Out of context, it seems slightly ridiculous, but many trading decisions come down to what I refer to as the “magic number” theory. Whether said number is derived from a complex calculation or simple observation, the fact is that a lot of trades are based on the belief that proximity to a certain level will spark a reaction. It could, for example be the belief that a retracement will end and reverse after giving back 38.2% of the gain that preceded it, as Fibonacci retracement analysis would imply, or that breaking a key level will trigger stops and increase the momentum of a move already underway. Either way it is, in the trader’s view, the number that moves the needle, not any fundamental change in conditions or expectations.
To those not versed in technical analysis, that makes little sense, but the simple fact is that what really moves markets is the relative balance between buyers and sellers, both in terms of their numbers and their determination (or desperation), and that balance is affected by many things, including magic numbers. So, as some energy stocks hit a certain level in the latest drop it is time to consider buying.
The “magic number” here is twenty percent. A twenty percent drop in an index or stock is considered significant in several ways, depending on context. It is generally considered to be the point at which a short-term move down that until that point was regarded as a consolidation becomes a correction. There are two ways of looking at that. One is that it implies a longer-lasting move down, the other that it means losses are close to ending. As market declines of over twenty percent are rare, it tends to have the second meaning most of the time. Related: Are OPEC And Its Allies Producing Too Much Oil?
The overall stock market is down about ten percent at this point in its drop, but with oil falling at the same time many energy stocks have fallen further than that. There are a couple of E&P stocks where that is the case, and where a twenty percent drop from recent highs has brought them close to longer-term lows, setting up trades with reasonable risk control. If we assume that twenty percent is significant, then both look worth buying at this point.
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The first is EOG, where the level concerned is around $95. That has been a support level on multiple occasions before and getting there would entail breaking through several other support levels. The stock is currently trading around $104, just over twenty percent off the recent high of $133.53 so is a candidate under the magic number theory.
The other candidate, Diamondback Energy (FANG) has dropped a similar percentage since the start of this month and is also close enough to a logical stop-loss level to allow for a reasonable set-up. As you can see, the stock has been trading in a range all year and is close to the bottom of that range now. That increases the chances of a bounce, making the trade even more attractive. A stop just below the logical level of $105 would limit losses here to around five percent.
Of course, for either or both these stocks to fully recover, fundamental conditions, or at the very least the market’s expectations, have to change. The fact that both have fallen around twenty percent and are close to support levels that allow for logical stops, however, makes it more likely that their declines will be stalled, thus allowing more time for that change to develop.
By Martin Tillier for Oilprice.com
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