How Markets Absorb Information: Interpreting Price Charts

By Dan Gramza
November 2006

There are three basic technical analysis components to determine how the markets absorb information: price (movement) display, direct analysis of price display, and indirect analysis of price display. I'll provide some examples of how the S&P 500 futures have reacted to market-moving events, and how we as traders can plan our strategy on days like these, using my favorite technical analysis method.

As elections have been on our minds this month, I'll take a look at how the market behaved in the days leading up to and following the 2004 election as an example to examine how markets absorb information, and how we can see the process unfolding on the charts. You can then do your own analysis of what the charts reflect for the 2006 elections.

(Editorial note: This article is based on a webinar Dan Gramza conducted on November 6, 2006, in conjunction with the Lind-Waldock/CME Trade with a Pro SimTrade Contest. You can view the webinar archive through Lind Events free)

First and foremost as a trader, you need to select your trading approach: fundamental, or technical. Fundamental traders trade on the expectation of how the market will react to the flow of news and information. Technical traders analyze the price reaction to the fundamentals, and formulate their trading approach based on interpretation of what the price charts are indicating.

As mentioned previously, there are three basic components of technical analysis to measure market absorption, and that's what we will focus on.

Price Displays

This is the basic chart display or type we are looking at to visually record price movement as we trade. This would include a candlestick chart, bar chart, line chart, point-and-figure chart, etc. Essentially, these are methods of recording price movements.

Line Chart. Chart 1 shows a line chart, which plots a single price for a designated period of time, such as 60 minutes, a day, or a week. The most commonly plotted price is the closing price, but the open, high and low prices can be used as well.

Chart 1

Bar Chart. A bar chart (Chart 2) is represented by a series of vertical lines, or bars, plotted on a price/time grid. Each bar represents the same designated time period. The top of each bar stops at the highest price traded during the period, and the bottom of each bar stops at the lowest price. The opening price of each period is indicated by a horizontal mark on the left side of the bar. The close is indicated by a horizontal mark on the right side of the bar. See the example in Chart 2 below of how a bar chart appears.

Chart 2

Direct Analysis of Price Displays

Direct analysis of price displays involves analysis of patterns and trends contained within price displays. We then look at the price display and make decisions about how the market is unfolding.

Indirect Analysis of Price Displays

Indirect analysis of price displays involves applying a mathematical study to the analysis of price displays, such as moving averages or stochastics. We then draw a conclusion about possible price action ahead by looking at a combination of the display of price action, analysis of the price display, and a mathematical study.

Let's look at a price display I prefer using, Japanese candlestick, and how I analyze this display. The Japanese candle construction is represented by the diagram below. I will use candle charts as I analyze the reaction of the S&P 500 futures market to two prior news events, so you can see how they looked.

A candle is made up of four prices: the open, the high, the low and the close. If the closing price is above the opening price, a green box is drawn, and if the closing price is below the opening price, the box is red. That box is the body of the candle, and my interpretation is the body represents buying or selling. A green body represents buying, and a red body represents selling. A shadow is a line on the top or bottom of the candle, and a line on the top represents selling, while a line on the bottom, buying. The size of the shadow and the size of the body tell us something about the strength of market behavior. Larger shadows on top represent sellers coming into the market.

S&P 500 and the Information Response

Let's take a look at the CME E-mini® S&P futures to give you an idea how the market absorbs information. Chart 3 illustrates how the market absorbed the 2004 presidential election between George W. Bush and John Kerry. Keep in mind our cash stock market trades from about 8:30 a.m. to 3:00 p.m. CT, while the E-mini futures trade nearly 24 hours a day and can react accordingly. This is a 15-minute chart of the E-mini market over the course of Election Day, and following. You can see how Europe's activity (already in the midst of their regular trading day) came to this market on the far left, and our market opened higher with big green candles on the chart. A positive start on Election Day.

Notice the candles between 9 a.m. and about noon CT. We see a series of alternating red and green candles, with prices in a trading range. The market is essentially saying: "I don't have a clue about what's going on." The market is waiting for something to react to. Around noon, we see some large red-bodied candles moving to the downside, and about that time, some news services were predicting a Kerry win. The S&P, for whatever reason, didn't seem to like that idea. So we see red body candles, and at the end of the red body candles, you see green candles. That represents a shadow at lower prices. Around 3:00 p.m. (15:00 GMT on the chart) the news media reported the election was too close to call, and that's reflected in market behavior. The market still needed more information to react to, so we continued to have alternating candles (red/green, red/green, red/green) for the next couple of hours.

So then market participants found out the early exit polls may not be reliable information, and the results imply Bush was ahead from about 6 p.m. on. At that time, the S&P started to show green candles moving to the upside. That move occurred when trading was most active in the Asian time zone, after the U.S. stock market had closed. That's an advantage of trading a 24-hour market like the E-mini futures--we can have moves at all hours, and a wide range of global participants.

Chart 3

Essentially, a chart like this one is nothing more than the collective beliefs of people coming into the market. It's a picture of human behavior, as market participants digest news and absorb information, and trade according to their view of where the market is headed next.

If you examine the low price of the chart to the high price on this chart, you can see how much the election was worth to the market. That is, how many points the absorption of that event was worth. Then you can see during the early part of the European time zone, in the aftermath of the election, the market starts moving sideways again.

Let's talk briefly about volume. Volume in the long-term can be an interesting barometer. You may think sideways price action means the market is stalled. But if volume increases as we go sideways, that would imply people are making a decision, putting on trades on whichever side they feel the market will go next, even though price hasn't moved. That's a healthy sign. When the market does move, it will take a side out, and the move can be significant and create even more order flow.

Now let's look at December S&P 2005 contract on a weekly basis. Chart 4 shows that the market was very positive for the two weeks prior to the coming into the election, and saw some movement to the upside. This weekly chart represents the collective beliefs at the end of the week. Weekly charts are interesting because on Fridays, people often are forced to make a decision because many traders don't want to head into the weekend with a position on. On this chart, we can see on Friday, November 5, no one abandoned ship. There's a big green body, with a shadow on the bottom. The market closed right at the high. The bulls essentially said, "I love the S&P, I'm going long over the weekend." But if we look farther out from election day, we see the confidence level isn't that high. The confidence level at higher prices isn't as high, and the market seems to struggle. We see smaller bodies, and shadows on the highs. Every time the market moved above 1240, it failed to close at the highs. Below 1180, we see a shadow on the bottom, so that means we are seeing buyers.

Chart 4

Looking at 2006, the first week of the year shows a big green candle. That tells us how the market sets the tone. The action beginning in March, and the candles afterward, is contained within the range of the big green benchmark candle of the month prior.

I'd like to show you another chart of a different event. It's a sad chart, but an interesting chart. Chart 5 is a 15-minute chart from July 2005. Starting on the left, around midnight, look for the big large red candle, and then a smaller red candle after, indicating loss of momentum. If we wanted to buy, we would want to take the highs out in three-four periods to meet the challenge. Then we see a change in market character, with shadows at the highs, and smaller bodies. If we bought it, we didn't get the follow-through I would hope for. There are shadows at highs and shrinking bodies, showing sellers coming in. A close below the prior low occurred. Then, you can see how incredibly quiet the market got. Since it was summer, maybe fundamental information was quiet and people just weren't reacting much.

Then about 3 a.m. CT, you start seeing big red candles. That was when news of bombings in London hit. While stock markets hate uncertainty, for commodity markets, it's typically the opposite--uncertainty represents potential opportunity. In the midst of uncertainty, we would expect the stock market to drop, the native currency to weaken, and for prices on interest rate products to go up as a flight-to-quality bid to credit instruments ensues. During the time represented in this chart, I looked at every index I could find, and every currency from Thailand to Australia, to Sweden. They all behaved in a similar fashion. What we saw here, which you don't usually see on the day of a disaster, is that between 3 - 4 a.m. CT at the bottom of the chart, shadows start to occur at the lower part, then volatility slows. The markets were absorbing information: how many people were injured, where were the locations, etc. The British did a great job reacting to and providing information. We then see evidence buyers are coming back in, even before our stock market opened.

Chart 5

If we were to look at a weekly chart covering this event, there is a very big candle in July when the market absorbed the data, then the market went on to close the week near its high. It's like the market said, "we'll continue on."

These examples illustrate how a 24-hour market absorbs information, including during non-U.S. stock market hours. The type of extended trading opportunities futures markets allow are but one advantage these markets have over equity-based vehicles, such as exchange-traded funds. Explore any futures markets that interest you on a day big fundamental news breaks, and see how the charts reflect and absorb various types of information for yourself.

Daniel M. Gramza is President of Gramza Capital Management, Inc. and DMG Advisors, LLC. He is a trader, consultant to domestic and international clients and an advisor to the St. Croix hedge funds. He is completing two books titled "Trading in the Eye of the Storm," and "The Handbook of Japanese Candle Trading Strategies" and has appeared on CNN's "Moneyline" program, Reuters TV, Bloomberg TV and WCIU-TV. He can be reached at dmgramza@worldnet.att.net.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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