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Martin Tillier

Martin Tillier

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Why OIL Will Break Out Of Its Range Soon & What To Do About It

In many ways the iPath Crude Oil Futures ETF (OIL) has been a trader’s dream over the last few months. Ever since the March resistance at around the $11.50 level was broken in April and a top around $13.20 was established the next month, OIL has been a very well behaved range trading instrument. That can’t last forever, however, and looks set to change any day now. The question for traders and investors, of course, is how they can position themselves to take advantage of that likelihood.

(Click to enlarge)

Before we get to that though, let’s take a look at why a breakout from that range looks to be imminent. The above chart for OIL over the last two months contains a good illustration of why that is so. The ETF has stayed in the range mentioned before as marked by the horizontal blue lines, but that is only part of the story. In addition, the range within that range, marked by the yellow wedge, has been gradually narrowing. Related: This Dutch Innovation May Solve The Energy Storage Problem

That is perfectly normal and understandable; in fact it is almost unavoidable given human nature. Once a range has been established the logical thing for traders to do is to buy at the bottom of it and sell at the top. After all, isn’t buying low and selling high what we are supposed to do? The problem though, when a range is clearly defined, is that everybody is looking to do the same thing. In order to gain an edge, traders will place their orders just above rather than at the previous support, or just below, rather than at, the resistance. Those new, tighter levels now become the range and the process is repeated; the narrowing wedge is gradually formed.

Eventually of course, a breakout from that wedge becomes inevitable. At that point, one would expect the original range to re-establish itself, but that is often not the case. A lot of people will have spotted the trend by now and, in order to make the same amount from each trade, and emboldened by past success, it is likely that position sizes will have grown. Bear in mind too that range trades such as this are, by their nature, short term, so are usually protected by a stop loss fairly close to the original position. Those stop loss orders tend to be clustered around the original chart points, often providing enough momentum to break through them when the wedge pattern is broken. Related: Why Has Chinese Spending On Oil Dried Up?

All of this is great in theory, of course, but OIL, like any financial instrument, doesn’t exist in a vacuum. The biggest influence on the price is not lines and squiggles drawn on a chart; it is the fundamental value of the underlying instrument, in this case the price of oil. The same technicals apply there, of course, with around $55-$62 being the initial range, but the current fundamentals of oil; the political situations in the Middle East and Russia, the prospects for global demand, and supply fluctuations from the rapid rise (and fall?) of fracking hardly add stability to the picture.

All in all, then, a breakout, and sooner rather than later, looks like a sure thing. The question remains…how to position for that.

As OIL is currently near the top of the range the logical place to start is with a short position. Your stop loss, however, would be for twice the original position size and quite tight to the last top, say at around $12.75 in this example. In the event of a breakout to the upside, therefore, you quickly flip to a long position. If the price falls towards the bottom of the wedge, avoid taking a profit too quickly; allow time for a break lower to develop. In the meantime, adjust your stop loss to close to the original position, eliminating the potential for a meaningful loss. Related: Solar Space Race Already Underway

The beauty of this for the average investor is that, while based on a fairly sophisticated trading strategy, it can all be set up at one time, with the kind of orders that most brokerage platforms accept. It doesn’t need constant monitoring, but enables you to be positioned for a breakout of a narrowing range, regardless of whether that is up or down. Of course, no trade is foolproof and a fake above the resistance followed by a rapid drop back would leave you whipsawed somewhat, losing on the way up and the way down. Given the likelihood of a complete breakout, though, that looks like a risk worth taking.

By Martin Tillier of Oilprice.com

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