Construction of Continuation Charts for Futures

The average futures contract has a trading life of about a year and a half before expiration. This limited life feature poses some obvious problems for the technician interested in constructing a long range chart going back several years. Stock market technicians don't have this problem. Charts are readily available for individual common stocks and the market averages from the inception of trading. How then does the futures technician construct longer range charts for contracts that are constantly expiring?

The answer is the continuation chart. Notice the emphasis on the word" continuation." The technique most commonly employed is simply to link a number of contracts together to provide continuity. When one contract expires, another one is used. In order to accomplish this, the simplest method, and the one used by most chart services, is to always use the price of the nearest expiring contract. When that nearest expiring contract stops trading, the next in line becomes the nearest contract and is the one plotted.

Other Ways to Construct Continuation Charts

The technique of linking prices of the nearest expiring contracts is relatively simple and does solve the problem of providing price continuity. However, there are some problems with that method. Sometimes the expiring contract may be trading at a significant premium or discount to the next contract, and the changeover to the new contract may cause a sudden price drop or jump on the chart. Another potential distortion is the extreme volatility experienced by some spot contracts just before expiration.

Futures technicians have devised many ways to deal with these occasional distortions. Some will stop plotting the nearest contract a month or two before it expires to avoid the volatility in the spot month. Others will avoid using the nearest contract altogether and will instead chart the second or third contract. Another method is to chart the contract with the highest open interest on the theory that that delivery month is the truest representation of market value.

Continuation charts can also be constructed by linking specific calendar months. For example, a November soybean continuation chart would combine only the historic data provided by each successive year's November soybean contract. (This technique of linking specific delivery months was favored by W.D. Gann.) Some chartists go even further by averaging the prices of several contracts, or constructing indices that attempt to smooth the changeover by making adjustments in the price premium or discount.