Pattern Detection is a critical component to designing an effective automated futures trading system. For long-term success, a good risk management plan must be applied to any system that is automated based on pattern detection.

Spotting recurring price patterns (price pattern detection) in futures markets is critical to achieving long term success. Volumes of material about technical analysis and futures trading are available, however there as less material available that describes components of automated futures trading (also known as algorithmic trading or black-box trading).

Some automated trading systems can be designed to detect classic chart patterns such as Head and Shoulders, Ascending Triangles and Candlestick patterns, to name a few. These systems can alert short-term futures traders, futures brokers who notify their clients trading opportunities, day-traders or futures traders operating in any time frame.

Automated trading systems can also be designed to apply any of the standard technical indicators such as Stochastics, Relative Strength Index, Bollinger Bands, Elliot Wave Patterns, Fibonacci Retracements and trend lines to futures prices.

Standard charting programs are more than sufficient for spotting opportunities using “classic” concepts mentioned above. However, one of the major benefits of using automated futures trading systems, or “black box” trading system, is that the futures traders can detect price patterns that do not necessarily relate to a futures chart or technical indicator found in a basic futures charting program.

A futures trader can conceive their own ideas, primarily through price pattern detection, make critical observations about prices, etc … and with the help of software development, ideas can be programmed. Once programmed, a futures trading plan can be tested objectively to determine performance results. Testing involves loading historical data into a software program that will apply the trading rules required to detect the recurring pattern. From there, one can analyze performance results.

This post describes a simple idea related to trading the opening range in E-Mini S&P futures, but before describing the details of the idea, I will describe the criteria for constituting a pattern: the pattern must adhere to clearly defined rules (with no exceptions) and must occur with a frequency of at least 60%. Ideally, this pattern should manifest across all futures markets with similar rates of frequency. Pattern detection is a critical part of designing certain automated trading systems. Recall that, as stated several times on this site, we believe that technical analysis techniques and automated trading systems should work across all futures markets.

Back to our pattern detection example. Let’s look at trading the opening range in E-Mini S&P Futures. The rules are as follows: 1) At 9:30 AM (CST), plot the trading range between 8:30 AM (CST) and 9:30 AM (CST); 2) determine the number of points within that range. For example, the low of the 60 minute bar beginning at 8:30 AM (CST) is 1263.25 and the high of that bar is 1271.25. We have an 8 point range;3) wait for price to trade above 1271.25 (the bar’s high) or below 1263.25 (the bar’s low);4) after 9:30, we wait for a breakout of the range established in the previous hour - go long above the bar’s high or go short below the bar’s low. Our profit objective is 8 points.

Okay, so the rules are simple, the concept is simple. The next step is to use a software program, which would need to be designed either by the futures trader or by a third-party resource. Some futures brokers or futures brokerage firms offer value-added services that may include assistance with develop software programs to create automated trading systems.

Once the idea is incorporated into a software program, the process of back testing and system optimization can begin. In summary, we have three goals: 1) pattern detection; 2) software development; 3) optimization of the system based on the pattern being studied.

Click here for information about futures trading software services and where you may find resources to provide assistance designing a system that implements your ideas.

You may also want to check out this section of our site for more information about
automated futures trading systems.

Oscillators - When should oscillators be used?

Oscillators fluctuate above or below a pre-determined level - this is either a centerline or a set of values, such as “30″ or “70″, or “20 or “80″.

Examples of oscillator indicators include Stochastics, MACD (Moving Average Convergence/Divergence) and RSI (Relative Strength Index).

For RSI, the bands for overbought and oversold are usually set at 70 and 30 respectively. A reading greater than 70 would be considered overbought and a reading below 30 would be considered oversold. For the Stochastic Oscillator, a reading above 80 is overbought and a reading below 20 oversold.

Although these are the recommended band settings, futures markets may not adhere to these ranges and might require fine-tuning. Making adjustments to the bands is usually a judgment call that will reflect a trader’s preferences, based on the volatility of the market under analysis.

Over-bought or over-sold conditions, respectively, can remain in overbought or oversold territory for extended periods, however eventually, such levels cannot be sustained indefinitely.

It is critical to know when to use oscillators for technical trading - a trader can be short an over-bought market for days or weeks and experience considerable equity draw-down, prior to the market turning in favor of the expected market direction.

Oscillators are most effective in indecisive markets. In a trending market, oscillators can be ineffective technical analysis indicators. For example, in a strong bear market, a market can remain oversold for weeks. The reverse is true in a bear market.

As indicated, oscillators are calibrated around center values or pre-determined absolute values. In either case, trading on one side or the other indicates overbought or oversold conditions. When overbought, traders look to enter new short positions or liquidate existing long positions. The opposite is true for oversold conditions - when oversold, traders seek to enter new long positions or liquidate existing short positions.

There are many different types of oscillators. An important thing to understand about oscillators is when to use them.

Centered Oscillators

Centered oscillators fluctuate above and below a central point or line. This point can be optimized to be calibrated to the time frame in which you are trading.

Oscillators can be useful for identifying the strength or weakness behind a future’s market move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line.

MACD (Moving Average Convergence Divergence) is a centered oscillator that fluctuates above and below zero. Typically, MACD is the difference between the 12-day exponential moving average and 26-day exponential moving average of a futures market. However, these values can be modified to optimize your futures trading program.

MACD is unique in that it has traits that both lag and lead price action. Moving averages tend to “lag” the market. However, by analyzing the combined differences in both moving averages that comprise the indicator, MACD incorporates a “leading” indicator component to the “lagging” component.

The difference between the moving averages represents the rate of change. Clearly, by integrating moving averages and rate-of-change, MACD creates a unique oscillator that is both a lagging and a leading indicator. In summary, MACD is an important technical indicator that should be reviewed by technical analysts.

The Relative Strength Index (RSI) is a commonly used technical analysis oscillator. See it in action below.

The below chart is a classic example of bearish divergence, using a daily chart of September Crude Oil Futures and an RSI overlay study.

Tecnical Analysis - Bearish Divergence In Crude Oil

Rate of Change (ROC)

Rate-of-change (ROC) is a centered oscillator that fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC Oscillator. When the indicator is above 0, the percentage price change is positive (bullish). When the indicator is below 0, the percentage price change is negative (bearish).

Many, but not all, banded oscillators fluctuate within set upper and lower limits. The Relative Strength Index (RSI) is trades in a range bound by 0 and 100 and will never go higher than 100 nor lower than zero.

The Stochastic Oscillator is another oscillator with a set range and is bound by 100 and 0 as well. However, the Commodity Channel Index (CCI) is an example of a banded oscillator that is not range bound.

Overbought and Oversold Extremes

Banded oscillators are designed to identify overbought and oversold extremes. Since these oscillators fluctuate between extremes, they can be difficult to use in trending markets. Banded oscillators are best used in trading ranges or with markets that are not trending.

In a strong trend, oscillator signals against the direction of the underlying trend are less robust than those with the trend. The trend is your friend - do NOT fade the trade, even if the oscillator tells you to do so. If a market is in a strong uptrend, buying when oscillators reach oversold conditions (and near support tests) will work much better than selling on overbought conditions.

During a strong downtrend, selling when oscillators reach overbought conditions would work much better. If the path of least resistance is up (down), then acting on only bullish (bearish) signals would be in harmony with the trend. Attempts to trade against the trend are foolish.

In another post, I will identify were we feel oscillators are very powerful. They are used to identify divergence patters (bullish or bearish).