergences:
Go long when there is a bullish divergence.

Go short when there is a bearish divergence.
Stop-losses should be placed below the most recent low (when going long) and above the
latest high (when going short).
Figure 5 and 6 (Generated by stockchart.com) present an example of the bullish and bearish
divergences for Alcoa and Delta Air Lines stocks. As you can see from figure 5,
Figure 5: Bullish Divergence
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The A/D line forms a bullish divergence over several months. From August to
November, the stock price was going down whereas the ADL was going up. The stock
price finally caught up with the A/D line when it broke the resistance line in November.
In figure 6, during the June-July rally, the stock recorded a new local high, but the
Accumulation/Distribution Line failed to confirm the new local high, thus setting up the
negative divergence.
MONEY FLOW INDEX (MFI)
The Money Flow Index (MFI) is a volume-weighted momentum indicator that measures
the rate at which money is invested into a security and then withdrawn from it. It is
27
related to the Relative Strength Index, but where the RSI only incorporates prices, the
Money Flow Index accounts for volume. It compares "positive money flow" to "negative
money flow" to create an indicator that can be compared to price in order to identify the
strength or weakness of a trend. The MFI is measured on a 0 - 100 scale and is often
calculated using a 14 day period (Stockcharts, 2006)
Signals:
The common interpretation of the MFI is similar to the RSI in that readings above 80
imply overbought while readings below 20 imply oversold. MFI can also be used to
imply reversals, when prices trend higher and the MFI trends lower (or vice versa), a
reversal may be imminent.
Formula :
The "flow" of money is the security and its volume shows the demand for a security at
certain price. The money flow is not the same as the Money Flow Index but rather is a
component of calculating it. So when calculating the money flow, we first need to find
the average price for a period. Since we are often looking at a 14-day period, we will
calculate the typical price for a day and use that to create a 14-day average.
The MFI compares the ratio of "positive" money flow and "negative" money flow. If
typical price today is greater than yesterday (uptick), it is considered positive money and
if typical price today is lesser than yesterday(downtick) it is considered negative money
flow. For a 14-day average, the sum of all positive money for those 14 days is the
positive money flow. The MFI is based on the ratio of positive/negative money flow
(Money Ratio).
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Money Flow Index (MFI) = 100 - (100/(1 + Money Ratio))
The fewer number of days used to calculate the MFI, the more volatile it will be.
Trading rules: The MFI can be interpreted much like the RSI in that it can signal
divergences and overbought/oversold conditions.
Figure 7 (Generated by stockchart.com) shows example of overbought/oversold
conditions for People Soft and figure 8 shows bearish divergence for Washington Mutual
stock using MFI indicator. Overbought conditions in September resulted to a minor
correction and in January resulted in reversals of the uptrend, and the oversold condition
in March resulted in a minor correction.
Figure 7: Overbought/Oversold Concept
29
Figure 8 shows how the MFI bullish/bearish divergences can be used to anticipate trend
reversals. If prices are trending upwards and the MFI is trending downwards, reversals
such as those December and March may occur. However, divergences between price and
MFI can exist for long periods of time. Therefore, as with all indicators, the MFI should
be used in combination with other indicators that can provide confirmation of any signals
it sends.
Chaikin’s Money Flow (CMF)

Developed by Marc Chaikin, the Chaikin Money Flow oscillator is calculated from the
Accumulation/Distribution Line that we saw above. CMF argues that buying support is
normally signaled by increased volume and frequent closes in the top half of the daily
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range. On the other hand, selling pressure is evidenced by increased volume and frequent
closes in the lower half of the daily range.
Chaikin Money Flow is calculated by summing Accumulation/Distribution for 21 periods

and then dividing by the sum of volume for 21 periods.
Trading Signals: When CMF is greater than zero, it is bullish and when it is negative it
is bearish. In addition the concept of bullish/bearish divergence can be applied to CMF.
Williams PRO-GO Indicator

This indicator has two lines. The Public Buying (green line) and the Professional Buying
(red line). I really like this indicator, it give great buy and sell signal.
This technique is to create two Advance/Decline lines.
The Public Advance/Decline line is constructed by using the change from

yesterday's closes to today's open.
The Professional Advance/decline line is constructed by using the change from
today's open to today's close.
The lines are calculated by taking a moving average, usually 14-days, of the results.
This study can be used on daily charts or weekly charts like all other indicators. The
common interpretation of this study is if the Professional line (red) goes below the Public
line (green) it is a sell signal and if the Professional line (red) goes above the Public
line (green) it is a buy signal.
Figure 9 (Generated from Barchart.com) shows the chart of DJIA and Euro currency
from July to December 2006. Below the price chart, the 14-day Pro-Go indicator is also
drawn. According to this indicator, as long as the Red Line (Professional A/D line) is
above the green line (the public’s A/D line) a trader should stay long. And when the Red
line goes below the green line one should go short. In Figure 9, since the DJIA was
trending strongly, the Pro-Go did not generate many signals. However, for the same
period, the Euro has generated a few buy and sells signals. Again, we emphasize that this
indicator should be used with combination of other indicators.
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Figure 9
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VIX - CBOE Volatility Index:
The following definition is taken from: (http://www.investopedia.com)
Vix is “The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility
Index, which shows the market's expectation of 30-day volatility. It is constructed using
the implied volatilities of a wide range of S&P 500 index options. This volatility is meant
to be forward looking and is calculated from both calls and puts. The VIX is a widely
used measure of market risk and is often referred to as the "investor fear gauge".
There are three variations of volatility indexes: the VIX tracks the S&P 500, the VXN
tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average.”
So VIX is a volatility gauge or investors sentiment. You can trade vix in the
future market or as an option trader.
Many investors use VIX as a contrarian indicator to gauge the market direction. The
higher the VIX value, the more panic there is in the market. The lower the VIX value, the
more complacency there is in the market. A Prolonged period of low VIX values indicate
a high degree of complacency and are generally regarded as bearish. Some investors view
readings below 20 as very bearish. On the other hand, prolonged period of high VIX
values indicate a high degree or nervousness or even panic among options traders and are
regarded at bullish.
The following chart of the S&P 500, SPY (Top part of the chart), taken from:
http://www.onlinetradingconcepts.com/TechnicalAnalysis/VIXVXN.html
33
Shows the general inverse relationship between S&P500 and the VIX volatility index,
bottom half of chart. In figure 11, I generate the VIX chart usingStockcharts.com.
Figure 10
As you can see, the VIX has been very high in the first quarter of 2009
which corresponded to low of stock market. As the VIX cam down from
March to June 2009, the stock market went up.
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Average True Range (ATR):
ATR shows the volatility of the market under consideration. Developed by Welles Wilder
in his book "New concepts in technical trading systems”. Extreme levels (both high and
low) usually predict turning points and prices will reverse direction soon. Also a
prolonged periods of low volatility implying low ATR values are followed by large price
moves.
Estimation:
The True Range is defined as the largest difference of:
Current high minus the current low.

The absolute value of the current high minus the previous close.
The absolute value of the current low minus the previous close.
The ATR then is estimated as a moving average of the True Range over a series of days,
usually, 14-days.
Some investors use the ATR indicator to establish a trailing stop that is based on the
volatility of the security.
Stop when the price falls 1*ATR or 2*ATR below the recent maximum. Most use
2*ATR in order to avoid whipsaws.
Important consideration is that the ATR does not predict the market direction but it gauge
market volatility. And from market volatility some investor can conclude price
movements.
Figure 11 (Taken from: http://www.incrediblecharts.com/technical/average_true_range.php) shows

Microsoft Corporation chart with 14 day exponential moving average of Average True
Range. Here are the observation from Incrediblechart.com:
1. Average True Range peaks before price bottoms.

2. Low Average True Range readings - the market is ranging.
3. Average True Range peaks before the market top.
4. Average True Range peaks after a secondary rally.
5. Average True Range peaks during the early stages of a major price fall.
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Figure 11
A general note on oscillators:
i. In my view and also in Pring’s view, the strongest interpretation of

oscillators is their use of bullish/bearish divergence and not
overbought or oversold interpretation. Also, please remember that
in a strong trending market, the first bullish/bearish divergence
usually will not work if using the daily chart, a conservative trader,
usually should wait for the third signal in a trending market if
using daily chart. Personally, for my retirement account, I look at
weekly charts and move funds between equity and Treasury
Inflation Protect bond or money market funds. When weekly charts
are over bought (oversold) with bearish (bullish) divergence, in
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combination with daily chart to time the intermarket transfer, I
usually trade between 3 to 5 times in my retirement account
looking basically at weekly chart.
ii. Here is an example of looking at weekly charts of Dow Jones:
Looking at the above chart, there is many negatives around the end of 2007
and again around may 2008.
Around end of 2007, the Dow has made a new high and none of the
indicators confirmed this new high, MACD did not conformed, RSI neither,
stochastic neither. So around this high, one could move par5t of retirement
equity money to a bond found. If the new high is taken, and indicators would
confirm, then one could go back to equity.
The negative signal around May 2008 is even better; all of moving averages
have been turned down, and the price coming back to MA40 week, this is
37
the time to get out of the equity market, if not all, at least 50% should be
taken out of equity. Wait till the MAs turn up with bullish divergence to get
gradually back to market.
38
Finance 6364

Chapter 4
Basic Concept of Trend
By Dr. Massoud Metghalchi
Whether you invest in futures, stocks, bonds, mutual funds, or options, first
you always need to understand the primary trend. Remember “trend is your
friend”.
Almost all successful trading requires the determination of the market’s

prevailing trend. Is the primary trend up or down?
Is the market involved in secondary counter trend or choppy sideways

action? Making these determinations (for the short-, mid- and long-term) is
very important for successful trading.
As you know from the Dow Theory chapter the “primary trend” is a long-
term trend that usually last for several months (9 months) to 2-4 years.
Knowing what the current primary trend is allows you to trade with the trend
and caution you “Do not play against the market”.
The technicians look for a trend in their charts. Chart analysis is based on the
theory that prices tend to move in trends, and that past price behavior could
provide clues to the future direction of the trend.
The easiest trend determination is a trendline construction. Schabacker

defines (Technical Analysis and Stock Market Profits by Richard
Schabacker) a trendline as follow:
"a trendline is a straight line drawn on a chart through or

across the significant limits of any price range to define the
trend of market movement”
As Pring points out, in order to construct a trendline in a rising market, you

connect a series of rising bottoms by a straight line, this line becomes your
support line in a rising market. Figure 1 depicts a simple trendline for a bar
chart.
1
Trend line
is broken.
Figure-1: Simple Trend Line
In order to construct a trendline in a declining market, you connect a series

of declining tops by a straight line; this line becomes your resistance line in
a declining market. Figure 2 depicts a simple trendline in a declining market.
We could construct short term trendline (60 minute chart), intermediate

trendline (daily chart) and long term trendline (weekly chart). However, the
primary trend is seen best if you use weekly or monthly charts.
For example on November 22, 2005 I have constructed two trendlines for
DJIA 60 minutes chart (Figure 3). I have two support lines (or redraw
trendline as market evolves). These are short term trendlines because I am
using 60 minutes bar chart. (Advfn.com was used to generate the chart).
2
Trenline is
broken
Figure – 2
Figure 3
3
TECHNICAL PRINCIPLES: constructing trendline is an art not a science.
Figure 4 shows the daily chart of DJIA constructed on

11/23/05 (Advfn.com was used to generate the chart). As you can see from this chart,
I have drawn three trendlines. The first one (July-September) represents a
resistance line (trendline can be horizontal). The second one (September –
October) is a down trendline (secondary or intermediate reaction). The third
one (October – November) is an upsloping trend line. The down trendline
was broken in early November, one would cover his/her short and go long
Figure 4
In Figure 5, I have drawn the weekly chart of DJIA (Advfn.com was used to generate
the chart) on November 23, 2005. As you can see from this chart, there are few
trendlines. The first parallel lines (2003 – Early 2004) defines support and
resistance line of the primary movement (lasting more than a few months).
From March 2004 to October 2004, the parallel lines define the support and
resistance of the Secondary (intermediate) trend. From October 2004 till
4
March 05, Dow moved up without a trendline and made a double top on
March 2005 (or M formation). From March 2005 till November 2005, it
seems that Dow is consolidating. If Dow can break the high of March 2005
(10,985) convincingly, then it is possible we could have another up trend. In
that case, I would consider the whole price action from Early 2004 to
November 2005 as a consolidation (secondary reaction). At the time of
writing (November 23, 2005), DJIA closed at 10,916 with today high of
10,950.
Figure 5
NOTE: Trendline can also be drawn on line or candlestick chart. For

example Figure 6 shows monthly candlestock chart for DJIA From 1995 to
2005. (Advfn.com was used to generate the chart). Figure 5-a is also a weekly
candlestick chart taken from ExpressTrade. Figure 5-a is similar to Figure 5.
5
Figure 5-a
6
Figure 6
TRENDLINE BREAKS:
Trendline breaks have two interpretations:
1. A break of trendline could mean the end of the trend. This shown in
Figure 6 by line A. As the trendline A is broken, the trend is over.
2. A break of trendline could also mean a CONTINUATION pattern.

Line B in Figure 6 presents a continuation trendline break; this time
the trend does not reverse but it still it is up, however, the price is
moving up at a reduced rate.
Unfortunately, we cannot tell at the time of break whether it is a reversal

break or a continuation break. However, if the slope of the trendline is very
steep, probably the first break is a continuation break. Also looking at other
indicators that we will learn in later chapters can guide us whether the break
is a reversal or a continuation break. All these discussions also apply in a
bear market down trendline.
7
NOTE: If a trendline is broken (reversal), then after the break, this trendline
becomes the resistance line. For example in Figure 7, the beginning of the
line is the support line, but after it is broken (reversal), the line becomes the
resistance line.
Figure 7
Figure 7
TREND INTERPRETATION:
As we mentioned above that we cannot tell at the time of break whether it is

a reversal break or a continuation break, we can however interpret its
significance. As Pring points out, a trend significance depends to the
following three factors:
1. The length of time the trend is being made

2. The number of time the trend has been touched
3. The slope of the trendline
The longer the trend, the more important it is. If a few week’s trend is
violated it is less important than if a two years trend is violated. Big trend
results in important signal whereas small trend results in minor signal.
8
The more the trendline touches prices, the more significant will be its
violation. Each time the price reaches its support (trendline) the buyers come
in and the trend continuous.
A very steep trendline will sooner or later be broken; therefore, a break of

steep trendline usually does not mean that the trend is over. A new trendline
should be redrawn with smaller slope (see Figure 6). The break of steep
trendline is continuation rather than reversal.
OTHER FACTORS:
Thomas A Meyers (The Technical Analysis Course, MC Graw Hill, 2003)

discusses the following factors to decide on the Validity of trend line
penetration:
1. The extend of penetration: How far do prices should move before we

call it a valid break? It depends to the volatility of the security. Most
technicians apply a one (less volatile) to three (more volatile) percent
rule from the trendline
2. Some technicians use a filter. For example, if price closes above a
downsloping line or below a up trendline for two days in a row, it is
viewed as a valid penetration.
3. On occasion, prices will break a trendline on intraday basis (but not at

the close of the day). Is this a valid break? No, most technicians look
at the closing price for trendline penetration. (However, one could
redraw the trendline).
4. The validity of break is enhanced if it is accompanied by extending

volume; however, it is not essential.
Also looking at other indicators (Stochastics, RSI, MACD, Moving

Averages, etc..) that we will learn in later chapters can guide us to determine
whether the break is a valid break.
Trading Strategies for Long Positions:
1. Go long when the price closes above the downtrend line

2. Go long as soon as the price penetrates the downtrend line
9
3. Go long in a bull market every time price comes down toward the
trendline.
The exit for the above strategies would be to get out of your position if price
breaks below the trendline as soon as possible or at the close of the day.
Trading Strategies for Short positions:
4. Go short when the price closes below the uptrend line

5. Go short as soon as the price penetrates the uptrend line
6. Go short in a down market every time price comes up toward the
trendline.
The exit for the above strategies would be to get out of your position if price
breaks above the trendline as soon as possible or at the close of the day.
MINIMUM PRICE EXPECTATION AFTER A BREAK OF A

TRENDLINE:
In figure 8, we measure the maximum vertical distance from the trendline

(AB). After the trend breaks, the minimum price objective would be C. C is
AB length (distance) lower from the breaking point. This C is the minimum
price objective, but it could go lower. If you short the market when price
goes below the trendline, you could cover your short when price reaches C.
The same principle applies if the trendline is downsloping, we could deduct
a minimum price objective if the price breaks above the down trendline.
TREND CHANNELS:
Many times, prices repeatedly move approximately the same distance away
from a trendline before returning to the trendline. In an up trendline, when
we connect the peaks of rallies, then we have a line that is parallel to the
trendline and this line is called a Return line or channel line, see figure 9 for
uptrend channel and figure 10 for downtrend channel.
Trend channel can be used in couple of ways:
1. Sell when prices are near the upper channel line, buy when price is about
lower channel line.
10
Figure 8
Figure 9
2. In an uptrend channel, if prices break above the upper channel, it means

the price advance has begun to accelerate (buy). In a downtrend channel, if
11
prices break below the lower channel line, it means the price decline has
begun to accelerate (sell).
Figure 10
CAUTION: There could be false signal: For example, figure 11 (taken from
http://www.stockcharts.com/education/ChartAnalysis/priceChannel.html) shows a false
Figure 11
12
Break out for Chevron Texaco in February-Mach 2000. A false break out
usually is accompanied with high volume and signal a major reversal. In
figure 11, if we assume that the breakout is false, then its significance would
be that the downtrend in Chevron Texaco is over. Therefore, a breakout in
the direction of the channel has two interpretations:
1. Prices are over extended; this implies a major reversal (false break).
2. Prices are at the beginning of a runway market.
Therefore, we should evaluate these breakouts in context of other indicators

and studies and time frame to gain clues about the true market conditions.
A third way to trade a channel or trend is when the break occur, we should
wait for the market to make a reaction back to the channel (usually it
happens) and then take a position as the price comes back toward the
original breakout.
Usually, breaking out from a horizontal channel is very profitable. During

the horizontal duration, the price has consolidated and when it breaks out, it
means it has ways to go in the direction of break (except false break).
In chapter 15 we will discuss more on trends, especially speed resistance fan

lines and Fibonacci numbers.
Summary:
We have three types of trends:
1. Major or primary trends - is a long-term trend that usually last for

several months (9 months) to 2-4 years. The price rise or decline is at least
20% for this trend. When the primary trend is up, this is called a bull market.
When it's down, it's referred to as a bear market.
2. Intermediate or secondary trends - Secondary (intermediate trend)

or correction movements, which take place from weeks to months. These run
contrary to the primary trend. These counter trend movements generally
retrace from 25%, 33% to 62 % (occasionally 100%) of the primary price
change. A secondary trend could be an intermediate decline during a bull
market or an intermediate rally during a bear market.
13
3. Minor trends - brief fluctuations (One to three weeks). These are
random fluctuations without any meaning.
Note: A secular trend is the longest possible trend that last a few decades
and composed of many primary and secondary trends. (Example is the bull
market in stocks from 1982 to 2000).
Excerpts from an interview with Bob Prechter, the Editor of Elliott Wave
International (Taken from Elliottwave.com on 11/23/05).
“Will you at least admit that professional traders have an unfair advantage because they
have instantaneous access to resources that part-timers and amateurs do not?
Bob Prechter: Think a minute. Isn't that the case with every business? Why would anyone
expect a professional commodity trader to trade as poorly as does the general public? So they
have an advantage, but it is not an "unfair" advantage.
Even then, there are several points to make. First, if anyone would like to become a professional,
he or she can choose to give up regular life and crawl into the pits with the professional traders,
thereby gaining all the latest "information." Secondly, the "information" a professional trader gets
is, nine times out of 10, erroneous or misleading or irrelevant to the trend of the market. Finally,
even a cursory examination of commodity charts shows a remarkable propensity to trend, and
split-second timing is really unnecessary. If you call the trend right, you'll make money.
If you make a lot of casual assumptions about hot, up-to-the-minute "information" without
studying the way markets act, you'll deserve to lose every penny you put at risk. In fact, it's long
been shown that the in-and-out trader who relies on the latest news flash has the worst results.
Many so-called insiders blow themselves out in just that way.”
SUPPORT AND RESISTANCE
In their classic book Technical Analysis of Stock Trends, Edwards and

Magee define support as buying a stock or future in sufficient volume to
halt a downtrend in prices for an appreciable period. While resistance is
defined as selling a stock or future sufficient in sufficient volume to stop
prices going higher for a time.
The following is taken from Pring.com
Quote:
Think of resistance as a temporary ceiling and support as a temporary floor, as

illustrated in Figure 2. In order to become a floor, a support area must represent
14
a concentration of demand. I emphasize the word concentration because supply
and demand, by definition, are always in balance. At whatever price a stock
trades, there will always be the same amount bought as is sold. It is the relative
concentration or enthusiasm of either buyers or sellers that determines the price
level. A support area, then, is one in which sellers become less enthusiastic or
less willing to part with their assets and buyers, at least temporarily, are more
strongly motivated.
End of quote.
PROPORTION TECHNIQUE:
Support and resistance should tell us where a trend may temporarily be

halted or be reversed, the principle of proportion can also do the same when
support or resistance cannot do the job (Like new price area where there is
no support or resistance). Two of the most important ratio principles are the
Gann Fans and Fibonacci ratios.
Fibonacci ratios
Nothing will move straight forward. All major trends will have corrections
or retracements. The most important retracement that technicians look is the
Fibonacci ratios. In order to find the Fibonacci ratios, let’s look at the
Fibonacci numbers: You add the last two numbers or two adjacent numbers
and you get the followings:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 and so on are known as Fibonacci

numbers.
15
After the first couple of numbers, the ratio of each number to its next higher
is .618 (61.8 %). The ratio of each number to its next lower is 1.618.
Keep these two numbers in mind for forecasting. Also look at following
numbers for retracements:
.618 * .618 = .382 or 38.2 %

Square root of .618 = .786 or 78.6 %
1.618 - .618 = 1 or 100 %
Or 1.618 * .618 = 1 or 100 %
1 - .618 = .382 or 38.2 %
1.618 * 1.618 = 2.618 or 261.8 %
1 divided by 2 = .50 or 50 % (using second and third Fibonacci numbers)
3//13 =5/21 = 8/34 = 13/55 = .238 or 23.8 %
To summarize, according to Fibonacci ratios, the retracements or the
correction will stop at the followings:
• 23.8 %
• 38.2 %
• 50 %
• 61.8 %
• 78.6 %
• 100 %
•
Therefore, in order to forecast the end of a correction or retracement we take
two extreme points, a peak and a trough on a security chart, and dividing the
vertical distance by the above key Fibonacci ratios of 23.6%, 38.2%, 50%,
61.8%, 78.6% and 100%. Most people use 38, 50, 62 %. Once these levels
are identified, horizontal lines are drawn and used to identify
possible support and resistance.
The direction of the previous trend would probably continue once the
price of the security has retraced to one of the ratios listed above.
Figure 12 (Taken from: http://www.tradingday.com/c/tatuto/funwithfibonacci.html) shows how

Fibonacci numbers are used to find resistance for Telllabs stock.
16
Figure 12
Figure 13 (Taken from: http://www.tradingday.com/c/tatuto/funwithfibonacci.html) shows how

Fibonacci numbers are used to find support for Compaq stock.
Figure 14 (Taken from: http://ensignsoftware.com/tips/tradingtips39.htm) shows how

Fibonacci numbers are determined for Xilinx stock.
Point A in figure-3 is the high ($92) and point C is the trough ($35). When
price bounces back from the low of $35, the next resistance is determined as
follows:
First resistance: ($92 - $35 = $57 * 23.8 =13.57 + 35 = $48.57).
Second resistance: ($92-$35 = $57 * 0.382 = $21.77 + $35 = $56.77).
Third resistance = ($92-$35 = $57 * 0.50 = $28.5 + $35 = $63.50).
17
Figure 13
Figure 14 - Xilinx, Inc. (XLNX)
18
FIBONACCI FANS (Speed Resistance Lines):
To draw Fibonacci fans we first find two extreme points, one

trough and one peak. Then we draw a vertical line through
the second extreme point (The peak). This vertical line
presents 100 percent. Then we mark on this vertical line the
Fibonacci levels of 38.2%, 50%, and 61.8% . The next step
would be to draw three lines from the first extreme points to
the vertical line at the Fibonacci levels and extend them.
For example figure 15 (Taken from:

http://www.metaquotes.net/techanalysis/linestudies/fibonacci_fan)
shows construction of
Fibonacci fans. The bottom of the red line is the extreme
point 1 and the top of the red line is the extreme point 2.
From extreme point 2, you draw an imaginary vertical line
and mark three Fibonacci levels on it. Then from extreme
point 1 you draw three lines to those marks and extend
them. This way you can forecast support and resistance in
the future.
19
Figure 15
Figure 16
20
Figure 16 (Taken from: www.fibonaccisolution.com/fibonacci_studies.doc) also shows fan
lines that are drawn using two extremes (blue circles). The fan lines will
determine support and resistance in the future.
Another important proportion principle is the concept of Gann Fans.
Gann Fans
W. D. Gann (1878-1955) was a famous commodity trader in early 1900s.

The concept of Gann fans is similar to Fibonacci fans of previous section.
Gann postulated that geometric patterns and angles had unique
characteristics that could be used to predict price action. The most important
concept of Gann was that a 45-degree angle was perfect balance between
price and time. The characteristic of 45 degree line for a security chart is that
the distance between the price and the time is the same (arithmetic scale).
This 45-degree line is called 1 x 1 trend line or angle. The 1 x 1 or the 45-
degree line being the most important line, 8 other lines are also advocated by
Gann, four larger than 45 degree and four smaller than 45 degree as follow:
1 x 2 or 63.75 degree (1 for time scale, 2 for price scale)

1 x 4 or 75.00 degree

Note: some people’s notation could be different, for example 1 x 2 could be:
2 x 1 or 63.75 degree (2 for price scale, 1 for time scale).
Gann fans (angles) are drawn between a significant bottom and top or a
major high and low at the above 9 angles.
Gann felt that the 1 x 1 or 45-degree fan line provides major support during
a bull market; when this 45-degree line is broken, according to Gann it
signifies a major reversal in the trend.
21
On the other hand, during a bear market prices are falling and are below the
downward sloping 1 x 1 or 45-degree line.
Practical way of drawing the Gann lines: we first locate or observe a major
top or a major bottom, let's assume it's a major bottom, we then draw a 45
degree line that increases by one unit of price for every one unit of time.
Then we draw the other 8 Gann lines from that point, then draw these Gann
fan lines at the above degree.
Note: in order for the values of angles (e.g., 1 x 1, 1 x 8, etc.) to match the actual angles in
degrees, the x- and y-axes must have equally spaced intervals, in other words one unit on the x-
axis must be the same distance as one unit on the y-axis. Most char providers calibrate the chart
in such a way that a 1 x 1 angle produces a 45 degree angle.
For example Figure 17 (Taken from: http://www.dd.bib.de/~ai11rich/taaz/gannangles.html) shows

various Gann fans for S&P500 at a major low.
Gann advocated that each of these angles can provide support and resistance
depending on the trend.
Figure 17
Another way of finding support and resistance would be to place a Gann fan
on the relevant high AND on the most relevant low. This will give you one
Gann shooting up and another shooting down.
22
Figure 18 (Taken from: http://www.macleanreport.com/ccchapters/42_gann_fan.html ) shows Gann
lines from the relevant high AND on the most relevant low.
Figure 18
Figure 19 is taken from www.tradersnetwork.com: Hello Massoud,
Trader's Network gives authorization to make reference John Crane's

"Advanced Swing Trading" for the Reversal Date timing system and Joe
Kellogg's technical analysis in the Traders Market Views (TMV)
newsletter. This also includes authorization to access our web site
link,www.tradersnetwork.com for the Traders Market Views (TMV)
newsletter andReversal Date updates. Please send me an email for
confirmation, including University of Houston letter head and class
name in which this will be used with your name as the instructor.
Thank you for your interest in Traders Network.
Jeff
23
Traders Network
Jeff Staley
Office 800-521-0705
Local 970-663-5016
Fax 970-663-1767
E-mail <mailto:Jeff@tradersnetwork.com>
Web Site <http://www.tradersnetwork.com/>
MARCH SILVER (12/15/06)

The fund buying we’d expected late last week hasn’t materialized yet, and if we don’t see it by Friday, one would have to
wonder if that’s it…the top?
FEBRUARY GOLD
The 1 X 1 Gann support line is at $620.00 and a correction down to that level should generate buying interest.
24
MARCH JAPANESE YEN
I had projected a rally to 89.12 and I was wrong. Friday’s steep decline pushed the market down to 87.00.
MARCH WHEAT
Cancel winter! Reports of spring-like conditions along the Austrian Alps where green, not white, cover the slopes has
some wondering if winter will be cancelled this year. But the drought in Europe may threaten more than the ski industry.
With reduced world wheat stocks and drought conditions in Australia, China and Europe, wheat could become the new
gold. A few weeks ago, I had recommended buying wheat on a dip to 4.75. I missed it then, but wheat is again correcting
25
—closing today at 3.90, and that 4.75 buy order still looks good.
MARCH CORN
Technically, one might look at this market and conclude that it’s topped. I’m not one of those folks, not as long as those
‘Long Only’ index funds continue buying. Yes, there’ll be corrections, but the smarter bet may be in waiting for the
correction and buying.
MARCH COFFEE
Despite coffee’s strong rally today, the chart pattern looks quite bearish. A break below 124.25 should kick in the selling
programs.
MARCH EURO CURRENCY (1/5/07)

Chart-wise, the Euro looks heavy, even more so after breaking it’s 1 X 1 Gann line this morning. Friday, I’d
26
expect a small rally, as the market tests the 1 X 1 breakout area, but such rallies should be viewed as selling
opportunities. Look for this market to work down toward 129.80.
MARCH WHEAT (1/5/07)

Heavy wet snow blankets much of the western wheat belt after last week’s double blizzards, causing some
fund trades to lighten up wheat positions and brace for lower prices. To many, the storm couldn’t have come
at a better time, possibly ending the three-year drought and blanketing the crop from January’s sometimes
fledged temperatures. Through much of December, I’d been suggesting a dip to 4.75 should be a good buy.
We reached that point and dropped through it today—closing at 4.67 ¾. Pattern-wise, the market still holds
promise, but we’ll likely witness a more sideways trend—possibly testing 4.55 before turning higher again.
Figure -19
27
28
Finance 6364
Technical analysis of Stocks and Commodities
Very Short Term Price Patterns
M. Metghalchi
In the previous chapters we discussed reversal chart patterns and

continuation chart patterns that take some times to complete (10 to 30 days,
reversal patterns are usually longer than continuation patterns). In this
chapter we cover one to two bar price patterns, this applies to all charts from
5 minutes bar charts, 15, 30, 60 minutes bar charts, daily, weekly, and
monthly charts.
NOTE: one to two bar price patterns should not be used for intermediate or
long term forecasts, their influences on prices are very short term. They are,
however, somehow reliable signals for very short term trend reversals.
Outside Bars:
(Usually reversal): On a daily bar chart when a price makes both a higher
high and lower low, technicians call this an Outside Bar. In this situation the
trading range (today’s bar) totally encompasses yesterday’s range or bar. It
usually happens at the top or bottom of a minor or major trend. Figure 1
shows outside bar top and bottom.
Outside
Bar
Outside
Bar
Figure 1
1
General Guidelines according to Pring:
• The wider the outside bar vis a vis the previous one, the stronger the
signal.
• The sharper the previous trend, the stronger the signal.
• The more previous bars are encompassed, the stronger the signal.
• The greater the volume relative to previous bars, the more significant
the signal.
• The closer the price closes to the extreme of the bar, away from the
direction of established trend, the stronger the signal.
As we have said, one- or two-bar price patterns generally reflect an

exhaustion point that will reverse the prevailing or established trend.
As Pring points out for these patterns, the implications are for a very short-
term reversal. How short depends to time span of the bars. On a daily bars,
the new trend can normally be expected to last for at least three to five days,
often longer. On the other hand, a one- or two-bar formation that can be
observed in a 10-minute bar chart, is likely to be effective for the next hour
or two.
In conclusion, I would say that Outside days can occur frequently on daily
charts. The important point for outside day is the bigger the better and it has
more meaning if found at the end of a trend. It is usually a reversal, but
could be continuation.
Figure 2 shows two examples of Outside Days taken from:

(http://www.actionforex.com/articles_library/technical_analysis_articles/outside_day_trading/). The
first occurred at the end of a down trend and the second occurred at the end
of an up trend.
2
Figure 2
Inside Bars: (Usually reversal, but it also represents consolidation)
For a bar to qualify as an inside day the high must be lower than the high of
the previous day and the low of the day must be higher than that of the
previous day. Or today’s bar must be inside of yesterday’s bar. Figure 3
shows two inside days, one at the top of a trend and the other at the bottom
of a trend.
3
Inside Bar
Inside Bar
Figure 3
General Guidelines according to Pring:
• The wider the first bar relative to inside bar, the stronger the signal.
• The sharper the previous trend, the stronger the signal.
• The smaller the volume of the inside bar relative to previous bars, the
more significant the signal.
Inside days also can be found on candlestick charts. For example in Figure 4,
taken from (http://www.actionforex.com/articles_library/technical_analysis_articles/inside_day_trading/),
We show a few inside days.
In conclusion, I would say that inside days can occur frequently on daily
charts. An inside day could signal a reversal or a continuation, but very
often it is followed by change of direction in the next few days. The
important point for inside day is that the bigger the day one bar relative to
inside day bar the better the signal and it has more meaning if found at the
end of a trend. It is usually a reversal, but could be continuation.
4
Figure 4
Wide Ranging Day:
Wide Ranging Day is a result of an event that will cause very strong move
either up or down, it is suggested that a Wide Ranging Day usually will be
followed be a reversal, but not for sure, a general guideline is that the
direction of the close (whether the close is near the high or the low) would
be a good indication of next few days’ move. Wide-ranging days have a true
range that is far larger than the days on either side and are usually
meaningful after a strong trend.
In figure 5, we show two wide ranging bars. As you can see the range of
these two bars are much larger than the other ranges.
5
Wide Ranging
Bar
Wide Ranging Bar
Figure 5
KEY REVERSAL DAY: (Signal short term change of direction)
Key reversal day is a new high during the day but closes lower than
yesterday’s close. Or the price makes a new low during the day but closes
higher than previous day’s close. Reversal days signal a change of direction.
Figure 6 (Taken from: http://www.incrediblecharts.com/technical/key_reversal.htm) show two key

reversal bars in the top and bottom.
• NOTE: A key reversal day may or may not be an outside day. In

Figure 6, it is both a key reversal day and an outside day. For
example Figure 7 (Taken from:http://trading-stocks.netfirms.com/tradingtriggers.htm)
shows a key reversal bar that is not an outside day.
6
Figure 6
Figure 7
7
Figure 8 also presents a key reversal day for cattle that is not an outside day
(Taken from: http://www.lambertganneducators.com/newsletters/reversalkeyreversal.php). Look at the
CATTLE CHARTS of figure 7. On May 6th (Circled) you had a KEY
REVERSAL that came after several days down. The rally that followed
lasted for two weeks.
Figure 8
8
TWO-BAR REVERSAL:
A two-bar reversal is also a signal for change of direction. Usually this

signal will be more reliable after a prolonged advance or decline. Again, all
of these reversal days should be looked with other indicators. For example,
if the volume is high in the second day, then it will be a better signal than if
the volume is low in the second day.
The first bar has a range that is larger than the average bar (large bar) and is
in the direction of the prevailing trend. The close of the first day is around
the high of the first day. The second day bar is also large (similar to the first
day bar) and the second day opens around or above the close of the first day
but closes around the low of the second day. Figure 9 shows top and bottom
two-bar reversal pattern.
2 bar reversal
2 bar reversal
Figure 9 – Two Bar Reversal
In a two-bar reversal pattern, the second bar implies a change in psychology

against the prevailing trend that could last a few days to 10 days.
The following guidelines apply according to Pring:
• A trend must have been established

• Both bars should be large relative to previous bars.
9
• The open and close of each day should be at the extreme point of each
bar.
• Volume should be higher than previous volumes in both bars.
10
Finance 6364
Chapter 5
Major Reversal Patterns
By M. Metghalchi
As we have seen in previous chapters, prices usually move in trends of

varying duration. Usually, chart patterns will develop for BOTH trend
continuation and trend reversal. Therefore we should look for two types of
chart patterns:
1. Reversal chart pattern

2. Continuation chart pattern
As Pring points out (page 64) “Transitions between a rising trend and falling
trend are often signaled by price patterns”.
We first discuss the following REVERSAL PATTERNS:
1. Head and Shoulder Tops and Bottoms

2. Double and triple tops and bottoms
3. Rectangle Tops and Bottoms
4. Rounding Tops and bottoms
5. Diamond formation
6. V formation
7. Broadening formation
8. Triangles (Caution: triangles are both continuation and reversal patterns).
9. Rising and Falling wedges
Some of the above patterns could be also a continuation patterns (Triangle).

However the continuation patterns are formed within three weeks on a daily
chart whereas the reversal pattern could take much longer. For example if a
triangle is formed in two weeks on a daily chart, then this probably is a
continuation pattern but if it takes two month for a triangle pattern to form,
then this could be a reversal pattern.
HEAD AND SHOULDER (H&S) TOPS AND BOTTOMS:
Head and shoulder most of the time is a reversal pattern, very rarely it is a
continuation pattern. A head and shoulders top consists of a peak (left
shoulder) followed by a higher peak (head) and then a lower peak (right
1
shoulder). A neckline can be drawn by connecting the bottom of two
shoulders. See Figure 1.
RS
LS Neckline
Minimum Price
target
Figure 1
The neckline is drawn through the lowest points of the two intervening
troughs and could slope upward (Figure 1) or downward. Some technicians
believe that a downward sloping neckline is more reliable as a signal than
an upward sloping neckline, and the most reliable signal, according to some
technicians, is when the neckline is leveled (slope is zero).
After the right shoulder (RS) is formed and price come down and penetrate
the neckline, then we confirm that we have seen the top of the market (trend
has been reversed). After breaking the neckline, the MINIMUM price target
is estimated as follow:
a. Measure the peak of the price (highest price) from the neckline.
b. Then project down the above measure from the break outpoint to get
the minimum price objective. (See figure 1).
Head and should formation is usually of the most reliable reversal pattern.
Volume Confirmation:
High volume on the left shoulder,
2
Moderate volume on the middle peak,
Low volume on the right shoulder,
A sharp increase in volume on the break below the neckline
Trading possibilities:
1. Go short at breakout below the neckline and place a stop-loss above the
right shoulder.
2. After the breakout, price often rallies back to the neckline which then acts
as a resistance level. when the price comes back to the neckline, then go
short and place a stop-loss above the neckline.
Head and Shoulder Bottom:
It is an inverted head and shoulder as can be seen from Figure 2. Usually the
inverted head and shoulder signals the end of downtrend (Reversal of trend).
Figure 2 (From www.incrediblecharts.com)
For a head and shoulder bottom, volume usually picks up on each rally. The
greatest volume will be on the right shoulder.
Caution:
3
On rare occasion, the H&S formation shows up as a continuation pattern and
not as a reversal chart pattern. If the H&S is continuation pattern, then the
H&S signal will be a failure. It means, in an uptrend, when there is a H&S
formation and price breaks below the neckline, it will come back and
violently moves above the neckline and will make a new high. In a
downtrend the reverse happens.
DOUBLE AND TRIPLE TOPS AND BOTTOMS:
After a established uptrend, price will peak, and then declines and again rise
to form a second peak at or about the level of the first peak, a double top is
said to have formed. A double top looks lime a M. Usually the second peak
has lower volume. If the volume on the second peak is higher than the first
peak, be cautious, it could be a false signal. A neckline can be drawn across
the base of the two peaks. When price breaks below the neckline, it
confirms the reversal in trend, see Figure 3. Minimum price objective is
similar to H&S pattern, see Figure 3.
Minimum price
target
Figure 3 – Double Top
A double top looks like a M. Usually the second peak has lower volume. If
the volume on the second peak is higher than the first peak, be cautious, it
may not be a double top.
Double Bottoms:
4
The double bottom is a major reversal pattern that forms after an extended
downtrend. Similar to double top, the pattern is made up of two consecutive
troughs that are roughly equal, with peak in between. It looks like a W.
Usually the second trough has higher volume. If the volume on the second
trough is lower than the first trough, be cautious, it could be a false signal. A
neckline can be drawn across the base of the two troughs. When price
breaks above the neckline, it confirms the reversal in trend, see Figure 4.
Minimum price objective is similar to H&S pattern, see Figure 4.
Minimum Price
Objective
Figure 4 – Double Bottom
It looks like a W. Usually the second trough has higher volume. If the
volume on the second trough is lower than the first trough, be cautious, it
could be a false signal.
Note: With any reversal pattern, there must be an established trend to

reverse. Also please note that the double bottom or top is an intermediate to
long-term reversal pattern that will not form in a few days, it probably will
take between few weeks to few months for the formation to be valid.
Triple tops or bottoms are similar to double top and bottoms. For triple
tops, we will have three peaks approximately at the same levels. Volume
will be decreasing as we move from the first to second and then to third
peak.
5
For triple bottoms, we will have three troughs approximately at the same
levels. Volume will be decreasing as we move from the first to second and
then to third trough. Very high volume when we break out up of the third
bottom. If the upside break-out is with low volume, that could be a false
signal. The price objective is similar to double tops and bottoms.
Triple tops and bottoms are more reliable signal than double tops and
bottoms.
Figure 4-a and 4-b taken from Stockcharts.com summarize the triple
tops and bottoms reversal patterns.
Figure 4-a- Triple Tops (Stockcharts.com)
1. Prior Trend: With any reversal pattern, there should be an existing trend to
reverse. In the case of the triple top, an uptrend or long trading range should be in
place. Sometimes there will be a definitive uptrend to reverse. Other times the
uptrend will fade and become many months of sideways trading.
2. Three Highs: All three highs should be reasonable equal, well spaced and mark
significant turning points. The highs do not have to be exactly equal, but should be
reasonably equivalent to each other.
3. Volume: As the triple top develops, overall volume levels usually decline.
Volume sometimes increases near the highs. After the third high, an expansion of
volume on the subsequent decline and at the support break greatly reinforces the
soundness of the pattern.
6
4. Support Break: As with many other reversal patterns, the triple top is not
complete until a support break. The lowest point of the formation, which would be
the lowest of the intermittent lows, marks this key support level.
5. Support Turns Resistance: Broken support becomes potential resistance, and
there is sometimes a test of this newfound resistance level with a subsequent
reaction rally.
6. Price Target: The distance from the support break to highs can be measured
and subtracted from the support break for a price target. The longer the pattern
develops, the more significant is the ultimate break. Triple tops that are 6 or more
months old represent major tops and a price target is less likely to be effective.
Figure 4-b: Triple Bottoms (Stockcharts.com)
1. Prior Trend: With any reversal pattern, there should be an existing trend to
reverse. In the case of the triple bottom, a downtrend or long trading range should
be in place. Sometimes there will be a definitive downtrend to reverse. Other
times the downtrend will fade away after many months of sideways trading.
7
2. Three Lows: All three lows should be reasonable equal, well spaced and mark
significant turning points. The lows do not have to be exactly equal, but should be
reasonably equivalent.
3. Volume: As the triple bottom develops, overall volume levels usually decline.
Volume sometimes increases near the lows. After the third low, an expansion of
volume on the advance and at the resistance breakout greatly reinforces the
soundness of the pattern.
4. Resistance Break: As with many other reversal patterns, the triple bottom is not
complete until a resistance breakout. The highest point of the formation, which
would be the highest of the intermittent highs, marks resistance.
5. Resistance Turns Support: Broken resistance becomes potential support, and
there is sometimes a test of this newfound support level with the first correction.
Because the triple bottom is a long-term pattern, the test of newfound support may
occur many months later.
6. Price Target: The distance from the resistance breakout to lows can be
measured and added to the resistance break for a price target. The longer the
pattern develops, the more significant is the ultimate breakout. Triple bottoms that
are 6 or more months in duration represent major bottoms and a price target is
less likely to be effective.
End of the quote from Stockcharts.com
RECTANGLE TOPS AND BOTTOMS
Most of the time, rectangles are continuation pattern, but sometimes they
could be a reversal pattern (So, you can see technical analysis is not a
science). Rectangle chart pattern is formed by sideway price progressions
that are contained within to parallel lines. When this happens at the top
(bottom) of a uptrend line (downtrend line), we say that the reversal pattern
is a rectangle top or bottom formation. When we have a rectangle top
formation, we say we have a distribution from strong hand to weak hand.
When we have a rectangle bottom formation, we say that we have a
accumulation from weak hand to strong hand.
Note: Rectangles are also continuation patterns. I my personal experiences,

most rectangles are continuation patterns. Figure 5 presents a rectangle top
reversal and figure 6 shows a rectangle continuation pattern.
8
Figure 5- Reversal Rectangle
Rectangles are also referred as trading area or range. You buy a security at
the lower horizontal line and sell it at the top horizontal line. If price breaks
out from either of these horizontal lines, the trend will be on the direction of
the break out.
Technical Principles: Generally, the longer the duration of a price pattern,

the more violent will be the price move that follows.
9
Minimum
Price target
Figure 6- Continuation Rectangle
Figure 7 shows a bottom rectangle reversal pattern
Figure 7- Bottom Rectangle Reversal
Minimum Price Objective of rectangle chart patterns:
10
If the rectangle is a continuation pattern, then the minimum price objective
after a break out is the distance between the two horizontal lines from the
breakout point. Although this objective is the minimum price move, usually,
price will move more than the minimum objective (See figure 2).
Note:
In order to have a valid breakout, some technicians would wait for a 2-4
percent of penetration of boundaries. This 2-4 % penetration is very
arbitrary, here the analyst should use his/her judgment and experiences. For
example, 4 percent could be used for more volatile securities and 2 percent
for less volatile securities.
Also on a daily chart, a valid breakout should hold for at least a couple of
days. If we have a breakout, then if in couple of day price comes back within
the boundary lines, the breakout could be false signal. As a matter of fact,
this type of breakout would be the opposite possibility (Exhaustion), prices
move above the boundary for couple of day and than breaks out in the other
direction, see figure 8.
False breakout
Figure 8 – False breakout
We could also use volume analysis to verify whether a breakout is valid. As

Pring points out “volume usually goes with trend”. In an uptrend, volume
should rise and in a downtrend volume should declined. Volume should lead
11
the price, especially on upside breakouts. So, if we breakout from upper
boundary of a rectangle with low volume, this could signal that the breakout
could be a false signal.
ROUNDING TOPS AND BOTTOMS
Rounding tops (Saucers) happens as expectations gradually shift from

bullish to bearish. This steady gradual shift forms a rounded top. Rounding
bottoms (Saucers) happens as expectations gradually shift from bearish to
bullish. Figures 9 and 10 present rounding top and bottom respectively.
Figure 9 – Rounding Top
12
Figure 10 – Rounding Bottom
Typical Volume Action:
Volume should decline during the first portion of the saucer (For both Top
and Bottom). Volume should rise in the second portion of the pattern.
Rounding tops and bottoms are very rare, however, personally I like them if
I see them I will trade with their signals, they seem to be very reliable.
Trading is very simple because you have time to go long around bottom of
the pattern and also have time to go short around top of the pattern.
DIAMOND FORMATION
Diamond formation is reversal pattern that could happen at the top or

at the bottom. At the top it signals the end of the uptrend and at the
bottom it signals the end of the downtrend. Diamond formation is
relatively uncommon. This pattern is called a diamond because of the
shape it creates on a chart.
13
In the example of figure 11 (taken from Investopedia.com) we see an
example of Diamond Top formation for Australian/US daollar
exchange rate.
Figure 1 – Identifying a diamond top formation using the AUD/USD.

Figure 11
Diamond formation has some similarity with Head and Shoulder (H&S).
Trading the diamond top would be similar to H&S formation. The formation
is completed when price breakout from boundary line D. This breakout is the
area that a trader would short the security.
Volume usually increases during the first half of diamond formation and
decreases during the second half of the formation.
Diamond formation is usually a reversal pattern but sometimes in rare

occasion, the formation turns out to be a continuation pattern. Figure 12
(Taken from: www.gold-eagle.com) shows top, bottom and continuation diamond
formation.
14
Figure 12
V-FORMATION
A bottom V-formation price pattern indicating that the security price has
bottomed out, and is now in a bullish trend. Contrary to most reversal
patterns that gradually reverse direction, the V formation suddenly reverse
the trend. Examples of V formation top and bottom are provided in figures
13. Figure 14 shows the chart of Dow Jones on June 2009. It seems that in
March 2009, the bottom was a V-shaped bottom.
Volume is usually high throughout the pattern. Since this formation

happened quickly, profit opportunity is hard.
15
Figure 13
16
Figure 14 (Generated by: advfn.com)
BROADENING FORMATION
In a broadening top formation, price fluctuates and the fluctuations become

wider. This pattern its orthodox form is a series of three higher highs and
two lower lows, each swing occurring no more than two months apart. The
pattern can also have a flat top or bottom. Figure 15 (Taken from stockcharts.com)
show a broadening top formation for XO communications Inc.
17
Figure 15
Figure 16 (Taken from: http://www.trending123.com) presents both top broadening and

bottom broadening formation.
Figure 17 presents right angle broadening formations.
Caution: Most of the times broadening formations are reversal patterns,

however, on occasions, we could have broadening patterns that are
continuation patterns. Therefore one should always look at chart patterns
with other indicators for possible top or bottom detections.
18
Topping Pattern
Bottoming Pattern
Figure 16: Broadening formation
19
Figure 17
TRIANGLES
Triangles, the most common of all price patterns, are a classic type of chart
formation that can signal either a reversal or a continuation (consolidation of
price) of a trend. Most of the times they are part of continuation trend. We
have two types of triangles: 1) Symmetrical and 2) right angled triangles.
Figure 18 (From North Dakota State University of Agriculture and Applied Science) shows a
descending right angled, an ascending right angled, and a symmetrical
triangle formations.
Figure 18
20
Right angle triangles have a horizontal boundary. Right angled
triangles are most likely continuation patterns. The ascending triangle
has a flat upper trendline while the lower trendline slopes upward. This
implies more aggressive buying than selling as the lows get progressively
higher, while the highs make it to about the same level each time before
breaking out to the upside.
Volume Analysis: usually, volume decrease as price moves toward the apex
of either descending or ascending triangle. The volume will increase at the
breakout. This also applies for symmetrical triangles.
Note: Whether a triangle formation is a reversal or a continuation pattern,

traders should take position on the direction of the breakout.
Figure 19 (Taken from: http://www.trade10.com/Triangles.html ) shows a reversal
symmetrical triangle formation.
Figure 19
21
Note: In figure 19 and 20, the triangle formation takes a few months,
therefore most likely it is a reversal pattern.
Figure 20 (Taken from: http://www.trade10.com/Triangles.html ) shows a

descending triangle formation.
Figure 20
RISING AND FALLING WEDGES
Wedges are similar to triangles, but they are irregular triangles, wedges are
characterized by two boundary lines being at a slant that converge. Wedges
should not be mistaken for pennants, which are much shorter in duration.
Rising wedges
Rising wedges can be identified by both boundary lines heading up, the
slope of the lower line is greater than the upper one, indicating fluctuating
22
and strengthening price activity, with the lines eventually meeting. The
formation of a rising wedge takes between three weeks to a few months.
Falling wedges
Falling wedges can be identified by both boundary lines heading down, the
slope of the lower line is smaller than the slope of the upperline, with the
lines eventually meeting.
Figure 21
A falling wedge is generally considered bullish. Foe example the top part of
Figure 21 shows two falling wedges, the first one (in an uptrend) is a
continuation pattern. The second one (In a downtrend) is a reversal pattern.
and is usually found in uptrends.
A rising wedge is usually considered bearish. For example in the bottom

part of figure 21, we have two rising wedges, the first one (In an uptrend), it
is a reversal pattern. The second one (In a downtrend) it is a continuation
pattern. (Caution: not all technicians believe in the above. Some say rising wedges are
bullish and falling wedges are bearish)
23
Traders should play any wedges in the direction of the breakout. Breakouts
usually occur at least 2/3 of the way to the apex of converging lines.
In figure 21, we present many triangle formations that are continuation

patterns, usually they are formed within 3 weeks in a daily chart.
Figure 21 (Taken from: blogs.siliconindia.com)
All rights reserved, 2009, Massoud Metghalchi
24
Finance 6364
Chapter 6
Continuation Patterns
By M. Metghalchi
As we have seen in previous chapters, prices usually move in trends of

varying duration. Usually, chart patterns will develop for BOTH trend
continuation and trend reversal. Therefore we should look for two types of
chart patterns:
1. Reversal chart pattern

2. Continuation chart pattern
Last chapter we discussed reversal patterns and in this chapter we discuss

the following consolidation or continuation patterns:
1. Flags
2. Pennants
3. Triangles
4. Rising and Falling wedges
5. Broadening formation
The continuation chart patterns usually take a few days up to three weeks on
a daily charts (a few weeks on a weekly charts). Their formations usually are
faster than reversal patterns that last few weeks on a daily chart.
FLAGS
A flag occurs when there is a straight move up (or down) in a security. This
movement is almost nearly vertical, and at the very least is very steep and
very rapid. This rapid and steep move is the pole of the flag (Flagpole) and
usually is accompanied with strong volume and lasts a few trading days.
Gaps may be present within this part of the move.
The flag part of this formation usually takes the shape of a parallelogram or
a rectangle that is tilted on its side and is sloping downward in an uptrend
and sloping upward in a downtrend (Flag part leans away from direction of
the trend). In Figure 1, Wyckoff believes that on 12/16/05 the Euro currency
1
is in the middle of a bullish flag continuation formation. (Taken from
Expresstrade.com).
Figure 1
FOREX: Potential Bull Flag in Euro Currency-U.S. Dollar
Jan. 12
Today, let’s examine the FOREX market and the Euro Currency-U.S. Dollar pair, also called
Euro-Dollar. See on the daily bar chart that Euro-Dollar recently saw a solid rebound from the
late-December low. This solid rebound was followed very recently by a pause, to form a
potential bull flag chart pattern.
An upside “breakout” in prices from this bull flag chart pattern would suggest another solid leg
up in prices in the near term.
See also that bulls are encouraged by the fact that Euro-Dollar is now trading above the key
100-day moving average that professional traders monitor very closely.
See support and resistance levels on the chart.
Stay tuned!—Jim Wyckoff
2
Figure 2 (Taken from: http://chart-patterns.netfirms.com/bearflag.htm) shows a bearish
flag continuation pattern.
“Bear Flag is a sharp, strong volume decline on a negative fundamental development, several
days of sideways to higher price action on much weaker volume followed by a second, sharp decline
to new lows on strong volume.
The technical target for a bear flag pattern is derived by subtracting the height of the flag pole
from the eventual breakout level at point (e).
Bear flag formations involve two distinct parts, a near vertical, high volume flag
pole and a parallel, low volume consolidation comprised of four points and an
upside breakout.
The actual flag formation of a bear flag pattern must be less than 20 trading
sessions in duration.
Most bear flag patterns occur at the middle of the larger move lower for a stock.
Downside breakouts often lead to small 2-3% declines followed by an immediate
test of the breakout level. If the stock closes above this level (now resistance) for
any reason the pattern becomes invalid.
Figure 2
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Bear flags are favored among technical traders because they almost always lead to large and
predicable price moves. Like all continuation patterns, bear flags represent little more than a brief
lull in a larger move lower. Indeed, in many cases the flag pattern will actually take shape in the
middle of the ultimate move lower. Like bull flags, bear flags occur because stocks rarely move in
one direction for an extended period, instead, the move is broken up by brief periods where traders
catch their breath. These periods are flags and pennants. “
3
Traders should play a flag formation in the direction of the trend.
PENNANTS
A pennant is similar to a flag formation except that instead the parallelogram

or rectangle; we will have a triangle (Mostly irregular triangles). Figure 3 (Taken
from: http://www.wallstreetsecretsplus.com/contributors/tom_ventresca/art120605.aspx)
shows both bearish and bullish pennant formation.
“Pennant Formations: Pennant formations are very common and can be either bullish or
bearish depending on how the formation is formed. A pennant or triangle resembles a
flag with the pole being on the left side of the formation created by either a sharp rise in
the stock’s price or an acute decline. The flag or pennant is formed as the stock trades in
an increasingly narrow range for several days, usually five to twenty. The longer that the
flag process takes, the larger the ensuing move will be.
Figure 3
Typically, the stock will come out of the flag formation in the same
direction that it came in. If a pennant is formed after a sharp rise, the
odds favor a resumption of the advance once the stock breaks out to
the upside. Conversely, a pennant formation formed after a sharp
decline will see lower prices once the flag is broken to the downside.”
In Figure 4, Wyckoff believes that Dollar-Swissy is in the middle of a

bearish pennant formation in January 2006.
4
Figure 4
“FOREX: Bearish Pennant Pattern Develops in “Dollar-Swissy”
Jan. 11
Today, let’s examine the FOREX market and the U.S. Dollar-Swiss Franc currency pair, also
called “Dollar-Swissy.” See on the daily bar chart that Dollar-Swissy has formed a potentially
bearish pennant pattern with recent price action. Prices dropped sharply and then paused to form
the bearish pennant.
A downside “breakout” from the pennant pattern would suggest another solid leg down in prices
in the near term. The bears are in firm technical command.
Stay tuned!—Jim Wyckoff (Expresstrade.com)”
TRIANGLES:
Triangles, the most common of all price patterns, are a classic type of chart
formation that can signal either a reversal or a continuation (consolidation of
price) of a trend. Most of the times they are part of continuation trend. We
have two types of triangles: 1) Symmetrical and 2) right angled triangles.
Figure 5 (From North Dakota State University of Agriculture and Applied Science) shows a
5
descending right angled, an ascending right angled, and a symmetrical
triangle formations.
Figure 5
Right angle triangles have a horizontal boundary. Right angled

triangles are most likely continuation patterns. The ascending triangle
has a flat upper trendline while the lower trendline slopes upward. This
implies more aggressive buying than selling as the lows get progressively
higher, while the highs make it to about the same level each time before
breaking out to the upside.
Volume Analysis: usually, volume decrease as price moves toward the apex
of either descending or ascending triangle. The volume will increase at the
breakout. This also applies for symmetrical triangles.
Note: Whether a triangle formation is a reversal or a continuation pattern,

traders should take position on the direction of the breakout.
Figure 6 ( taken from: http://www.tradersexchange.com/trianglepatterns.html)

Shows a right angle triangle (Continuation) pattern and a reversal
symmetrical triangle formation.
6
Figure 6
Figure 7 (Taken from: http://www.investopedia.com/articles/technical/02/031102.asp)

shows a descending triangle formation that is a continuation
pattern.
The minimum number of lows and highs required to form any triangle is two
of each, for a total of four. If this pattern were followed by a breakout to the
downside from within the triangle formation, it would be a reversal pattern.
As has happened in figure 7, if the price breaks out to the upside, it would
become a continuation pattern rather than a reversal.
Figure 7-a (Taken from: http://www.alpari-idc.com/en/market-analysis-guide/technical-

) also shows a symmetrical triangle formation that is a
analysis/triangles.html
continuation. The dollar versus Yen in figure 7-a shows that a trader
should play a triangle formation in the direction of the break.
7
Chart Created with Tradestation
Figure 7
Figure 7-a
8
Note: The continuation pattern of chart 7-a is an exception to our general
rule that implies that most continuation patterns should form within three
weeks.
There must be at least four reversal points in order for a triangle to be

recognized, but there may be more (for example, six: three peaks and three
troughs).
RISING AND FALLING WEDGES
Wedges are similar to triangles, but they are irregular triangles, wedges are
characterized by two boundary lines being at a slant that converge. So
wedges are similar to a Symmetrical Triangle but generally stubbier or not
as elongated. Wedges should not be mistaken for pennants, which are much
shorter in duration.
Rising wedges
Rising wedges can be identified by both boundary lines heading up, the
slope of the lower line is greater than the upper one, indicating fluctuating
and strengthening price activity, with the lines eventually meeting. The
formation of a rising wedge takes between three weeks to a few months.
Falling wedges
Falling wedges can be identified by both boundary lines heading down, the
slope of the lower line is smaller than the slope of the upperline, with the
lines eventually meeting.
9
Figure 8
A falling wedge is generally considered bullish. Foe example the top part of
Figure 8 shows two falling wedges, the first one (in an uptrend) is a
continuation pattern. The second one (In a downtrend) is a reversal pattern.
and is usually found in uptrends.
A rising wedge is usually considered bearish. For example in the bottom

part of figure 8, we have two rising wedges, the first one (In an uptrend), it is
a reversal pattern. The second one (In a downtrend) it is a continuation
pattern. (Caution: not all technicians believe in the above. Some say rising wedges are
bullish and falling wedges are bearish)
Traders should play any wedges in the direction of the breakout. Breakouts
usually occur at least 2/3 of the way to the apex of converging lines. Figure
9 (http://chart-patterns.netfirms.com/risingwedgec.htm) shows a rising continuation wedge
pattern formation for Qlogic stock.
10
Figure 9
The falling wedge can also fit into the continuation category. As a
continuation pattern, the falling wedge will still slope down, but the slope
will be against the prevailing uptrend, see figure 9-a, or see figure 8 top left
chart. As a reversal pattern, the falling wedge slopes down and with the
prevailing trend, see figure 8, top right chart. Regardless of the type (reversal
or continuation), falling wedges are regarded as bullish patterns.
11
Figure 9-a
http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:fal
ling_wedge
1. Prior Trend: To qualify as a reversal pattern, there must be a prior trend to
12
BROADENING FORMATION
In a broadening top formation, price fluctuates and the fluctuations become

wider. This pattern in its orthodox form is a series of three higher highs and
two lower lows, each swing occurring no more than two months apart. The
pattern can also have a flat top or bottom. Figure 10 (Taken from stockchart.com)
show a broadening top formation for XO communications Inc.
Figure 10
Figure 11 (Taken from: http://www.fx-dealer.com/articles/broadening.asp) presents both

reversal and continuation broadening formation.
Caution: Most of the times broadening formations are reversal patterns,

however, on occasions, we could have broadening patterns that are
continuation patterns. Therefore one should always look at chart patterns
with other indicators for possible top or bottom detections.
13
Figure 11
Volume is difficult to characterize though at the market tops volume is very

high. Broadening formation with flattened top is usually very bullish.
It can also develop as continuation patterns.
Cup and Handle
The Cup with Handle is a bullish continuation pattern that marks a

consolidation period followed by a breakout. The Cup and Handle has
recently been developed by William O'Neil in his 1988 book, How to Make
Money in Stocks.
Figure 12
14
Figure 12 (Taken from invstopedia.com) show a cup and handle bullish
continuation pattern. As John Murphy in his Stockcharts.com points out, a
cup and handle has two parts: the cup and the handle. The cup, forms after
an established trend, looks like a bowl or a rounding bottom. As the cup is
completed, a trading range develops on the right hand side and the handle is
formed. A subsequent breakout from the handle's trading range signals a
continuation of the prior trend. Below we explain a bit more what are the
requirements for a cup and handle:
1. Trend. Since this is a continuation pattern, a trend of at least a few

months should have been established.
2. The Cup. The cup could either be a U-shaped or a rounding cup.
3. Cup Depth: The depth of the cup should ideally retrace 1/3 of previous
advance. Although it is possible that we could have ½ retracement.
Rarely, we could even have 2/3 retracement.
4. Handle: After the top of the right side of the cup, there is a pullback
that forms the handle. It is possible that this pull back resembles a
pennant or flag. The handle represents the final consolidation or
pullback before the breakout. The handle can retrace up to 1/3 of the
cup's advance, but probably not more. The smaller the handle
retracement is, the more bullish the formation and significant the
breakout.
5. Duration: according to John Murphy the cup formation can take from
1 to 6 months, sometimes longer on weekly charts and . The handle
can be from 1 week to many weeks and ideally completes within 1-4
weeks on a weekly chart. On a daily chart, it also takes a few months.
6. Volume: Tremendous volume increase at breakout.
7. Target: The projected price rise after the breakout can be estimated
by measuring the distance from the right peak of the cup to the bottom
of the cup.
Copy right 2009, Massoud Metghalchi, all rights reserved.
15
Fin 6364
MOVING AVERAGES
By Dr. Massoud Metghalchi
One of the most important trend determinations is the moving average (MA)
technique. There are three major variation of moving averages in technical
analysis:
1. Simple moving average

2. weighted moving average
3. Exponential moving average
A simple moving average shows the average value of a security's price over
a period of time. To find a10 - day moving average of S&P 500, you would
add up the closing prices from the past 10 days and divide them by 10. Since
prices are constantly changing it means the moving average will also
change.
Assume the following daily prices for NASDAQ tracking stock, symbol:
qqqq. (Taken from Yahoo.com)
Date Open High Low Close
29-Nov-05 41.76 41.85 41.34 41.34
28-Nov-05 41.97 42.00 41.50 41.54
25-Nov-05 41.84 41.94 41.73 41.89
23-Nov-05 41.73 42.02 41.71 41.80
22-Nov-05 41.46 41.87 41.36 41.70
21-Nov-05 41.40 41.58 41.24 41.55
18-Nov-05 41.51 41.65 41.27 41.45
17-Nov-05 40.91 41.32 40.85 41.31
16-Nov-05 40.65 40.78 40.46 40.77
15-Nov-05 40.73 40.90 40.38 40.52
14-Nov-05 40.77 40.86 40.60 40.71
11-Nov-05 40.77 40.92 40.68 40.71
10-Nov-05 40.18 40.69 39.92 40.60
9-Nov-05 40.12 40.33 40.03 40.16
1
Calculate the sample (Arithmetic) moving average of 3 days (MA3) of
QQQQ for the closing price.
Solution:
On November 29th, 2005, the MA3 is:

MA(3) = (41.34 + 41.54 + 41.89)/3 = 41.59

MA(3) = (41.54 + 41.89 + 41.80)/3 = 41.74

MA(3) = ( 41.89 + 41.80 + 41.70)/3 = 41.80
It is very easy to estimate Moving Averages in Excel. Moving average will

smooth price fluctuations; the longer moving averages are smoother than
shorter moving averages. For example moving average of 50 days is much
smother than moving average of 5 days.
Compare:
Compare
QQQQ vs S&P Nasdaq Dow
Figure 1
2
As you can see from Figure 1, the MA50 of NASDAQ index (QQQQ), the
green line, is much smoother than MA5, the red line. (Taken from
Yahoo.com).
For stocks and stock indexes, the most common use of MA is the MA50,
MA100, and MA200.
Many technicians believe that as long as the stock price or Index price are
above these moving averages, the trend is up. On a daily chart, many use
MA50 for short term trend and MA200 for long term trend. For example in
Figure 2, we show the daily bar chart and MA50 and MA200 for QQQQ.
(Taken from Yahoo.com on 30/11/05).
Compare:
Compare
QQQQ vs S&P Nasdaq Dow
Figure 2
As figure 2 shows, the price is above both MA50 and MA200 on November
30th 2005 (At the writing of this lecture), that means the short term and long
term trends are up. As Pring points out
CHANGE IN TREND HAPPENS IF PRICE CROSSES ITS MOVING

AVERAGE, NOT BY A REVERSAL IN THE DIRECTION OF THE MOVING
AVERAGE.
3
Not all believe in the above statement, some technicians believe that you
should be in the market as long as the moving average is going up and be out
of the market when the moving average slopes down. (I prefer price
crossing MA method because reversal of MA direction method is too slow
or too late for short term trading, however, reversals are more reliable and
therefore could be used for long term positioning).
For short term trades when using price crossing moving average method,
please keep in mind that:
If price crosses a MA but the MA is still moving in the direction of

the prevailing trend, this could be a preliminary warning that the trend
may be ending soon. However, if the slope of the MA is very steep, a
crossing of moving average my not result in a trend reversal, similar
to a violation of a steep trendline (see chapter 4).
The longer the MA, the greater the significance of a crossing the MA.
Moving averages can also be drawn on weekly and monthly charts for
longer term trend analysis and on 60 minutes and 30 minutes charts for very
short term trend analysis.
MA crossover should be looked in the context of all other clues (Indicators,

price pattern, breath, trendline, ..etc) to decide whether a crossover is a valid
signal or possibly a false signal.
For example in Figure 3 (Nov. 2005) of daily DJIA, The price crossed over
the MA20 (the blue line) approximately at the same time as the down
trendline was broken. In addition looking at the stochastic at the time of the
cross, this indicator was signaling a buy, therefore, one could reasonably
assume that the crossing of MA(20) was a valid signal. (although one could
look at additional indicators like RSI, MACD, price patterns, ..etc).
NOTE: it is possible to calculate MA of high, low, open, however, most of

the time we construct MA by using closing prices.
4
Figure 3
CHOICE OF TIME PERIODS:
How many periods (5, 10, 20, 40, 50, 100, 200) should we use to construct
moving averages?
There is no best answer to the above question. We need to consider the

followings:
Are we studying the short term, intermediate, or the primary trend?

What market is being studied? Since Gold market cycle is different
than oil and stock market cycles, the best MA for gold probably will
be different than the best MA for oil and stock market.
Most technicians use the following time periods:
5
Suggested Time Period for MA
Short Term Intermediate Term Long Term
5-day 30-day, 40-days 40-week
9-day 50-day (10 weeks) 45-week
20-day 100-day (20 weeks) 104 week
25-day 150-day (30 weeks)
30-day 200- day (40 weeks)
For example, Jim Wyckoff of Expresstrade.com uses MA(9) and MA(18)

for his analysis. If MA(9) crosses MA(18) from below, then this will be a
buy signal. On the other hand if MA(9) crosses MA(18) from above, then
this will be a sell signal.
Figure 4 (generated from: ADVFN.COM)
6
For example figure 4 shows the daily bar chart of DJIA including MA(9),
the green line and MA(18), the blue line. As you can see from figure 4, in
late October of 2005, the MA9 crossed MA18 from blow and this would be
a buy signal. The insert figure 4-a is from Jim Wyckoff’s commentary on
12/2/05:
To view this email as a web page, go here.
FOREX: U.S. Dollar-Japanese Yen Remains in Strong Uptrend
Dec. 2
7
Today, let’s take a look at the FOREX market and the U.S. Dollar-Japanese Yen currency pair, also
called “Dollar-Yen.” See on the daily bar chart for Dollar-Yen that prices are in a strong uptrend as
prices just recently hit a fresh 27-month high.
See on the chart that the shorter-term moving I follow (9- and 18-day) are still in a bullish mode as the
9-day is above the 18-day moving average. One early clue that the uptrend in Dollar-Yen is losing
power would be if these two moving averages produced a bearish crossover signal, whereby the 9-day
crossed back below the 18-day moving average.
At present, the uptrend in Dollar-Yen is indeed powerful. See at the bottom of the chart that the
Directional Movement Index has an ADX line reading of 39.46. Any ADX line reading above 30.00 is
suggestive of a powerful trend being in place in a market. However, there has been some bearish
“divergence” with the ADX line. See that the ADX line has recently turned down from its higher level,
while at the same time Dollar-Yen has moved to new highs. This is one early bearish clue that a top
may be in place.
Stay tuned!—Jim Wyckoff (Expresstrade.com)
Insert figure 4-a
CONVERGENCE OF MOVING AVERAGES:
Some technicians plot three moving averages on top of a bar chart.

Personally, I prefer MA 9, 18 and 40 (Others prefer 4, 9,18). In my
experience in future trading, the convergence of three MAs is one of the
most reliable signals. You should trade on the direction of the break out.
Here is the buy and sell signals:
Buy Signal:
When three moving average converge and MA9 is just above MA18 and
MA18 is just above MA40 and all three MAs have positive slopes.
Sell Signal:
When three moving average converge and MA9 is just below MA18 and
MA18 is just below MA40 and all three MAs have negative slopes.
For example in figure 5, we show weekly bar chart of S&P 500 from
January 2002 to November 2005. It also shows MA9 (red), MA18 (green),
and MA40 (lemon).
In that chart I have market four areas:
8
Convergence 1 (Con-1): where three MAs converge and MA9 is below
MA18 and MA18 is below MA40. This would be a good sell signal.
Convergence 2: where the three MAs converge and give a buy signal.
Convergence 3: where the three MAs converge and give a buy signal.
Convergence 4: where the three MAs converge and give a buy signal in
early November 2005. At the time of writing this lecture note (12/1/05), the
convergence studies has given a buy signal for intermediate term (since we
are using a weekly chart, this signal is good for next few months).
9
Figure 6 (generated from Barchart.com)
In Figure 6, we show the daily bar chart for Japanese Yen. As you can see
from Figure 6, the MA of 9, 18, and 40 were converging in late September
of 2005. As MA 9 was below 18, and 18 below 40 that was a good sell
signal.
WEIGHTED MOVING AVERAGE AND EXPONENTIAL MOVING

AVERAGE:
In the above discussion we used simple or arithmetic MAs (SMA), where all
past data have EQUAL weights. Some technicians would prefer to give most
recent prices more weights than older prices. This can either be done if we
use a weighted MA (WMA) or an Exponential MA (EMA).
In a WMA, each period’s price weight is based on its age. The oldest period
price is given weight of 1, the next oldest is given a weight of 2, the next
oldest is given a weight of 3 and so on. Computer programs will do this very
easily.
Here is an example of WMA calculation taken from

http://www.investopedia.com:
For example, suppose we 5 days prices and we would like to calculate a 5-period WMA. The
calculation would be as follows:
10
An EMA takes a percentage of today's price and adds in the prior
day's exponential moving average times 1 minus that percentage.
For instance, suppose you wanted a 20% EMA. You would take
today's price and multiply it by 20% then add that figure to the prior
day's EMA multiplied by the remaining percent or 80%
(Today's close * .20) + (yesterday's exponential moving average * (1-.20))
To obtain the Exponential Percentage, we use the following formula:

Exponential Percentage = 2 / (Time Periods + 1).
So if you wanted a 40 period EMA you would use (2/(40+1)) = 4.88 %

as your percentage for the calculation.
The most important point for both WMA and EMA is that they both give
more weights to recent data than simple MA. Many chart providers, will
give the user the option to choose any of these MAs.
11
For example figure 7 shows daily closing chart for DJIA for two years. I
have included three MA100s in this chart; they are SMA100, WMA100, and
EMA100. As you can see, they are very similar.
ENVELOPES
Trading bands or envelopes are based on moving averages. The MA will be

the basic line and two lines, one above and one below, are drawn parallel to
the MA line. The distance of these upper and lower lines to the MA line is a
certain percentage. This percentage will be different for different security,
the more volatile the security, the higher will be the percentage. Many
technicians use 2% to 5%. This would mean that most of the time, prices
should trade within 2- 5% of the moving average.
Interpretation: if prices break above the upper envelope line, it signal

strength and predicts higher prices in the future. On the other hand, if prices
break below the lower envelope line, it signal weakness and would predict
lower prices down the road. (Caution: we could have false signal: prices
12
break above the upper envelope and than collapse). For example Figure 8
show daily DJIA chart with a MA9 and a 2 percent envelope.
Figure 8 (Created from: ADVFN.COM)
BOLINGER BAND
Bolinger Band (developed by John Bolinger) is also based on moving

averages. The MA will be the basic line and two lines, one above and one
below, are drawn to the MA line. The distance of these upper and lower
lines to the MA line is a two moving standard deviation of prices (if MA20,
then you estimate standard deviation of these 20 prices and then multiply the
standard deviation by two to get the upper and lower distance from moving
average line).
When prices become very volatile, the band widens, when prices are quiet
stable, the band narrows. Figure 9 shows the one year daily chart of DJIA
and January 06 Crude Oil with a Bolinger band of MA 20 and stochastic
indicator.
13
Figure 9 (Created from: ADVFN.COM)
14
Interpretation:
1. When Bolinger band narrows, usually a sharp price change will

follow.
2. If prices break above the upper band, this is a sign of strength, on the
other hand, if prices break below lower band, this would be sign of
price weakness. Usually the price breaks several times the band before
it reverses. Question is how do we determine that when the price
breaks for the last time, or prices will reverse very soon? It is usually
difficult, but use of other indicators and price patterns should guide us
to determine the top and bottom of the Bolinger band. For example in
crude oil chart of Figure 9, the price kept touching the upper band
from May to July, however, in July the stochastic (see later chapter)
showed a bearish divergent, therefore, raising the red flag. The same
for price action in July-September, in September again the stochastic
showed a bearish divergence, that could give the signal that may be
this is the last time that the price is touching the upper band. The same
reasoning could be down for lower band.
3. Some technicians follow the following rule: in an up market (the slope
of MA is up), buy every time price moves close to moving average
(the middle line)and sell (get out of your position) when price moves
toward upper band. In a down market (slope of MA is down), sell
every time price moves close to moving average (the middle line) and
cover your short when price moves toward lower band.
Below is a commentary on Dollar-Yen using Bolinger Band by Jim

Wyckoff, provided by Expresstrade.com on 12/13/05.
15
FOREX: U.S. Dollar-Japanese Yen Bulls Still in Technical Command
Dec. 13
Today, let's examine the FOREX market and the U.S. Dollar-Japanese Yen currency pair, also
called "Dollar-Yen." See on the daily bar chart that Dollar-Yen remains in a strong price uptrend
and has just recently hit a fresh 2.5-year high. There are no early technical clues that a market
top is close at hand.
See on the daily chart that the Bollinger Bands indicator shows Dollar-Yen continues to trade
near the top of the upper Bollinger Band. This is a bullish signal. If Dollar-Yen moves into the
lower portion of the Bollinger Bands and trades near the lower band, then that would be a
warning signal that the currency pair is seeing the uptrend weaken and that a market top may be
close at hand.
Stay tuned!--Jim Wyckoff
The following is taken by permission from Pring.com:
Envelopes and Bollinger Bands
One popular method of moving-average interpretation is to plot envelopes or

bands around the moving average at a set interval, as in Chart 1. If the bands
are selected carefully, they serve as support or resistance points. In effect, this
16
approach plots a dynamic form of momentum indicator. In my opinion, these
envelopes may look good on paper, but they have relatively little practical use
since the price often exceeds the envelope boundaries.
Chart 1, however, does demonstrate one very helpful pointer. First of all, we
have two simple moving averages at 5 percent of a 30-day moving average.
Let’s say the moving average itself was at 50. Then, the + 5 percent average
would be plotted at 52 ½ (i.e., 5 percent above the average). If you look at the
period on the left, a bull market, you will see that the upper envelope was
touched quite a bit, but the lower one not at all. When the lower one was
touched for the first time, in October, it was a warning that the trend had
changed to the downside. In fact, the price was never able to touch the upper,
overbought envelope during the whole period of the decline; yet, it did touch the
lower envelope several times. The rule, then, is that periods are likely to be
bearish when the upper envelope is not touched and those when the lower line is
not reached tend to be bullish.
Chart 1 - JP Morgan
Bollinger Bands are an alternative to the envelope approach. They were

developed by the innovative technician John Bollinger. Unlike envelopes, which
are plotted as fixed percentages above and below a moving average, Bollinger
bands are plotted as standard deviations (Chart-2). What this means in a
practical sense, is that the two bands expand and contract as the volatility of the
price series changes.
The lower panel of this chart compares the price with two 20-day moving-
average envelopes. The top panel does the same thing with 20-day Bollinger
bands. The 20-day time span is recommended for shorter-term intermediate
price moves. It is apparent that the Bollinger series in the upper panel is much
more sensitive to price changes in sharp up or down trends.
17
Chart 2 - International Paper
Chart-3 eliminates the lower panel so that we can take a closer look at the
Bollinger band. You can see that the price occasionally moves outside the band
for a day or two, but is normally unable to sustain itself in this position. When
the trend moves persistently in one direction, such as in early 1991 at Arrow 1,
touching the upper band no longer offers a timely signal. This is much the same
was as a momentum indicator, which is virtually useless when a persistent trend
is in force. It is the exception rather than the rule, for in most cases, when the
price moves above the band and then back below it, an exhaustion move has set
in from which a correction follows. Look at what happened to the price at Arrow
2, and again at Arrow 3 These were clearly great places to take profits.
Chart 3 - International Paper
18
Also, if you have a good idea from the other technical indicators of the
direction of the primary trend, it is possible to use those few occasions when the
price moves to the lower band to enter long in a short-term trade. Look at the
Arrows numbered 4, 5, and 6 and see what good opportunities they were.
Moving Averages Applied to Long Term Charts
As we have already said, any technical analysis should start with the long
term chart. We need first to see the primary trend in the market; we can do
this by looking at the weekly chart superimposed with moving average of 10
and 40.
As you can see from figure 10 below, I generated the chart of S&P 500 by
using stockcharts.com. This is a weekly chart with moving average of 10
and 40 weeks. As you can see from the weekly chart, in late 2006 and early
2007, The moving average 10 is above MA40, and both moving averages
are going up, this is positive. But then in January 2008, the big picture
changes, from 1/2008, the big picture becomes negative since MA 10 is
below MA40 and both MAs are sloping down.
The long-term picture at the time of writing (6/27/09) has become mixed to
slightly positive. MA 10 is sloping upward and has crossed MA 40, this is
positive, however MA 40 has not turned upside yet. Off course, since it is
moving average of 40 weeks, it takes a long time for it to turn its direction.
So, as a technician, the long term picture is a little positive; we need a
confirmation of change in direction of MA 40 to say that tall is clear to go
aggressively long.
Also note that if we come down toward 80 in SPY, and then move up, this
could be a reverse head and should bottom. It is very important to look at
long term chart and have an understanding of the big picture. MAs are
excellent tool for trending market, but if a market is not trending, it is
difficult to use MAs, we should use oscillators for non-trending markets
(See next chapters).
19
Figure 10
Mechanical System Trading: The 4 week rule:
According to this rule, buy signals (cover all short) are emitted when the
price exceeds the high of past 4 weeks and sell signals (liquidate longs and
go short) are emitted when price goes lower than the low of the past 4.
20
You can use this model or a variant of this model for your mechanical
trading project.
A variant of the model is that you is as follow:
Buy: buy signals (cover all short) are emitted when the price exceeds the
high of past 4 weeks.
Neutral: if you are in the market, if price goes lower than the low of the past
two week, sell your position (don’t short) and be out of the market (Neutral).
Short: sell signal, go short if price goes lower than the low of the past 4.
For variation of this 4-week rule, see your textbook, pages: 216:221.
Another good mechanical system trading project for this course could be the
channel Breakout System.
21

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Futures Markets

1. The International Monetary Market (IMM), a subsidiary of CME

Raison d’etre of futures markets (Primary purpose):

Professional traders. Many individuals devote 100 % of their time in speculation of

What Futures Are Not:

Your financial position

Your level of knowledge and experience in future trading

Disclose risk associated with futures trading.

Customized versus Standardized Transactions-- whereas forward contracts are customized to

Variable Counterparty Risk versus the Clearinghouse:

You can get forward rates from: http://www.fxstreet.com/rates-charts/forward-rates

Participants in the Futures Markets

Speculators and hedgers:

Most trades are reversed before the maturity of contract

F = S(1 + r)T = 640 * ( 1 + .05)3/12 = 640 * 1.012272 = $647.85

Trading in the futures market:

We have two types of futures contract:

Major categories of future contracts:

Examples of futures trading.

SP500 futures: contract specification

Examples of trading SP500 future:

Estimate your profit?

Profits = (827.95 – 800.25) * $250 = $6,925

Another way is as follow:

Profits = 250 * ((827.95 – 800.25) = $6,925

Loss = (810.05 – 800.25) * $250 = $2,450

Loss = (810.05 – 800.25) * $50 = $490.00

Contract Specification on Mini Nasdaq, (From:www.cme.com)

Examples of trading Mini-NASDAQ 100 future:

Profits = (881.40 – 840.35) * 20 = $821

Profits = (881.40 – 840.35) * 100 = $4,105.00

Again for a lots of futures, please go to: http://www.cmegroup.com/.

Understanding Foreign currency quotes:

Reading a foreign exchange quote is simple if you remember two things:

Major futures contracts that have a lot of liquidity (Easy to trade):

Example of Euro Future:

Contract Specification on the Euro, (http://www.cmegroup.com)

Contract Size 125,000 euro

125000 * (1.4415 – 1.4325) = $1,125

Here is the contract specification for JY/USD taken from CME.com.

Contract Size 12,500,000 Japanese yen

The way I estimate profits and loss is as follow:

12,500,000 /100 * (1.08040 -1.0740) = $800

Eurodollar Interest Rate Futures Contract

Selected Interest Rate Futures Contract

Example of Treasury Bill Future:

13-Week U.S. Treasury Bill Futures

Open High Low Close

As we saw above, minimum tick=.005 = $12.5 or .01 point (1 basis) = $25

Treasury Bond Future Contract: Trades on CBOT

30-Year U.S. Treasury Bond Futures

Size: $100,000 face value U.S. Treasury bonds

Minimum Price fluctuation = tick= One thirty-second of a point, or $31.25

Example of 30-year Treasury Bond Future:

Profits = (113.18-112.10) =1 points + 8 basis = $1,000 + 8(31.25) = $1,250.00 (Commission

. 10 Year U.S. Treasury Notes Futures

Each point = $1,000

108-050 = 108 + 5/32 = 108.1563

Another way of estimation:

Loss = 1 point plus 22.5 ticks = $1,000 + 22.5* 31.25 = $1,703.125

Futures Order Types:

Stop Limit Order

Stop Close Order (SCO)