Lecture 3 Fundamental and Technical Analysis

1. Lecture 3Fundamental and Technical Analysis Primary Texts Edwards and Ma: Chapter 16 CME: Chapter 8 Web Resources http://stockcharts.com/school

2. Volatile Futures Prices

3. 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 • There are various strategies for managing the risks associated with trading.

4. 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

5. Fundamental Analysis • 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.

6. Fundamental Analysis … • Various Techniques of Fundamental Analysis • The Demand-Supply Framework • Price Elasticity • The Balance Table • Stocks-to-Disappearance Ratio • The Tabular and Graphic Approach • The Regression Analysis • Econometric Models • Seasonal Price Index

7. Fundamental Analysis:The Demand-Supply Framework • Market Demand: Market demand represents how much people are willing to purchase at various prices. Thus, demand is a relationship between price and quantity demanded, with all other factors remaining constant. • The economics of consumer behavior derives the law of demand • When price of a good goes up, people buy less of that good • Leads to downward sloping demand curve

8. Fundamental Analysis:The Demand-Supply Framework Changes in Market Demand • Price change does not lead to change in demand • Change in anything other than price lead to demand changes - Entire curve shifts • Income • Price of related goods - Substitutes and Complements • Consumer preference or Taste • Sales Tax • Consumer Expectations about future prices, product availability, and income • Rise in demand – the demand curve shifts to the right • Fall in Demand – the demand curve shifts to the left.

9. Fundamental Analysis:The Demand-Supply Framework • Market Supply: Market supply represents how much producers are willing to sell at various prices. Thus, supply is a relationship between price and quantity supplied, with all other factors remaining constant. • The producer theory derives the law of supply • When price of a good goes up, quantity supplied goes up • Leads to an upward sloping supply curve

10. Fundamental Analysis:The Demand-Supply Framework Changes in Market Supply • Price change does not lead to change in supply • Change in anything other than price lead to supply changes - Entire curve shifts • Production costs • Improvement in production technology • Change in the wage rate • Weather condition • Excise Tax • Rise in Supply – the supply curve shifts to the right • Fall in Supply – the supply curve shifts to the left.

11. Fundamental Analysis:The Demand-Supply Framework • Market Equilibrium: Actual price and Quantity determined by interactions between demanders (consumers) and suppliers (sellers) • Equilibrium Point: The point where the market demand and supply curves intersect • Price at which quantity demanded equals quantity supplied

12. The Effects of Supply and Demand Shifts

13. Fundamental Analysis:The Demand-Supply Framework • Although price is determined by the intersection of the market demand and supply curves, typically demand is not readily quantifiable. • The only theoretically acceptable means of quantifying demand is to estimate demand curves through a detailed analysis of historical consumption and price data. • Demand function for corn: • With historical data on QCorn, PCorn, PWheat, and I, one can estimate α, β, γ, and δ. • Similarly the supply function can also be estimated using historical data.

14. Fundamental Analysis:The Demand-Supply Framework • The law of demand implies that the demand curve is negatively sloped. However, the slope may vary. • Steeply-sloped demand curve – Inelastic demand • Large change in price leads to small change in quantity demanded • Flat demand curve – Elastic demand • Small change in price leads to large change in the quantity demanded • The elasticity of demand is primarily determined by two factors • Availability of substitutes • Percentage of total income spent on the good

15. Fundamental Analysis:The Price Elasticity of Demand • The price elasticity of demand is a measure of the responsiveness of quantity demanded to a price change • Own Price Elasticity of Demand: The percentage change in the quantity demanded relative to a percentage change in its own price. • For a smooth (differentiable) demand curve, the price elasticity of demand is given by

16. The Price Elasticity of Demand • Elasticity is a pure ratio independent of units. • Since price and quantity demanded generally move in opposite direction, the sign of the elasticity coefficient is generally negative. • Interpretation: If ED = - 2.72: A one percent increase in price results in a 2.72% decrease in quantity demanded

17. Forecasting price using the price elasticity of demand • Example • Elasticity of Demand for Cotton: Ed = − 0.67 • Cotton disappeared in quarter 3 of 2010 = 6.64 bill. Lbs • Cotton disappeared in quarter 4 of 2010 = 7.45 bill. Lbs • % change in Eq. Quant. Dem. = ∆Q/Q = (7.45−6.64)/6.64 = 0.122 • Ed = (∆Q/Q ) /(∆P/P ) • − 0.67= 0.122 /(∆P/P ) • ∆P/P = − 0.122/ 0.67= −0.182 • If price of beef in quarter 3 of 2011 is 120 cents/lb, then forecasted beef price for quarter 4 of 2011 is • P*= (1+∆P/P)×P = (1 −0.182)×120 = 0.818×120 = 98.15 cents/lb.

18. Fundamental Analysis:Cross Price Elasticity of Demand • The cross price elasticity of demand is a measure of the responsiveness of quantity demanded of X to a price change of Y • Cross Price Elasticity of Demand: The percentage change in the quantity demanded of X relative to a percentage change in the price of Y. • For a smooth (differentiable) demand curve, the cross price elasticity of demand for Xis given by

19. Fundamental Analysis:Income Elasticity of Demand • The Income Elasticity of Demand is a measure of the responsiveness of quantity demanded to change in consumers’ income • Income Elasticity of Demand: The percentage change in the quantity demanded relative to a percentage change in income. • For a smooth (differentiable) demand curve, the income elasticity of demand is given by

20. Fundamental Analysis:The Price Elasticity of Supply • The price elasticity of supply is a measure of the responsiveness of quantity supply to a price change • Own Price Elasticity of Supply: The percentage change in the quantity supplied relative to a percentage change in its own price. • For a smooth (differentiable) demand curve, the price elasticity of demand is given by

21. Forecasting Price Using theEquilibrium Displacement Model • The concept of elasticity is also useful for forecasting changes in prices and quantities resulting from supply and demand curve shifts. • Supply of pork decreases due to a tougher regulation on manure treatment and disposal • Demand for pork increases due to an increase in the price of beef • If we know the elasticities of demand and supply, we can calculate the changes in price and quantity demanded (or supplied) by incorporating elasticities into a model called an equilibrium displacement model.

22. Equilibrium Displacement Model… • Demand Equation • Qd= (price, income, tastes and preferences, expectations, and prices of other goods) • Demand changes (shifts) if any right hand side factor other than price of the commodity changes • Supply Equation • Qs=  (price, input prices, prices of other goods, expectations, technological change, number of producers) • Supply changes (shifts) if any right hand side factor other than price of the commodity changes

23. Equilibrium Displacement Model… • Equilibrium: Price and quantity are determined by the intersection of the demand and supply curves, where • Qd = Qs (i.e., quantity demanded = quantity supplied) • Equilibrium changes (gets displaced) if demand and/or supply changes because of changes in any right hand side demand and/or supply factor other than the price of the commodity. • Suppose that an increase in income shifts the demand curve to the right, and an increase in the production cost shifts the supply curve to the left. As a result, new equilibrium price will be higher and equilibrium quantity will be lower.

24. Equilibrium Displacement Model… • We can formalize this concept and write the demand equation as • %∆Qd= Ed×(%∆P) + Sd • Where, Edis the elasticity of demand • Sdrepresents any exogenous demand shift – the percentage change in quantity demanded due to a change in the value of any right hand side variable other than own price • Similarly, we can write the supply equation as • %∆Qs= Es×(%∆P) + Ss • Where, Esis the elasticity of supply • Where, Ssrepresents any exogenous demand shift – the percentage change in quantity supplied due to a change in the value of any right hand side variable other than own price

25. Equilibrium Displacement Model… • In equilibrium the percentage change in quantity demanded must equal the percentage changed in quantity supplied, i.e., %∆Qd= %∆Qs Ed×(%∆P) + Sd = Es×(%∆P) + Ss Es×(%∆P) − Ed×(%∆P) = Sd − Ss [Es − Ed]×(%∆P) = Sd − Ss %∆P = [Sd − Ss]/[Es − Ed] • Thus, once we know the values of percentage change in demand and/or supply because of an exogenous shock, we can easily calculate the percentage change in price

26. Equilibrium Displacement Model… • %∆P = [Sd − Ss]/[Es − Ed] • Note that the denominator [Es − Ed] is always positive, because Es is positive and Ed is negative. • If Sd >0 and Ss =0, then %∆P >0 • If Sd =0 and Ss >0, then %∆P <0 • If Sd >0 and Ss >0 and Sd > Ss , then %∆P >0 • If Sd >0 and Ss >0 and Sd < Ss , then %∆P <0 • Once we calculate the percentage change in price %∆P, we can substitute that value into the demand or supply equation to calculate the percentage change in quantity demanded or supplied • %∆Qd= Ed×(%∆P) + Sd = Ed× [Sd − Ss]/[Es − Ed] + Sd

27. Equilibrium Displacement Model… General steps in solving an equilibrium displacement model • Step 1: Determine the values of percentage change in demand (Sd) and supply (Ss) • Step 2: Specify the % changes in quantity demanded and supplied as %∆Qd= Ed×(%∆P) + Sd %∆Qs= Es×(%∆P) + Ss • Step 3: Set %∆Qd= %∆Qs and solve for %∆P • Step 4: Plug the calculated value for %∆P into the %∆Qdor %∆Qsequation to calculate the percentage change in quantity.

28. Equilibrium Displacement Model… Example: Impact of manure regulation in the pork market • Elasticity of pork demand, Ed = −1.96 • Elasticity of pork supply, Es = 2.15 • Because of a newly introduced tighter manure regulation, pork supply falls by 4.3%, i.e., Ss= −4.3% • There is no change in pork demand, i.e., Sd= 0 • Suppose that the current price for pork is $100/cwt and the quantity bought and sold is 1,000 cwt per day. • What would be the new equilibrium price and quantity?

29. Equilibrium Displacement Model… % change in pork price and quantity due to the supply shift • %∆P = [Sd− Ss]/[Es − Ed] = [0 − (− 4.3)]/[2.15 − (− 1.95)] = 4.3/4.10 = 1.05% • Thus the pork price increases by 1.05% • So, the new equilibrium price would be • P* = (1+ %∆P)*P = (1+0.0105)*50 = 50.525/cwt. • %∆Qd = Ed× [Sd− Ss]/[Es − Ed] + Sd = (− 1.95) × [0 − (− 4.3)]/[2.15 − (− 1.95)] + 0 = (− 1.95) × 4.3/4.10 = (− 1.95) × 1.05 = 2.05% • Thus the pork price decreases by 2.05% • So, the new equilibrium quantity would be, Q*= (1+ %∆Q)*Q = (1- 0.0205)*1000 = 979.5 cwt.

30. Fundamental Analysis:The Balance Table • The Balance Table summarizes the key components of current-season supply and disappearance, along with prior-season comparisons.

31. Fundamental Analysis:The Balance Table • Sources: • http://www.nass.usda.gov/Publications/Ag_Statistics/index.asp • http://www.ers.usda.gov/data/feedgrains/Tables.aspx • The balance between supply and disappearance indicates a season ending stocks – it is the relative magnitude of the stocks-to-disappearance ratio that is considered the primary price determining statistic. • Total Supply = Beginning Stocks + Production + Imports • Total Disappearance = Domestic Use + Exports • Year Ending Stocks = Total Supply – Total Disappearance • Stocks-to-Disappearance Ratio = (Stocks/Disappearance) ×100 • Typically, some benchmark ratios are established for various crops using historical stocks and disappearance data. • By comparing the current year’s stocks-to disappearance ratio to the benchmark ratio, analysts estimate the price trend – direction and extent.

32. Fundamental Analysis:The Balance Table • Examples: • For wheat, the benchmark stocks-to-disappearance ratio is typically 20% • If the current year’s stocks-to-disappearance ratio for wheat falls below 20%, prices are likely to rise in the coming months • If the current year’s stocks-to-disappearance ratio for wheat is above 20%, prices are likely to fall in the coming months • For corn, the critical stocks-to-disappearance ratio is typically 12% • For soybeans, the critical stocks-to-disappearance ratio is typically 10% • Thus, appropriate trading strategies can be developed by comparing the current year’s stocks-to-disappearance ratio with the historical averages for different crops (USDA).

33. Fundamental Analysis:The Tabular and Graphic (TAG) Approach • The balance table only involves supply and disappearance statistics, without any direct consideration of price – thus, may lead to incorrect conclusions. • The tabular and graphic (TAG) approach examines the relationship between the balance table statistics along with prices. • The TAG method also considers other factors such as the supply of substitute goods and income • Using the TAG approach, analysts collect and plot historical disappearance data against corresponding prices, and analyze the correlation. • Inconsistencies are further explained by using disappearance data for substitute goods. • The TAG approach is only well-suited to situations in which price fluctuations can be largely explained by one or two variables.

34. Fundamental Analysis:The Regression Analysis • Regression analysis provides a statistical procedure that can be used to formalize the TAG approach. • For example, the price prediction equation for hogs can be expressed as follows: • The values of the coefficients α, β1, β2, and β3, can be estimated by regressing historical hog prices on hog and cattle slaughter data along with the time trend. • Given the estimates α, β1, β2, and β3, and projections for hog and cattle slaughter and the time trend, one can plug those values into the above equation and obtain a precise price forecast. • Regression analysis is probably the single most useful analytical tool in fundamental analysis.

35. Fundamental Analysis: The Regression Analysis • Example: Hog slaughter and pig crop • Y = a + bX; Assume that estimates of a = 0.232, and b = 0.9256. • Y = June-Nov Hog slaughter • X = Dec-May Pig crop • If X = 46 million, then Y = 0.232 +0.9256×46 = 42.8 million. Econometric Models • Regression analysis employs only a single equation. • In some instances, it is theoretically more accurate to construct multiple-equation models in which the equations are interrelated and must be solved simultaneously. • Such models are frequently referred to as econometric models.

36. Fundamental Analysis:Seasonal Price Index • Various markets exhibit seasonal tendencies. • The concept of utilizing seasonal patterns in making trading decisions is based on the assumption that seasonal influences will cause biases in the movements of market prices. • Calculating a Seasonal Index – the Average Percentage Method • Calculate an annual average for each year or season • Express each data item as a percentage of the corresponding annual average • Average the percentage values for each period. The resulting numbers are the seasonal index.

37. Fundamental Analysis:Seasonal Price IndexMarch Sugar Contract: Average Monthly Prices

38. Fundamental Analysis:Seasonal Price IndexMarch Sugar Contract: Monthly prices as percentage of annual averages

39. 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

40. Technical Analysis: Chart Analysis 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

41. Technical Analysis: Chart Analysis 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

42. Technical Analysis: Chart Analysis – Bar Chart

43. Technical Analysis: Chart Analysis – Bar Chart • Bar charts can also be displayed using the open, high, low and close. The only difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar.

44. Technical Analysis: Chart Analysis – Bar Charts • 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

45. Technical Analysis: Chart Analysis – Line Charts • 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.

46. Technical Analysis: Chart Analysis – Candlestick Charts • Candlestick Charts: • Originating in Japan over 300 years ago, candlestick charts have become quite popular in recent years. • 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.

48. Technical Analysis: Chart Analysis – Candlestick Charts Common Shapes of Candles

49. Technical Analysis: Chart Analysis – Candlestick Charts Bulls vs. Bears • A candlestick depicts the battle between Bulls (buyers) and Bears (sellers) over a given period of time. • Long white candlesticks indicate that the Bulls controlled trading for most of the period – buying pressure. • Long black candlesticks indicate that the Bears controlled trading for most of the period – selling pressure. • Small candlesticks indicate that neither the bulls nor the bears were in control of trading – consolidation. • 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. • 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. • 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.

50. Technical Analysis: Chart Analysis – Candlestick Charts • 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.