Right now, Crude Oil prices are in major focus, as it is one of the hottest things to trade in the market and has been for some time. It has been in a strong downwards trend for several months, falling from over $100 a barrel to less than $30. It fluctuates in value by large amounts, and daily price changes greater than 5% have not been unusual. This is a lot of volatility.
It is normal that whenever one of the most significant commodities such as crude oil falls to a historically very low price, speculation immediately turns to how low it is going to go before it turns around. A quick search of the internet using the right search terms will bring up a lot of articles purporting to explain that the price of crude oil will eventually reach $10, or cannot possibly fall lower than $20, etc. The authors will usually be using economic fundamental analysis as well as an analysis of oil supply, which really is an important issue with commodities such as oil, unlike currencies where supply is rarely a factor.
Fundamental and supply analysis both have an important place in trading commodities such as crude oil, but I strongly believe that the best thing that a crude oil trader can do is ignore this speculation, at least until the price chart starts to look noticeably different. Fundamental analysis should be used as a confirmation of technical analysis and not the other way around.
Don’t Pick Bottoms!
The problem with this speculation is that it is a psychological distraction that traders fall for. Traders are trying to convince themselves they can pick the bottom price, exit any shorts for maximum profits, and then start buying and sit tight while they wait for oil to get back up to $100 per barrel again, or some similar high price. There are so many things wrong with this approach it is hard to know where to begin!
Let’s start with two old trading maxims that are as old as the hills: “It’s a bear market, you know” and “The first 1/8th is the most expensive 1/8th you ever tried to buy”. The market in crude oil is a bear market. The price is in a strong downwards trend. At the time of writing, the price made a new 12 year low yesterday. There is no question about the trend: the price is lower than it was 1 month ago, 3 months ago, 6 months ago.
When the market is moving this strongly, any analysis you do shows that the most probable next movement is in the same direction as the strong trend. This means that statistically, you can put the odds in your favor by taking short trades – betting that the price of crude oil will fall – and not long trades.
To prove my point, let’s look at how the price of WTI Crude Oil has behaved from September 1997 until the end of 2014. Let’s say you simply bought at the start of every week, and sold one week later. You would have made a total return of 131.30% (note I exclude the costs of trading, which would have quite possibly erased all this profit). Compare that with what would have happened if you had tried to buy crude oil cheap, buying every week the price was lower than it was both 3 months and 6 months ago and selling one week later. You would have suffered a loss of 40.99%. Now finally, imagine if you had instead traded with the trend, buying crude oil every week it was higher than its price both 3 months and 6 months previously. You would have made a profit of 92.91%. This might sound unfavorable compared to the return of buying every week of 131.30%, but you would only have traded 445 weeks as compared to 900 weeks covering the entire time period, so per trade it is a superior return. This is why it is a good idea to trade with the trend.
The old saying about the first 1/8th being too expensive to worry about refers to the way that markets tend to consolidate before turning around when the reach a really significant maximum or minimum price. For example, let’s say hypothetically that crude oil will soon reach the price of $25 per barrel and this will be the cheapest price we are going to see over the next ten years. This sounds great, but there are two major flaws. Firstly, you really have no way of knowing that this price of $25 is going to be the low. Secondly, the price might spend months chopping around at $26 or $27 per barrel. There is no reason to believe that the price is going to turn around and shoot back up again right away. Markets usually do not work like that, and prices tend to spend some time failing to move any further in one direction before they really turn around in the other.
“It Can’t Go Any Lower”
We are hearing this again and again, with explanation as to why the price can’t go any lower than $20 or $10 or any other number you care to pick. Of course, there is a logic here, as crude oil has intrinsic value, and there has to be a price below which it is very unlikely to go. However there is no point in speculating as you are unlikely to get it right! There is another old trading maxim that fits well with what is going on here: “prices are never too high to go higher or too low to go lower”.
Trade with the Trend, until the Bend in the End!
You’ve heard “trade with the trend” a thousand times before, but are you acting on it? After all it’s less glamorous to be selling oil than being a heroic buyer – but the odds favor you selling it. Of course you might sell into the bottom tomorrow and lose a short trade or two, but what is the rush? If the price does bottom out and start to rise, you can start buying then, maybe a few dollars higher but why care if you buy at $35 instead of $25 if the price goes back up to $100? You will usually save money by waiting for the trend to change instead of trying to pick the exact turn at the lowest price.
How to Measure & Trade the Trend
Traders often confuse themselves trying to use all kinds of fancy tricks to tell what the trend is or how strong it is. You can actually simplify it easily by just asking yourself this question: is the price higher or lower than it was 6 months ago, 3 months ago, 1 month ago. If the answers regarding 3 months and 6 months are mixed, you can say there is no trend. If the answers match, you do have a trend, and if the 1 month also matches you have a very strong trend with a lot of momentum.
There are clear trends at the moment in the market that can be exploited:
Long: USD, JPY
Short: Crude Oil, British Pound, Canadian Dollar, Australian Dollar
Don’t try to be a hero. Put the odds in your favor and trade with the trend. At least until the bend in the end!
