There are many factors that traders look at and analyze when choosing a futures contract to trade. Some traders might look for trends on a chart while other traders might look to see if demand might be increasing for a commodity.
The evidence that traders use will typically be classified into two broad categories, fundamental analysis and technical analysis.
Both types of analysis allow a trader to collect evidence to form a decision about the trades they are considering placing in the market. The analysis will form the basis of where the trader thinks the market will move and thus, whether to buy or sell a given futures contract.
Some traders will use one type of analysis or a combination of fundamental and technical analysis to select trades and time their entries and exits. Evidence is collected by traders from all sources and rarely will it fall in to just one category. Having data from varied sources and of different types helps traders paint a more complete picture of the market they are trading.
Fundamental analysis refers to analyzing the factors that contribute to a futures contract’s supply and demand. For example, a trader might review Crude Oil Inventories to form an assumption about whether supply will increase or decrease in the future, causing the price of Crude Oil to move up or down in the future. This trader might choose to buy oil now with the assumption that prices will move higher based on his fundamental analysis from the inventories report.
There are many factors that will increase demand and supply for a market. These factors are complex, interrelated and their effect on price can change over time. A detailed model and analysis is required to create a complete fundamental picture of the market. Supply and demand is typically slow to react as supply and demand are with a strategy which protects them from shocks to the market either in the form of supply or demand. These shocks can come from events such as natural disasters, supply chain issues or product defects. For example, if there a natural disaster and a major port for unloading of crude oil is damaged so that ships cannot unload their cargo, creating a surprise and immediate reduction in supply, that was not forecast or predicted in a supply and demand model.
Technical analysis uses patterns on a chart created by price to determine where the market is moving. The movement of price is tracked on charts with various indicators or patterns to help determine where price is going to move next. Technical analysis uses the visual representation of price to help illustrate where price is and where it may move in the future. Common areas of interest to traders on charts are levels of supply and resistance. Supply and resistance can be indicated by many indications, such as moving averages, previous highs and lows and previous price levels that price could not move above or below. Traders will look at these levels and make buy and sell decisions when price is at a level that the technical analyst believes is a key buy or sell level.
While each form of analysis relies on different data and different assumptions, since they are both referencing the same market the information provided can be used together to build a more complete analysis of the market you want to trade.
A fundamental analysis for the ES contract can be created by looking at anticipated forward earnings for the 500 stocks that make up the S&P500 index. Stock prices are based on the earnings of a company. Stock prices should increase if the company is growing and earnings and profits are increasing. If earnings and profits are decreasing, the stock price will move down reflecting this decrease in earnings. Price is also dependent on future earnings, if future earnings are expected to grow due to prospects, the current stock price may increase to reflect this anticipated financial growth. The S&P500 index is created by looking at the price of 500 stocks. The price of each stock has an influence on the overall index. Each stock contributes to the index based on the size of its market capitalization. If overall stocks are in a growth cycle and earnings are increasing across the market then the price of the index should move up.
For example, an analyst might have an opinion that future earnings will actually be higher than what is currently being priced in by the index. If the trader is correct and earnings do increase more in the future than expected, then the ES contract should increase in price. The trader in this example would want to buy contracts in the S&P 500 futures contract to take advantage of this possible move up.
Another example is in the Crude Oil market. A technical analyst might believe that there is strong resistance at $100 per barrel of oil, because every time price has reached that level it is followed by a price decrease. Price has not been able to move through $100 because buyers cannot create enough demand to buy at that price and above to move the sellers out of the way.
Continuing with the same example but from the fundamental persepective. The fundamental trader may have researched production costs of different producers and realized that at around $100 per barrel that many oil producers will once again turn on wells with higher production costs that were not operating when the cost of Crude was lower, increasing supply and decreasing price. Crude oil has a range of extraction costs, some wells might be cost effective below $40 and others might not be cost effective until Crude reaches $60 or higher. The reason for this is because not all oil is extracted from the same geology, ranging from deep under sea wells to shale oil production, each with different exploration and extraction costs.
When looking at future demand and supply, technical analysis and fundamental analysis are many times combined to give the trader a bigger picture view of the market. There are many traders who will build pricing models and then look at charts to confirm their assumptions or fine tune entries and exits. There are also many traders who review charts then look at the fundamentals to see if future supply and demand is sufficient to potentially move price through support or resistance or create a supply or demand situation which makes price potentially trend for a long period of time. There are some shocks to the market that have supply and demand effects that can last months or years.
Markets are interconnected, many times a trader will need to look at more than one market to build a complete picture of what they are trading. The fundamental analyst will model the relationship between two markets and attempt to understand how supply and demand in one market can affect supply and demand in another market.
An example is cost of livestock feed and the cost of livestock. If feed costs increase so too will the cost per head of raising livestock. If the cost of feed is too high then farmers might liquidate herds in the short term, pushing down prices, and creating a situation where future supply is reduced and livestock prices increase in the future. These relationships can be complex and sometimes difficult to model easily, a trader will need to be aware that there are many factors that can move the market they are trading.
A technical analyst is interested in the correlation between two markets. The technical analyst will chart both commodities they are interested in analyzing on a single chart and look for correlations between the two products. They will look to see if the price of both markets move up and down at the same time or does the price in one market move up when the price in the related market moves down. The carts can also show that there is no relationship between the two markets.
Like any trading or analysis strategy, each trader will look at the data in a slightly different way and incorporate their own set of rules to make decisions.