Stock Market Crash! Blog

Oil Taking a Pause (Update 1)

In a previous post, I postulated that the oil market was taking a breather after its explosive move to an all time high of $75 per barrel, leaving the whole world stunned in the process.

Im that post, I even took a stab at what type of consolidation pattern the market would create, concluding that a rising pennant formation might be in the works. Sure enough, several weeks later, it now appears that we have rising pennant formation! :

One year chart:



Six month chart:



My joy of having forecasted this pattern was quickly overpowered when I realized what this pattern actually implies. In another post, Is Oil Approaching $82? I used well-known chart patterns to determine price targets for oil's rally, arriving at a harrowing $82 per barrel or more.

The recent rising pennant formation lends further credibility to the price targets determined in April. A breakout above the pennant's overhead resistance will likely lead oil over $82 per barrel. The rising pennant's price target is obtained by measuring rally's dollar value before the pennant consolidation began and adding this to the price level at the overhead resistance, which is $74. Measured conservatively, oil climbed $12 since late March 2006. Adding the two figures gives an estimated target of $86. Its best to be conservative and stick with the $82 figure, while still realizing the potential for an even greater upside.

As the cold war between Iran and the West escalates, oil will attempt to breach its triangular-shaped confinement, eventually breaking out if both sides start mobilizing for a "hot war".

The best way to trade oil's impeding breakout is to enter in a trade upon a successful breakout above the resistance level at $74.

Previously, I had recommended buying a oil stocks as an excellent method of gaining exposure to oil. I even purchased quite a bit myself. And now I'd like to rescind that recommendation, as I found myself breaking even, despite the fact that oil was experiencing one of its most vigorous surges. After some thought, I realized that although oil stocks will rise as oil increases, some of that rise is offset by the across-the-board bearish sentiment towards stocks that accompanies such a move in oil. Not exactly the best proposition.

For the next move, I recommend a more pure oil-play, in the form of Amex's new Oil Fund, symbol USO, an ETF that moves in lockstep with the price of oil. Buying oil futures is another option, for those inclined to do so.

For this trade, keep a stop-loss order just underneath the $74 resistance level. Even though some trading scenarios sound like a "sure-thing", they can still break down in the most surprising fashion. The key to successful trading isn't being right all the time, but rather increasing the percentage of the time you are right, while aggresively preserving your capital for the times you will be wrong.

The best traders take many small losses while in pursuit of "the big one" or a highly profitable trend. You can still be highly profitable even if the majority of your trades are losers. The aim is to "cut your losses and let your winners run", a simple adage that is rarely adhered to when the powerful emotions of greed and fear take over in real-life trading. Following this risk management strategy is easier said than done, as it takes much discipline and emotional control, but is a skill that can be honed through practice and experience.