FINANCIAL DERIVATIVES

Financial derivative is a security whose value is derived from the value and characteristics of the
underlying securities.
Derivatives are useful in risk management since they help in:
1. Reducing costs
2. Enhance returns
3. Allows investors to manage risks with even greater certainty and precision

Derivatives when used speculatively, they can be very risky instruments as they are highly
leveraged and are often more volatile than the underlying instruments.
This means that as markets in the underlying assets move speculative derivative positions can show
even greater movements resulting in large swings to profits and losses.
The most common types of financial derivatives are:
1. Options
2. Swaps
3. Future contracts and forward contracts

Risks arising from the use of derivatives.

1. Valuation Risk

The most common risk for the over the counter (OTC) derivatives is the risk of mispricing the
derivative positions.
Since OTC do not trade in liquid markets where they can be traded at market price, valuation
models need to be used. These models are based on assumptions which are usually not valid and
practical in the economic world.
2. Liquidity Risk

Exchange traded derivative products are highly liquid and transaction can take at the market price.
The market of derivatives contract is therefore realized when it is sold.
OPTIONS
This is a financial arrangement which gives one party a right but not an obligation to buy or sell a
specified number of an underlying security at some future dates at predetermined price known as
exercise or strike price.
In case of an option contract the party which has the right but not an obligation will be required to
pay a non –refundable commitment fee known as premium.
TYPES OF OPTIONS
1. Call option
2. Put option

Call Option
This is a financial arrangement which gives a buyer a right but not an obligation to buy specified
number of an underlying security at some future dates at predetermined exercise price
The buyer will be required to pay the premium to the seller since the buyer will have a right but
not an obligation while the seller will be under an obligation to honour the option contract if
approached by the buyer.

The value of a call option is calculated as:

𝐕𝐂 = 𝐌𝐚𝐱𝐢𝐦𝐮𝐧(𝐒𝐓 − 𝐊, 𝟎)

Where: VC=value of call option

ST= spot market price of underlying asset
K=Strike price

𝐏𝐑𝐎𝐅𝐈𝐓/𝐋𝐎𝐒𝐒 = 𝐕𝐂 − 𝐏𝐫𝐞𝐦𝐢𝐮𝐦

Example
Consider a call option with the following characteristics:
 Strike price=ksh 100
 Premium per call option =ksh 10
 The time remaining to expiry of the option is 3 months

Required: Determine the value of the call option and the profit or loss assuming the following
market prices after 3 months; sh80, sh90, sh100, sh110, sh120
Solution
Spot market prices VC=Max(ST-K,0) Profit/Loss=VC-Premium
80 Max(80-100,0)=0 0-10=-10
90 Max(90-100,0)=0 0-10=-10
100 Max(100-100,0)=0 0-10=-10
110 Max(110-100,0)=10 10-10=0
120 Max(120-100,0)=20 20-10=10

NOTE:
1. An option is said to be in the money when, if it were exercised to day Profits will be
realized
2. An option is said to be out of the money when, if it were exercised to day losses will
be realized
3. An option is said to be at the money when, if it were exercised today there will be no
losses/Profits will be realized (break-even point)

Put Option
This is a financial arrangement which gives a seller a right but not an obligation to sell specified
number of an underlying security at some future dates at predetermined exercise price
The seller will be required to pay the (commitment fee) premium to the buyer. The seller will have
a right but not an obligation.
Value of a put option is computed as:
𝐕𝐏 = 𝐌𝐚𝐱𝐢𝐦𝐮𝐧(𝐊 − 𝐒𝐓, 𝟎)

𝐏𝐑𝐎𝐅𝐈𝐓/𝐋𝐎𝐒𝐒 = 𝐕𝐏 − 𝐏𝐫𝐞𝐦𝐢𝐮𝐦

Example
Consider a Put option with the following characteristics:
 Strike price=ksh 100
 Premium per put option =ksh 10
 The time remaining to expiry of the option is 6 months

Required: Determine the value of the call option and the profit or loss assuming the following
market prices after 6 months; sh80, sh90, sh100, sh110, sh120

Solution
Spot market prices VP=Max(K-ST,0) Profit/Loss=VP-Premium
80 Max(100-80,0)=20 20-10=10
90 Max(100-90,0)=10 10-10=0
100 Max(100-100,0)=0 0-10=-10
110 Max(100-110,0)=0 0-10=-10
120 Max(100-120,0)=0 0-10=-10
Categories of options
There are two main categories:
1. A European option can only be exercised at the end of the option period.
2. An American option is exercised at any time before the end of its life when it is
profitable to do so.

OPTION VALUATION MODELS

1. Binomial option pricing model

It involves constructing a binomial tree. This binomial tree represents different possible paths that
might be followed by the stock price over the life of the option.
Delta
Delta of a stock option is the ratio of change in the price of the stock option to the change in the
price of the underlying stock.

Assume a stock option with current price S and can move a high of Su or lower of Sd. Also consider
an option on the same stock whose current price is F. The option can move up Fu and down of Fd.
This can be explained in a diagram as below.

Su
Fu

S
F

Sd
Fd

∆
Calculating the value of delta .

𝐹𝑢−𝐹𝑑
∆=
𝑆𝑢−𝑆𝑑
Where: Fu=option price after an upward movement
Fd=option price after a downward movement
Su=stock price after an upward movement
Sd=Stock price after a downward movement
The present value of the portfolio= (𝑆𝑢∆ − 𝐹𝑢)𝑒 −𝑟𝑡 ………1
The present value is discounted continuously
 𝑆∆ − 𝐹……………….2
The cost of setting up the portfolio is
−𝑟𝑡
Hence 𝑆∆ − 𝐹= (𝑆𝑢∆ − 𝐹𝑢)𝑒 ……………….3
r=risk free rate
e=2.7183
t=time to expiration of the option
Equation 3 can be used to calculate the value of an option denoted by F.

∆ (delta) will be positive if the it is a call option and negative if it is a put option.
𝐹= 𝑒 −𝑟𝑡 {𝑃𝐹𝑢 + (1 − 𝑝)𝐹𝑑}
𝑒 𝑟𝑡 −𝑑
𝑃=
𝑈−𝑑
Where P is the probability of an upward movement in the stock price.
1-P=probability of the downward movement.
Example
Consider a stock price that starts at Sh 20 and in each of two time steps may go up by 10% or down
by 10%. Suppose each time step is three is 3 months long and the risk free rate is 12% per annum.
Let the strike price of the option Sh 21.
Calculate the call option price at the initial node of the tree.

Put option
Consider a two year put option with a strike price of Sh 52 on a stock whose current price is
Sh50.Suppose there are two time steps of one year and in each time step the stock price moves up
by 20% or down by 20%.suppose the risk free rate is 5%.Calculate the value of the put option
assuming:
i. It is a European option
ii. American option

BLACK AND SCHOLES OPTION VALUATION MODEL.

In 1973 Black and Scholes developed a model of calculating the value of a call option usually
given as follows:
𝐸
𝑉𝑐 = 𝑃𝑁𝑑1 − 𝑟𝑡 𝑁𝑑2
𝑒
𝑃
ln( )+(𝑟+0.5𝛿 2 )𝑡
𝐸
𝑑1 =
𝛿 √𝑡

𝑑2 = 𝑑1 − 𝛿 √𝑡
Where:
VC=value of a call option
P=market price of the underlying security
N (d1) =Area under the normal curve up to d1
E=exercise price
r= risk free rate
t= time to expiration in years
𝛿 =variance of the securities returns
e= 2.7183
Ln=natural logarithms

Steps in calculating value of a call option using Black-Scholes model

1. Calculate d1and d2
2. Determine N (d1) and N (d2) from the cumulative probability tables. Nd is equal to
the area under normal curve up to d.If for example d1=-0.25 then the area under
normal table is 0.0987.d1=0.0987 and Nd1=0.5-0.0987=0.4013
NOTE:
If the value is negative subtract it from 0.5
If it’s positive add 0.5 to obtain Nd1.
3. Substitute the values obtained in step 2 above in the formula to obtain the value of
the option.

Illustration
The shares of ABC ltd are currently selling at Sh 290 each at the stock exchange. The exercise
price for six months call option is Sh 260.The prevailing risk free rate is 12% p.a.The variance of
ABC Ltd share price is 15%.
Required:
Compute the value of the call option using Black-Scholes.
𝐸
𝑉𝑐 = 𝑃𝑁𝑑1 − 𝑟𝑡 𝑁𝑑2
𝑒
𝑃 290
ln( )+(𝑟+0.5𝛿 2 )𝑡 ln(
260
)+(0.12+0.5∗0.15)6/12
𝐸
𝑑1 = = = 0.7547
𝛿 √𝑡 √0.15 √0.5

𝑑2 = 𝑑1 − 𝛿 √𝑡=0.75-√0.5=0.48

Nd1=N (0.75) = 0.2734+0.5= 0.7734

Nd2 =N (0.48) =0.1844+0.5=0.6844
𝐸 260
𝑉𝑐 = 𝑃𝑁𝑑1 − 𝑟𝑡 𝑁𝑑2 = 290 ∗ 0.7734 −
𝑒 0.12∗0.5 ∗ 0.6844 = 𝑠ℎ 56.7
2.7183

Black-Scholes model of a put option is valued using the following formula

𝐸
𝑉𝑝 = 𝑟𝑡 𝑁(−𝑑2) − 𝑃𝑁 (−𝑑2)
𝑒
Vp=Value of the put option

Illustration
Assume on the above is a put option compute the value of put option.

Limitation of Black-Scholes Option

1. It applies only on the European option and not in an American option since American
option is exercised any time within the option contract period.
2. It assumes that the risk free rate is known and constant throughout the option period
3. It assumes that no dividends are paid during the period.
4. It assumes that there are no transaction costs and tax effects involved in buying and
selling of the option or underlying asset.
5. It assumes the standard deviation of the returns of the underlying security is
constant.
VALUATION OF SECURITIES

EFFICIENT MARKET HYPOTHESIS

Financial Markets are influenced by money flows and information -flows. In free and highly
competitive markets, demand and supply pressures determine the prices or interest rates. In a
theoretical sense, markets are said to be efficient, if there is a free flow of information and market
absorbs this information fully and quickly.

James Lorie has defined the efficient security market as follows: “Efficiency...means the ability of
the capital market to function so that prices of securities react rapidly to new information.

Such efficiency will produce prices that are appropriate in terms of current knowledge, and
investors will be less likely to make unwise investments.” In the above context, what will happen
is that market making mechanism is free and unfettered? There are no pockets withholding
information or interested parties making undue gains by insider information by manipulation of
supply and demand forces.

There will be no monopoly elements and malpractices or corruption etc. is not prevalent.
Information flow is free and costless. In the normal course, capital or money flows into areas which
are most profitable which in turn depends on their efficiency and competitiveness? Money flows
also from less profitable to more profitable avenues if information flow is free, fast and costless.
In such market scenario, all investors will have the same information, which is immediately
reflected in the stock prices and nobody can gain extra profits.

All instruments in the market will be correctly priced, as all the available information is perfectly
absorbed and any investor entering the market any time will have the same advantage or returns.
No excess profits are possible in this scenario. As the demand and supply forces are playing their
role freely, the emerging prices are fair and move in a random manner. Prices of today are no more
a function of the prices in the past as the day-to-day forces move in an independent and random
manner. This concept of randomness has led to the theory of random Walk in the determination of
prices. This Random Walk hypothesis is thus a special case of the Efficient Market Theory.

Assumptions
For the capital market efficiency theory to operate, the following assumptions are made
1. Information is free and quick to flow.
2. All investors have the same access to information.
3. Transaction costs, taxes and any bottlenecks are not there and not hampering the free forces
of market.
4. Investors are rational and behave in a cost effective competitive manner for optimization
of returns.
5. Every investor has access to lending and borrowing at the same rate.
6. Market prices are not sticky and absorb the market information quickly and the market
responds to new technology, new trends, changes in tastes, habits of consumers etc.,
efficiently and quickly.

Random Walk Theory

As per this theory, changes in stock prices are independent of each other. The prices of today are
independent of the past trends. The present price is randomly determined and only information
flow can influence prices. As information is free and independent, the resulting prices are free and
independent. A word of caution is necessary here.

This Random walk hypothesis was postulated by researchers on the basis of empirical work on the
market price behaviour. It does not therefore tantamount to the same theory as the capital market
efficiency theory.

Only market efficiency promotes randomness and is therefore not a necessary condition. The fact
that prices move independently has been found empirically and the analysts found an explanation
for this in the efficient functioning of the markets and the market absorption of the information
quickly and efficiently. The equilibrium price of a stock is determined by demand and supply
forces, based on the available information. Quickly as the fresh information becomes available, a
new equilibrium point is reached and the resultant price is thus independent of the part.

This Random walk hypothesis contradicts the Chartist and Technical School which believes that
the present prices are the result of the past trends and that averages discount all fluctuations and
that the average trends move in a predictable manner as the history of trends repeats itself.

On the other hand, fundamental school postulates that the prices are a function of the intrinsic
value of the stock and prices result from changes in the intrinsic value and information relating to
fundamental factors influence the equilibrium prices.

Random walk hypothesis is an offshoot or a phase of the capital market efficiency theorem. The
market efficiency theory postulates that prices are the result of free flow of information which the
market absorbs quickly and efficiently.

Assumption of Random Walk Theory

1. Market is supreme and no individual investor or group can influence it.
2. Stock prices discount all information quickly.
3. Markets are efficient and that the flow of information is free and unbiased.
4. All investors have free access to the same information and nobody has superior knowledge or
expertise.
5. Market quickly adjusts itself to any deviation from equilibrium level due to the operation of free
forces of demand and supply.
6. Market prices change only on information relating to the fundamentals, when the equilibrium
level itself may shift.
7. These prices move in an independent fashion, without undue pressures or manipulation.
8. Nobody has better knowledge or insider information
9. Investors behave in a rational manner and demand and supply forces are the result of rational
investment decisions.
10. Institutional investors or any major fund managers have to follow the market and market cannot
be influenced by them.
11. A large number of buyers & sellers and perfect market conditions of competition will prevail;
Random Walk and Efficient Market Theory
Random Walk hypothesis is considered as restatement or a form of Efficient Market Theory by
some Analysts. The EM - (Efficient Market Hypothesis) is based on the flow of free and correct
information and the market absorption of it.

This information flow and its absorption by the market are the critical elements of this theory.
There are three types of information affecting the market, namely, past Prices and trends, other
public information and inside information.

If all these types are not absorbed perfectly by the market, there is a possibility of some gaining
above average returns, from the investments. Based on the above three types of information, the
analysis have placed the market absorption and the related theory under three heads; namely:
a. Weak Form of EMH, which absorbs only market price information,
b. Semi strong Form which absorbs price information and also all other public information and
c. Strong Form which absorbs all types of information including insider information.

Weak form of EMH is closely related to the Random Walk Hypothesis, as the past prices are
already absorbed by the market and the present prices move therefore independently of the pat,
which is the same as the Random walk hypothesis. The present trends are thus random variables,
and past data cannot be used to predict the future. All the information on the past data on price
trends and volumes was already absorbed earlier. It is futile exercise that the present day price can
be derived by any past data, at least in short run. If that is proved empirically, then prices move in
a random fashion like the walk of a Drunkard, each move independent of the other. It is anybody’s
guess or the result of a toss of coin of what will be the price of TISCO today or Dr. Reddy Labs
tomorrow. Thus the Random Walk hypothesis states that prices move in random manner,
independent of the past prices.

In the real world, the weak form of market efficiency may exist, as prices do move in an
independent manner which the empirical evidence has shown as the past prices are already
absorbed by the market. However, it is to be conceded those market imperfections, costs of
information and blocks to the free flow of information may stand in the way of free play of market
forces. Speculators and groups of interested parties or even brokers may manipulate the prices
through cornering of shares and reducing the flatting stock of the market.

Both the Random walk hypothesis and weak form of EMH, state almost the same thing, namely,
that knowledge of the past stock price does not aid the investors to gain any improved performance.
The prices move independent of the other; although they may move in a random manner they move
around a trend line decided by the anticipated real earnings of the company and its fundamentals.
Both EMH in weak form and the Random Walk Theory thus postulate that analyzing the past does
not improve the forecasting ability of stock prices and new information and prices that result from
them cannot be predicted.

Efficient Market Hypothesis

As referred to earlier, there are three forms of the Hypothesis, namely, weak form of EMH
discussed under Random Walk Theory, semi strong from and strong form. In the words of Fama,
efficient market is defined as the market where there are a large number of rational profit maxi
misers actively competing with each trying to predict the future market and where the current
information is almost freely and equally available to all participants. Analysis of the Research
studies done so far confirm partly the weak form of EMH. But the other two forms of the Theory
are found not really realistic in the Practical Market Scene.

Semi Strong Form of EMH

This form of EMH postulates that the market absorbs quickly and efficiently not only the price
information but all publicly available information. Examples of this public information are found
in the financial reports, Balance Sheets and Profit and Loss Accounts, Earnings and Dividend
Reports, financial results etc. In addition to financial data, any material information affecting the
financial position, such as financial structure, liquidity, solvency etc. is also found relevant and
absorbed by the market in the price formation. Some data and information may be contradictory
and biased information, rumours etc. would also flow in as news affecting the market. Revision of
data or changes in conditions of the company also affect the price. Studies on the time lag involved
in the impact of any change of fundamentals on the company share price showed varied time lags,
some being discounted even before the event is announced and some before the event took place.
Such matters like earnings reports, bonus, and rights affect the market even in anticipation before
the formal announcement.

The studies on the semi strong form of market efficiency related to the effect of any public
information released, on the share price. The tests are invariably based on pricing models, as under
the CAPM or some econometric models. These studies showed that the absorption of this
information on share prices was inefficient and varied from scrip to scrip, and the time period
studied. The inefficiency in the market mechanism absorbing this data is found to be corrected
over a time period as investors take time to analyses and conclude the effect of any public
information. Thus, the semi strong form is empirically not well supported, but in many foreign
markets, the semi strong form is found to be applicable and markets quickly absorb all published
information.
This is possible in those markets due to strict law enforcement, but the market authorities,
instantaneous display of all market information through electronic media and investor awareness
of their impact and their quick absorption of the data. The revolution in informatics and
communication technologies has made it possible for the application of the semi strong form of
the EMH to these markets in developed countries.

Strong Form of EMH

Under this hypothesis markets are so perfect that all information including private information,
insider information and unpublished data, affecting the market are absorbed in the stock prices.
Any investor can then gain the same average returns, whenever he enters the market. The
information of all types is flashed to all investors simultaneously and all players have the same
information at the same time. This means that only superior analysis and interpretation can give
better market returns. This is possible for inside traders, floor brokers and institutional investors
who have highly efficient market research component. The acumen with which price movements
can be forecast can only result in superior return and not otherwise.
Studies made in developed markets have showed that strong form of efficient market does not exist
there also. Investors have not shown consistently higher returns seen with all the information
available to them. It was also found that average investor could do better by picking up securities
in a random fashion.

Critique of EMH
Opinion is divided as to the validity of the EMH particularly in the strong form. In weak form
Random Walk hypothesis holds good, as per some studies. The semi strong form has found less
support from the empirical studies. The perfect markets do not exist, as the stocks as a rule do not
sell at the best price based on intrinsic values. Many times, speculative fervor sentiment and
expectations play a greater role on the stock prices than the fundamental factors.

Similarly news does not spread evenly among all segments of the market and among all investors.
Institutional investors gain through market equity research and through economic of scale and
better expertise. But individual investors do not gain by speedy spread of information and the
absorption of the same by market. To gain, superior advantage, there was no adequate evidence
from any of the empirical studies, based on prices or information. There is thus a controversy on
the validity of Efficient Market Theory. In real market operations, this theory did not find support,
as portfolio managers did not perform better based on the results of this theory. This theory posed
a challenge to both the chartist school and the fundamentalist school. If Random Walk or Weak
Market Efficiency holds good, chartist school finds its tools are not of real value to gain superior
returns. Similarly if random walk holds good, chartist school finds its tools are not of real value to
gain superior returns. Similarly if random walk holds good, following the study of fundamentals
will not secure better returns, unless additional information and insights into the company or better
insider knowledge are available to investors

Anomalies
• Anomalies are unexplained empirical results that contradict the EMH:
– The Size effect.
– The “Incredible” January Effect.
– P/E Effect.
– Day of the Week (Monday Effect

The Size Effect

Beginning in the early 1980’s a number of studies found that the stocks of small firms typically
outperform (on a risk-adjusted basis) the stocks of large firms. This is even true among the large-
capitalization stocks within the S&P 500. The smaller (but still large) stocks tend to outperform
the really large ones

The “Incredible” January Effect.

• Stock returns appear to be higher in January than in other months of the year.
• This may be related to the size effect since it is mostly small firms that outperform in
January.
• It may also be related to end of year tax selling.

P/E Effect
 • It has been found that portfolios of “low P/E” stocks generally outperform portfolios of
“high P/E” stocks.
• This may be related to the size effect since there is a high correlation between the stock
price and the P/E.
It may be that buying low P/E stocks is essentially the same as buying small company stocks.

The Day of the Week Effect

• Based on daily stock prices from 1963 to 1985 Keim found that returns are higher on
Fridays and lower on Mondays than should be expected.
• This is partly due to the fact that Monday returns actually reflect the entire Friday close to
Monday close time period (weekend plus Monday), rather than just one day.
• Moreover, after the stock market crash in 1987, this effect disappeared completely and
Monday became the best performing day of the week between 1989 and 1998.

Efficient Markets and Fundamental Analysis

• Past vs. Future
– The EMH, importantly, considers the incorporation of available information, which
is primarily historic in nature.
– Much of what is involved in fundamental analysis, including aggregate market
analysis and industry analysis, involves estimating future values.
– Superior analysts are those who will be better at predicting this uncertain future

Efficient Markets and Portfolio Management

• Does active portfolio management pay off?
– Research indicates that most money managers do keep pace with the market
• Certainly with a superior analyst, recommendations should be followed
– Opportunities may be present in smaller, neglected stocks (although risk must be
taken into account)

The Rationale and Use of Index Funds

• Efficient capital markets and a lack of superior analysts imply that many portfolios should
be managed passively (so their performance matches the aggregate market, minimizes the
costs of research and trading)
• Institutions created market (index) funds which duplicate the composition and performance
of a selected index series

Fundamental and Technical Analysis

Trading Futures
Trading futures as a speculator is no different from trading any other commodity or asset. Success
depends on the ability to
 Accurately predict futures prices, and
 Efficiently manage risks
Two techniques are commonly used to forecast prices
 Fundamental Analysis
 Technical Analysis
Technical analysis involves the analysis of market prices in an attempt to predict future price
movements for the particular financial asset traded on the market. This analysis examines the
trends of historical prices and is based on the assumption that these trends or patterns repeat
themselves in the future.

Fundamental analysis in its simplest form is focused on the evaluation of intrinsic value of the
financial asset. This valuation is based on the assumption that intrinsic value is the present value
of future flows from particular investment. By comparison of the intrinsic value and market value
of the financial assets those which are underpriced or overpriced can be identified.

Fundamental Analysis
Fundamental analysis seeks to identify the fundamental economic and political factors that
determine a commodity’s price. It is basically an analysis of the (current and future) demand for
and supply of a commodity to determine if
 A price change is imminent, and
 In which direction and by how much prices are expected to change.
This approach requires
 gathering substantial amounts of economic data and political intelligence,
 assessing the expectations of market participants, and
 analyzing these information to predict futures price movement
Fundamental analysis focuses on cause and effect causes external to the trading markets that are
likely to affect prices in the market.
 These factors may include the weather, current inventory levels, government policies,
economic indicators, trade balances and even how traders are likely to react to certain
events.
 Fundamental analysis maintains that markets may misprice a commodity in the short run
but that the "correct" price will eventually be reached. Profits can be made by trading the
mispriced commodity and then waiting for the market to recognize its "mistake" and
correct it.

Various Techniques of Fundamental Analysis

1. The Demand-Supply Framework
2. Price Elasticity
3. The Balance Table
4. Stocks-to-Disappearance Ratio
5. The Tabular and Graphic Approach
6. The Regression Analysis
7. Econometric Models
 8. Seasonal Price Index
TECHNICAL ANALYSIS
Technical analysis is the study of historical prices for the purpose of predicting prices in the future.
Technical analysts frequently utilize charts of past prices to identify historical price patterns. These
price patterns are then used to forecast prices in the future. A basic belief of technical analysts is
that market prices themselves contain useful and timely information. Prices quickly reflect all
available fundamental information, as well as other information, such as traders’ expectations and
the psychology of the market
Role of Technical Analysis
 Identify and predict changes in direction of price trends

 Determine the timing of action – entry and exit decisions

Chart Analysis - the basic tool of technical analysis

A price chart is a sequence of prices plotted over a specific time frame. In statistical terms, charts
are referred to as time series plots. Chart analysts plots historical prices in a two-dimensional graph
in order to identify price patterns which can then be used to predict the futures direction of prices.
The goal of any chart analyst is to find consistent, reliable, and logical price patterns with which
to predict future price movements. Chart analysts rely primarily on three bodies of data
 Prices (monthly, weekly, daily, and intra-day)

 Trading volumes, and

 Open interest

Price Pattern Recognition Charts

The most commonly used price pattern recognition charts are: bar charts, line charts, candlestick
charts, and point-and-figure charts. On these charts, the Y-axis (vertical axis) represents the price
scale and the X-axis (horizontal axis) represents the time scale. Prices are plotted from left to right
across the X-axis with the most recent plot being the furthest right.
Bar Charts:
Bar charts mark trading activity of a specified trading period (e.g., day) by a single vertical line on
the graph
 This line connects the high and low prices for the trading period

 The closing price is indicated by a horizontal bar

Bar Charts: One-Day Price Reversals
Bar charts are frequently used to identify one-day price reversals. A one-day price reversal occurs
in a rising market when prices make a new high for the current advance but then close lower
than the previous day’s close. A one-day price reversal occurs in a falling market when prices
make a new low for the current decline but then close higher than the previous day’s close
Line Charts:
In a line chart, only the closing prices are plotted for each time period. Some investors and traders
consider the closing level to be more important than the open, high or low. By paying attention to
only the close, intraday swings can be ignored

Candlestick Charts:
.For a candlestick chart, the open, high, low and close are all required.
  Hollow (clear) candlesticks form when the close is higher than the open and Filled (solid)
candlesticks form when the close is lower than the open.

 The white and black portion formed from the open and close is called the body (white
body or black body). The lines above and below are called shadows and represent the high
and low.

 A daily candlestick is based on the open price, the intraday high and low, and the close. A
weekly candlestick is based on Monday's open, the weekly high-low range and Friday's
close.

Bulls vs. Bears

A candlestick depicts the battle between Bulls (buyers) and Bears (sellers) over a given period of
time.
1. Long white candlesticks indicate that the Bulls controlled trading for most of the
period – buying pressure.

2. Long black candlesticks indicate that the Bears controlled trading for most of the
period – selling pressure.

3. Small candlesticks indicate that neither the bulls nor the bears were in control of
trading – consolidation.

4. A long lower shadow indicates that the Bears controlled trading for some time, but
lost control by the end and the Bulls made an impressive comeback.

5. A long upper shadow indicates that the Bulls controlled trading for some time, but
lost control by the end and the Bears made an impressive comeback.
 6. A long upper and lower shadow indicates that both the Bears and Bulls had their
moments during the trading period, but neither could put the other away, resulting
in a standoff.

Hollow vs. Filled Candlesticks

 Hollow candlesticks, where the close is higher than the open, indicate buying pressure.

 Filled candlesticks, where the close is lower than the open, indicate selling pressure.

Long vs. Short Bodies

Generally speaking, the longer the body is, the more intense the buying or selling pressure.
 Long white candlesticks show strong buying pressure – buyers are aggressive.

 Long black candlesticks show strong selling pressure – sellers are aggressive.

 Conversely, short candlesticks indicate little price movement and represent

consolidation.

Point-and-Figure Charts:
Point-and-figure charts are constructed by filling in boxes with either a X or an O. A price increase
or decrease is defined as a price change that exceeds a specified magnitude – a price change less
than that magnitude does not receive an X or O in the chart. If prices are rising, the appropriate Xs
are entered in a particular column. When prices begin to decline, a new column is started, and Os
are entered in that column
 Each price reversal results in the start of a new column

 Point-and-figure Charts are based solely on price movement, and do not take time into
consideration. There is an x-axis but it does not extend evenly across the chart.

Point-and-Figure Charts:
The objective of point-and-figure chart is to provide a smoothing effect on the price changes that
appear in a bar chart in order to detect significant price trends and reversals. Point-and figure charts
can also be used to generate buy and sell signals.
  A buy signal occurs when an X in a new column surpasses the highest X in the
immediately preceding X column.

 A sell signal occurs when an O in a new column is below the lowest O in the
immediately preceding O column.

This focus on price movement makes it easier to identify support and resistance levels, bullish
breakouts and bearish breakdowns
Common Technical Price Patterns
Chart analysis uses both trend lines and geometric formations to predict market tops and bottoms,
as well as future price movements. The most popular technical price patterns are
 Support and Resistance,

 Trend lines,

 Double tops and bottoms, and

 Head-and-shoulder.

Support and Resistance

A support level is a price level at which there appears to be substantial buying pressure to keep
prices from falling further
A resistance level is a price level at which there appears to be substantial selling pressure to keep
prices from rising further
A congestion area occurs when prices move sideways, fluctuating up and down within a well-
defined range for a considerable time period
 A support level is a price level at which there appears to be substantial buying pressure to
keep prices from falling further

 As the price declines towards support and gets cheaper, buyers become more
inclined to buy and sellers become less inclined to sell. By the time the price reaches
the support level, it is believed that demand will overcome supply and prevent the
price from falling below support.

 Support can be established with the previous reaction lows.

A resistance level is a price level at which there appears to be substantial selling pressure to keep
prices from rising further
 As the price advances towards resistance, sellers become more inclined to sell and
buyers become less inclined to buy. By the time the price reaches the resistance
level, it is believed that supply will overcome demand and prevent the price from
rising above resistance.

 Resistance can be established with the previous reaction highs.

  Another principle of technical analysis is that support can turn into resistance and vice
versa.

 Once the price breaks below a support level, the broken support level can turn into
resistance. The break of support signals that the forces of supply have overcome the forces
of demand. Therefore, if the price returns to this level, there is likely to be an increase in
supply, and hence resistance.

 The other turn of the coin is resistance turning into support. As the price advances above
resistance, it signals changes in supply and demand. The breakout above resistance proves
that the forces of demand have overwhelmed the forces of supply. If the price returns to
this level, there is likely to be an increase in demand and support will be found.

Congestion Area – Trading Range

 A congestion area occurs when prices move sideways, fluctuating up and down
within a well-defined range for a considerable time period

A congestion area signals that the forces of supply and demand are evenly balanced.
 When the price breaks out of the congestion area, above or below, it signals that a winner
has emerged - A break above is a victory for the bulls (demand) and a break below
is a victory for the bears (supply).

 When the price breaks out of the congestion area by penetrating the support it is a signal
to sell.

 When the price breaks out of the congestion area by penetrating resistance it is a signal
to buy.
Support and Resistance Zones
 Because technical analysis is not an exact science, it is sometimes useful to create support
and resistance zones.

 Sometimes, exact support and resistance levels are best, and, sometimes, zones work better.

 Generally, the tighter the range, the more exact the level.

 If the trading range spans less than 2 months and the price range is relatively tight, then
more exact support and resistance levels are best suited.

 If a trading range spans many months and the price range is relatively large, then it is best
to use support and resistance zones.

 These are only meant as general guidelines, and each trading range should be judged on its
own merits.

 Identification of key support and resistance levels is an essential ingredient to successful

technical analysis.

 Even though it is sometimes difficult to establish exact support and resistance levels, being
aware of their existence and location can greatly enhance analysis and forecasting abilities.

 If a futures contract is approaching an important support level, it can serve as an alert to be

extra vigilant in looking for signs of increased buying pressure and a potential reversal.

 If a futures contract is approaching a resistance level, it can act as an alert to look for signs
of increased selling pressure and potential reversal. If a support or resistance level is
broken, it signals that the relationship between supply and demand has changed.

 A resistance breakout signals that demand (bulls) has gained the upper hand and a support
break signals that supply (bears) has won the battle.

Trend Lines
 Technical analysis is built on the assumption that prices trend.

 A common trading strategy is to identify a price trend and then go with the trend.
  A trend line is a straight line that connects periodic highs or lows on a price chart and then
extends into the future to act as a line of resistance or support.

 Two common types of trend lines

 Uptrend lines

 Downtrend lines

Uptrend Lines
An uptrend line has a positive slope and is formed by connecting two or more low points. The
second low must be higher than the first for the line to have a positive slope.
 Uptrend lines act as support and indicate that net-demand (demand less supply)
is increasing even as the price rises.

 A rising price combined with increasing demand is very bullish, and shows a strong
determination on the part of the buyers.

 As long as prices remain above the trend line, the uptrend is considered solid and
intact.

 A break below the uptrend line indicates that net-demand has weakened and a
change in trend could be imminent.

 When price falls below the uptrend

line, this is a signal to

sell or go short.
Downtrend Lines
 A downtrend line ha

 s a negative slope and is formed by connecting two or more high points. The second high
must be lower than the first for the line to have a negative slope.

 Downtrend lines act as resistance, and indicate that net supply (supply less
demand) is increasing even as the price declines.

 A declining price combined with increasing supply is very bearish, and shows the
strong resolve of the sellers.

 As long as prices remain below the downtrend line, the downtrend is solid and
intact.

 A break above the downtrend line indicates that net-supply is decreasing and that a
change of trend could be imminent.

 When price breaks above the downtrend line, this is a signal to buy or go long.

 The general rule in technical analysis is that it takes two points to draw a trend line
and the third point confirms the validity.

 It can sometimes be difficult to find more than 2 points from which to construct a trend
line.
 Even though trend lines are an important aspect of technical analysis, it is not always
possible to draw trend lines on every price chart. Sometimes the lows or highs just
don't match up, and it is best not to force the issue.

 Trend lines can offer great insight, but if used improperly, they can also produce false
signals

 Trend lines should not be the final arbiter, but should serve merely as a warning that
a change in trend may be imminent.

Double Tops or Bottoms

 Double tops or bottoms are frequently used to identify a price reversal.

 In an uptrend, the failure of prices to exceed a previous price peak on two occasions is
considered a double top.

 This is a warning signal that the uptrend may be about to end and a downtrend to
commence

 However, the formation of a double top is not considered confirmed until falling
prices penetrate the previous low from the above.

 A double bottom is just the mirror image of a double top.

 In a downtrend, the failure of prices to penetrate previous support levels on two occasions
is considered a double bottom.

 This is a warning signal that the downtrend may be about to end and an uptrend to
commence
Double Tops
 Prior Trend: In the case of the double top, a significant uptrend should be in place.

 First Peak: The first peak should mark the highest point of the current trend.

 Trough: After the first peak, a decline takes place that typically ranges from 10 to 20%.

 Second Peak: The advance off the lows usually occurs with low volume and meets
resistance from the previous high. Resistance from the previous high should be expected.
Usually a peak within 3% of the previous high is adequate.

 Decline from Peak: The subsequent decline from the second peak should witness an
expansion in volume and/or an accelerated descent, perhaps marked with a gap or two.

 Support Break: Breaking support from the lowest point between the peaks completes the
double top. This too should occur with an increase in volume and/or an accelerated descent.

 Support Turned Resistance: Broken support becomes potential resistance and there is
sometimes a test of this newfound resistance level with a reaction rally. Such a test can
offer a second chance to exit a position or initiate a short.

 Price Target: The distance from support break to peak can be subtracted from the support
break for a price target. This would infer that the bigger the formation is, the larger the
potential decline.
 Double Bottoms
 Prior Trend: In the case of the double bottom, a significant downtrend should be in place.

 First Trough: The first trough should mark the lowest point of the current trend.

 Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%.

 Second Trough: The decline off the reaction high usually occurs with low volume and
meets support from the previous low. Support from the previous low should be expected.
While exact troughs are preferable, there is some room to maneuver and usually a trough
within 3% of the previous is considered valid.

 Advance from Trough: Volume is more important for the double bottom than the double
top. There should be clear evidence that volume and buying pressure are accelerating
during the advance off of the second trough.

 Resistance Break: Breaking resistance from the highest point between the troughs
completes the double bottom. This too should occur with an increase in volume and/or an
accelerated ascent.

 Resistance Turned Support: Broken resistance becomes potential support and there is
sometimes a test of this newfound support level with the first correction. Such a test can
offer a second chance to close a short position or initiate a long.

 Price Target: The distance from the resistance breakout to trough lows can be added on
top of the resistance break to estimate a target. This would imply that the bigger the
formation is, the larger the potential advance.

Head-and-Shoulders Tops or Bottoms

 Head-and-Shoulders formations are among the most frequently used technical patterns for
identifying a price reversal.

 Head-and-Shoulders formations consist of four phases:

 The left shoulder

 The head

 The right shoulder

 The penetration of the neckline

 A head-and-shoulder reversal pattern is complete only when the neckline is penetrated,

either in an upward or downward direction.
  Head-and-Shoulder top: The formation is complete when price penetrate the
neckline from above indicating a reversal from a uptrend to a downtrend.

Head-and-Shoulder bottom: The formation is complete when price penetrate the neckline from
below indicating a reversal from a downtrend to an uptrend

Head-and-Shoulders Tops
Head-and-Shoulders Tops
 Prior Trend: Without a prior uptrend, there cannot be a Head and Shoulders reversal
pattern.

 Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high
point of the current trend. After making this peak, a decline ensues to complete the
formation of the shoulder (1). The low of the decline usually remains above the trend line,
keeping the uptrend intact.

 Head: From the low of the left shoulder, an advance begins that exceeds the previous high
and marks the top of the head. After peaking, the low of the subsequent decline marks the
second point of the neckline (2). The low of the decline usually breaks the uptrend line,
putting the uptrend in jeopardy.

 Right Shoulder: The advance from the low of the head forms the right shoulder. This peak
is lower than the head (a lower high) and usually in line with the high of the left shoulder.
While symmetry is preferred, sometimes the shoulders can be out of whack. The decline
from the peak of the right shoulder should break the neckline.

 Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the
end of the left shoulder and the beginning of the head. Low point 2 marks the end of the
head and the beginning of the right shoulder. Depending on the relationship between the
two low points, the neckline can slope up, slope down or be horizontal.
  Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in
confirmation. Ideally, but not always, volume during the advance of the left shoulder
should be higher than during the advance of the head. This decrease in volume and the new
high of the head, together, serve as a warning sign. The next warning sign comes when
volume increases on the decline from the peak of the head. Final confirmation comes when
volume further increases during the decline of the right shoulder.

 Neckline Break: The head and shoulders pattern is not complete and the uptrend is not
reversed until neckline support is broken. Ideally, this should also occur in a convincing
manner, with an expansion in volume.

 Support Turned Resistance: Once support is broken, it is common for this same support
level to turn into resistance. Sometimes, but certainly not always, the price will return to
the support break, and offer a second chance to sell.

 Price Target: After breaking neckline support, the projected price decline is found by
measuring the distance from the neckline to the top of the head. This distance is then
subtracted from the neckline to reach a price target. Any price target should serve as a
rough guide, and other factors should be considered as well. These factors might include
previous support levels, Fibonacci retracements, or long-term moving averages.

Technical Analysis:
Head-and-Shoulders Bottom

Head-and-Shoulders Bottoms
 Prior Trend: Without a prior downtrend, there cannot be a Head and Shoulders Bottom
formation.
 Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new
reaction low in the current trend. After forming this trough, an advance ensues to complete
the formation of the left shoulder (1).

 Head: From the high of the left shoulder, a decline begins that exceeds the previous low
and forms the low point of the head. After making a bottom, the high of the subsequent
advance forms the second point of the neckline (2).

 Right Shoulder: The decline from the high of the head (neckline) begins to form the right
shoulder. This low is always higher than the head, and it is usually in line with the low of
the left shoulder. When the advance from the low of the right shoulder breaks the neckline,
the Head and Shoulders Bottom reversal is complete.

 Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks
the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end
of the head and the beginning of the right shoulder. Depending on the relationship between
the two reaction highs, the neckline can slope up, slope down, or be horizontal.

 Volume: While volume plays an important role in the Head and Shoulders Top, it plays a
crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume,
the validity of any breakout becomes suspect.

 Volume on the decline of the left shoulder is usually pretty heavy and selling
pressure quite intense.

 The advance from the low of the head should show an increase in volume

 Neckline Break: The Head and Shoulders Bottom pattern is not complete, and the
downtrend is not reversed until neckline resistance is broken. For a Head and Shoulders
Bottom, this must occur in a convincing manner, with an expansion of volume.

 Resistance Turned Support: Once resistance is broken, it is common for this same
resistance level to turn into support. Often, the price will return to the resistance break, and
offer a second chance to buy.

 Price Target: After breaking neckline resistance, the projected advance is found by
measuring the distance from the neckline to the bottom of the head. This distance is then
added to the neckline to reach a price target. Any price target should serve as a rough guide,
and other factors should be considered, as well.
 Technical Analysis:
Head-and-Shoulders Tops or Bottoms

 70-80% reliable in terms of significant move after neckline is broken

 Time required to complete can be days or up to several weeks
 Frequently seen in grains and livestock commodities
 Easy to recognize
 Low trading volume on each side of the “head” confirms the formation

Market Trend Analyses:

Market trend analyses use more complex price charts as well as volume and open interest figures
to determine both the existence of price trends and the strength of these trends.
 Moving Averages

 Rate of Change Indicators: Momentum and Oscillator

 Volume and Open Interest

Moving Averages
Moving averages are used to determine price trends and trend changes. A moving average is a
statistical technique for smoothing price movements in order to identify trends more easily.
 A simple n-day moving average is the average of the most recent n daily closing prices. A
5-day moving average is the average of the last 5 daily closing prices.

 A 25-day moving average is the average of the last 25 daily closing prices.

 The number of days used to compute the average determines the sensitivity of the average
to new price movements

 The more days that are used, the less sensitive is the average

 Weighted moving averages can also be constructed

 If greater weights are given to more recent prices, the average becomes more
sensitive to price change