It is relatively simple to analyse the price chart of an underlying than its derivative. This is because a normal futures price chart does not offer enough data to determine a trend, as futures contracts have a finite life. This week, we look at how traders read patterns on futures price chart.

Linked prices

The NSE offers three dated futures contracts: the near-month, the middle-month and the farther-month. That means you can at best view three months data on a futures price chart, but that is unlikely to help you analyse trend in futures prices. 

You may argue that reading the chart of the underlying would suffice. That may be true for financial assets, especially stocks. It is not, however, true for indices and commodity derivatives. Why? Indices are not tradable assets. So, there is no demand and supply for, say, Nifty 50 Index. The actual demand and supply for index futures contracts could lead to futures prices being different from their underlying prices. Even though both single-stock futures and their underlying are tradable assets, their demand and supply may be different leading to different prices. This is also true of commodities. The demand and supply for physical commodities have a bearing but need not be similar to that of their derivatives. This is because demand for physical commodities is driven by manufacturers using the commodities as inputs whereas demand for commodity derivatives is driven by traders. 

If reading futures price chart is important, how do we analyse trends beyond three months? Two methods are typically used to display futures prices. One is called constant forward contract which maintains fixed number of days to expiry. This method is typically not preferred because the price pattern could be significantly different from the actual futures price (S&P 500 VIX Futures Index uses this method). The other method is the linked price method providing continuous price chart. This simply takes all one-month contracts on an underlying and shows futures price as a seamless one-month contract. You must use continuous price chart for analysing index futures. While such charts are preferable for single-stock futures too, you can use underlying price charts if such continuous charts are not offered by your service provider. 

Optional Reading

Futures price converges with its underlying price at expiry. Also, empirical evidence suggests that traders do not typically hold the near-month contract till expiry; they often roll into the next month contract starting the week before expiry. These factors mean that the near-month contract and the next-month contract may have a price gap at expiry. Some price-data vendors provide a feature on their charting tool to adjust for these price differences to arrive at linked prices. Your trading plan – entry price, price target and stop loss – is based on the price chart. Therefore, correctly capturing price trend over time is important. The continuous price chart with its linked prices is an accepted method for reading futures price trends.

(The author offers training programmes for individuals to manage their personal investments)