Question:
There is something I just don't understand
about the spread between the long term monthly and the daily quotes and why
they need adjustment.
I've always thought that the monthly and
weekly were mechanically established by taking the high, low of the frame
time selected, as well as the open of the first day and the close of the
last day of this specific frame. Why would this need adjustment?
Answer:
Thank you for your question. The fact that
you sometimes need to make adjustments between the long term and daily
charts is something that confuses a lot of traders, probably because it is
a concept that you would not have encountered anywhere else.
First off, you are correct in your
understanding of how the time frames are established. Any price bar on the
weekly chart shows the opening price on Monday, the closing price on
Friday, and the high and low price that occurred during the week in
question. Similarly for the monthly price bar, it shows the opening price
on the first day of the month, the closing price for the last day as well
as the high and low price for that month.
But this is not where the adjustment needs
to be made.
You need to adjust the figures because of
the "spread" between contract months. You see, because of carrying costs,
inventories, pending crops, etc, the further out the contract month is, the
more of a difference there will be between that month and the front month.
However, when the weekly and monthly
charts are drawn up, they use ONLY the front month data. For this reason,
if you are trading a month other than the front month, you need to adjust
the data so that they have the same "monthly bias".
Keep in mind that if you are trading the
front month, no adjustment needs to be made. You only adjust the figures if
you are trading another contract month.
Sugar is a great example. This time of the
year, the front month contract in sugar is January; however January has
very little volume or open interest and therefore is a difficult contract
month to trade. By contrast however, the March contract has huge volume and
open interest.
Remember, you want to be trading a month
with enough volume and open interest so that you can get good fills and
exits; therefore if you where trading sugar you'd be following the March
contract and not January.
But the weekly and monthly charts are
using January's data, not March - but as you have seen we want to be
trading March, so what do you do if you want to consult the long term chart
for information? You need to adjust the weekly/monthly data to become more
March like.
How do you do that? By comparing the
closing prices between the weekly and March charts and adjusting for the
difference. Right now sugar's a little screwy with holiday trading, but we
will stick with it as an example. The March contract closed the week at
591, while the weekly chart shows the closing price to be 320.
Obviously, 320 is an irrelevant number on
the March chart, but if you adjust for the 271 difference you can transfer
figures from one chart to another. March is trading 271 points higher than
the January contract. Therefore any figures you take from the weekly or
monthly charts (currently containing January data) you will need to add 271
to make the number relevant to the March chart.
What if you thought sugar was going to go
as low as the 230 low back in June 1985? What is the equivalent of 230 on
the March chart? It's not 230, is it?
No, it's not. 230 is not a relevant number
on the March chart. So what is the right number?
Well, if you adjust the figures then you
can find the March equivalent of 230. Therefore you would take 230 and add
the 271 difference, 230 + 271 (the difference between March and the front
month/weekly/monthly chart) and you get 501.
Now that's a number that is relevant in
March!
Therefore if the market breaks current
support you could use 501 as your longer term target (there is some
additional support before 501, but for the sake of clarity we will use 501
for this example).
Are you beginning to see why it is
important to adjust the figures between time frames?
Something to keep in mind too, when a
market is moving quickly the spread between months will change; therefore
you may need to adjust your target from time to time to allow for the
change in the spread.
While the front month may not necessarily
be the contract month you want to be trading, it is nevertheless the month
that is “driving” the other contract months. Therefore once the front month
finds support, the other contract months will follow suit and find support
as well.
-Erich
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The Spread Between Monthly and Daily Quotes
