From the February 01, 2008 issue of Futures Magazine • Subscribe!

Tech Talk: Pull-back coming but bull not over

Oxygen masks are generally a good idea at high altitudes. Without one, pilots, and traders for that matter, tend to get delirious and decision-making slows.

This will be another year of dizzying decision-making in the oil markets as volatility stays at a fevered pitch courtesy of tightening supply/demand balances.

While the weekly, monthly and annual candlestick formations on the Nymex crude oil futures chart indicate another year of solid gains are in the works, other technical indicators suggest an early year pullback is in the cards before the rally extends itself.

The advancing soldiers at the end of 2007 on the weekly candlestick chart following the November correction (see “Pullback and advance”) were a good sign that the most recent pullback to the $85.82 per barrel level was just another buying opportunity, which, indeed it turned out to be as prices subsequently rallied to $100 and ultimately will have more room to run on the upside. But the most recent leg up failed to impress as volume and breadth was lacking, leaving the move higher suspect.

Both the monthly and annual candlestick charts show a bullish engulfing pattern, which is a sure sign that this rally has not run out of steam. But that broadening formation is a reason to be cautious. Generally, a broadening formation is a sign that an interim top is in. Do not be surprised if there is a rather ferocious pullback to the 38.2% retracement level ($80.45) of the move to $99.29 from $49.90, the annual trading range in 2007. That is the place to not only cover shorts, but reverse into a long position. The $100 benchmark will ultimately prove to be a whimsical number that will handily be broken. The first layover will be $103.65.

The weekly parabolic is long. The monthly parabolic is long. The annual parabolic is long. The only low-risk long, however, is the weekly parabolic and the stop will get elected on that pullback into the low $80s. Therefore, use the weekly parabolic at $88.80 to stop into a short-term short position. This play will yield an $8.50 per barrel profit, should the market achieve that 38.2% retracement.

The weekly and monthly slow stochastic are at or near levels indicating the Nymex crude contract is overbought. The annual slow stochastic has room before reaching levels indicating market conditions are overheated, but the annual relative strength index (RSI) is up at 85.39, confirmation that the market is already overbought. Rarely can markets sustain a rally when the RSI is this high.

There are some final reasons the market will retreat before a fresh rally gets under way, and they are not necessarily technical. Non-commercials, which are primarily comprised of hedge funds and other large speculators, closed out the year with a long position much larger than seen in previous years. The climb in open interest in the final run-up to the last day of trading of 2007 also suggests that longs added to positions or fresh longs were established. As a rule, traders tend to reduce positions, not add to them, at the end of the year. This sort of market behavior would leave prices vulnerable to a wash-out to the downside.

Open interest in crude puts also indicates prices are vulnerable to a pullback. High open interest in the $90.00 and $85.00 puts leaves those who are short the option at risk. If prices probe the downside for all the above reasons, the sell-off will steepen as those short puts will need to sell futures to neutralize their positions.

Don’t remain bearish below $85.00. That could prove to be one of the many traps that were hallmarks of the crude oil market in the past five years. Thank you for flying with us today. We hope you enjoyed the trip.

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