Tuesday, January 18, 2011

Crude Oil: Potential for Very Strong Move

Whether it is due to increasing demand (unlikely) or too much money chasing too few assets (likely), crude oil is on a launching pad that could lead to a 50% plus gain.

Here is the technical set up.  See figure 1 a monthly chart of West Texas crude (cash data).  The indicator in the lower panel looks for statistically significant times when volatility is low.  This would be when the indicator is below the lower trading band as it is now.  One thing about volatility is that it is cyclical.  Low volatility leads to high volatility as price breaks out of its trading range.  The only thing we need to do as investors is get the direction of the price move correct.  So low volatility is our launching pad.

Figure 1. Crude Oil/ monthly

A simple strategy is to buy crude oil when volatility is low and price closes above the simple 10 month moving average.  For the sake of illustrating my point - that crude has the potential to make a monster move - we will exit our positions on any close below the simple 10 month moving average.

Since 1987, such a strategy has generated 6 trades.  There were 4 winning trades.  The average winning trade lasted 15 months with the average losing trade lasting 1 month.  This is typical of a trend following strategy.  To get an idea how potent this set up for crude oil can be, let's take a look at the maximum favorable excursion (MFE) graph for this strategy.  See figure 2.

Figure 2. MFE Graph

MFE looks at how much each trade runs up before being closed out for a loser or winner.  For example, look at the trade inside the blue box.  This one trade from 1990 ran up 95% (x -axis) before being closed out for a 4% profit (y axis).  What makes this setup potentially powerful is the fact that the 4 winning trades ran up greater than 40%.  This is to the right of the blue vertical line.  It should be noted that 3 of those trades ran up greater than 90%.  In other words, what the MFE graph shows is that this technical set up - low volatility  leading to price expansion - can produce extraordinary gains for crude oil.

What is the possibility that we will see gains like this in crude oil before prices cross back below the 10 month moving average?  The current trade is entering its 4 month and has already run up about 14%.  Although the data is limited, the two losing trades were closed out after 1 month and failed to run up greater than 5% (see MFE graph for losing trades).  The current trade looks more like a winner than a loser, and if this is the case the greatest run up is still in front of us.  

While the fundamental back drop for higher crude oil is present - i.e, increasing liquidity -, the economic back drop -i.e., increasing demand - is somewhat suspect.  This may limit crude oil's rise.  However, there is no question that crude oil is on the launching pad and the trend is up.  Past and similar set ups have led to extraordinary gains in crude oil.  

No comments: