A common question that crops up during the formative years of a trader is whether technical analysis is the same for both the stocks as well as the futures market, or for that matter any asset class that is traded on the bourses.
The answer to the question is both a yes and a no.
During the initial years when technical analysis was still being developed there was only the cash or the stock market to work on. Most of the initial principles of technical analysis like the Dow Theory have been developed on the cash market and its indices.
However, as futures markets developed and volume of traders and businesses shifted from the cash market to the futures market more tools were being developed to cater specifically for the futures markets and especially for short term trading.
The basic principles of technical analysis however, are valid for both the stocks and futures market. Definition of a trend and technical charting patterns remains the same for both the markets. The differences however are subtle. Before looking at the differences between technical analysis of stocks and futures market, we need to understand the differences between the two markets.
Difference between stocks and futures market
Stocks represent the companies that are traded. An investor as well as a trader both participates in buying the stock, either for a short term purpose or for a long term. Stocks derive their value from the fundamental performance of the company as well as the supply and demand dynamics in the market.
Equity Futures on the other hand have stocks as their underlying asset from which they derive their value. A future contract represents an exchange notified number of shares of each stock. Thus number of shares in a future contract can differ from company to company. Hence when a trader buys a future contract he is obliged to buy the defined quantity only.
Stocks on the other hand can be bought in the quantity that the trader or investor actually wants.
However, on account of the leverage that a future contract offers, volume in the futures market is generally higher than the spot market. While buying a futures contract the trader only has to pay the margin amount which is generally around 35 percent of the value of the contract. On the other hand share purchase generally requires the purchaser to pay the entire amount. A futures market is where the big fish hunts. Arbitrageurs, scalpers, day-traders all prefer the futures market on account of the leverage, liquidity and volatility.
A point to be noted is that one can create another segment within the cash segment stock market – it will be for those stocks in which future contracts are traded. Such stocks generally have higher volume than other stocks as arbitrageurs ensure that the price of futures contract is aligned with that of the cash market. A future contract normally replicates the movement of the stock in the cash market though it trades at a premium to the cash market.
As mentioned earlier, most of the laws of technical analysis are applicable for not only stocks and futures markets but all financial markets where trading takes place.
Dow Theory which defines the trend – whether it is a bull or a bear market, the various mathematical approaches to technical analysis like the Fibonacci Numbers, Gann and Elliott wave all holds true to every market. Trend lines, moving averages and chart pattern also remain the same. Rules and tools of intra-day trading and long-term trading remains the same. Also the rules of various types of charts – candlesticks, bar or line are the same for all markets.
Well when everything in technical analysis is the same for stocks and futures where is the difference?
The main difference is in the use of the tools.
A futures contract position has to be rolled over periodically. In India the futures position in the stocks and indices have to be rolled over every month. This causes high volatility especially during the last few days of rollover as trader and arbitrageurs search for opportunities in the new month in which the positions have to be carries forward.
Squaring off their position in the current month and opening a new position in the next month needs liquidity in both the time series of the futures contract. Despite good liquidity institutional activities on the last few days and especially the last few hours creates very high movement in the stock prices.
This sharp movement has the potential of triggering the stop losses of traders who keep a tight stop loss. In order to avoid the whipsaws, traders prefer to use different parameters in the technical analysis arsenal.
Thus if a trend trader who is active in both the stock and futures market is using a 50 day moving average in stocks he would prefer to use a smaller period moving average in the futures market as he can get a better exit closer to the top and bottom before the positions are rolled over.
As stocks are relatively illiquid when compared to futures, they result in higher number of false breakouts. A trader would prefer to use a pullback in an illiquid market rather than risk a false breakout.
Though pattern analysis is used in cash segment as well as futures market, the pattern in illiquid stocks are not as clear as they are in futures or liquid stocks, such as those in stocks where futures trading is allowed. Traders generally avoid using patterns in illiquid stock and even if they do they use another tool such as an oscillator as a confirmation before initiating a trade.
Technical analysis is a tool used by traders to predict the future direction of the market. A stock trader uses it in combination with his fundamental analysis to time his entry and exits. He can also use technical analysis along with news flows and other inputs like analyst recommendation, mutual fund or a savvy investor buying the stock to create a position.
A future trader on the other hand has one more weapon in his arsenal. He uses data which are unique to future contracts, such as open interest analysis or cost of carry analysis to create his position.
Application of technical analysis is an art more than a science. The trader needs to develop their strategies based on the situation on the ground. Various markets behave differently and a one-size-fits-all strategy will not work in all markets.