Some market bulls were caught off guard when the July 2013 canola futures contract peaked at $650 in the last week of May 2013 and lost $57 per tonne over the following three-week period.
Human nature makes it is very easy for market participants to get caught up in the bullish news and the news is always bullish at the top, just as it is always bearish at the bottom.
A recent example of this was in December 2012, when the nearby futures were around $575 per tonne and some farmers sold a portion of their canola on the fear of prices going lower.
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My February 2013 column was about canola, in which I explained, “The charts portrayed a different picture. Based on the monthly chart, the major uptrend in the canola market was firmly intact with the harvest low of $570 proving to be a strong area of support.”
To the delight of canola producers who waited, the market did indeed turn up from $570 in December 2012 and rallied $80 per tonne by the first week of February 2013 providing an opportunity to sell canola.
Just as charting and technical analysis succeeded in cutting through the bearish news at the bottom of the canola market in December, these same tools also alerted knowledgeable traders and canola producers of the impending downturn in late May of this year in the face of all the bullish news.
Identifying areas of support and resistance are basic components to determining future price direction. This combined with being attentive to the development of reversal signals at key points of support and resistance invariably provides invaluable buy and sell signals.
The $650 price level was proving to be a tough area of resistance for canola futures prices to overcome not only on the daily charts, but also on the weekly and monthly charts.
Combine this important piece of information with a sell signal on May 29, 2013 referred to as a two day reversal and it became ever more evident July futures prices were about to turn down from the contract high of $650.80.
Two-day reversal
On the first day, at a top, the market advances to new highs and closes very strong at or near the high of the day.
The following session, prices open unchanged to slightly higher, but cannot make additional upside progress. Quantity selling appears early in the day to halt the advance and prices begin to erode.
By day’s end, the market drops to around the preceding day’s lows and closes at or near that level. For a two-day reversal to be valid, the second day’s settlement must be below the mid-point of the previous day’s opening and closing price.
Market psychology
The two-day reversal is a snapshot of a turn in sentiment. On the first day the longs are comfortable and confident as the market closes higher. The market’s performance provides encouragement and reinforces the expectation of additional gains.
The second day’s activity is psychologically damaging, as it is a complete turnaround from the preceding day and serves to shake the confidence of many who are still long the market. The immediate outlook for prices is abruptly put in question. The longs respond to weakening prices by exiting the market. Some at first sell to take a profit, while others sell to cut losses. This action is referred to as long liquidation.
As illustrated in the accompanying chart, prices held up near the contract high for a few days after the two-day reversal developed providing ample opportunity to take advantage of the sell signal.
Once prices settled below the rising line of support “A”, sell stops were quickly triggered driving prices down under the low “B” in between the two highs and sparked additional long liquidation, which is often responsible for a market selling off in light of bullish news.
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