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Multiple Factors Suggest A Contrarian Trade In Oil

Trading Screen

Regular readers, god bless them, will be aware that I am a bit of a contrarian. Most dips are buying opportunities to me and commodity rallies result in my cursor hovering over the “Sell” button. It will come as no surprise to them, therefore, that with WTI rallying strongly in the last week and currently trading up around $50, I have been looking for a reason to sell. There are reasons for the run up such as the disruptions caused by Hurricane Harvey, but they are short-term in nature and the fundamental long-term reason for oil’s weakness remains…U.S. shale production is high, and growing.

Of course, the problem with any contrarian trade is knowing when to pull the trigger. Even if the commodity keeps going up way past the point of logic it will not happen in a straight line and the corrections can be profitable, but momentum is a powerful thing and losses quickly pile up if you jump in too early. If you are considering a contrarian trade, therefore, two things are needed, an indication of some sorts that a turnaround is imminent and a loss containment strategy that will limit your losses should you be wrong.

The trigger for a trade can be based on several things, but the most reliable indication comes when two or more of those things occur at the same time. That is the case with WTI right now, where two sell signals, one obvious and one not so much, have been hit in the last couple of days. The most obvious of the two is a technical setup that indicates a downward move, even if only a short-term correction, is coming.

(Click to enlarge)

The last couple of days of strong gains in oil futures have taken us to around $50, the level that marked the top of last month’s rally and therefore an obvious point of resistance. Backing off from there at this point would keep intact the long-term pattern of volatility, but gradual declines that we have seen all this year. That pattern makes sense in the context of a regulatory environment that encourages ever-increasing shale production even at lower prices and looks set to continue. The likelihood of this being a turning point is increased even further by the intraday price action that we have seen yesterday and early today.

(Click to enlarge)

While the first three days of the week saw steady buying throughout the day, resulting in a close very close to the day’s high, yesterday we saw an initial run up reverse later in the day, and early indications are that that pattern will repeat today. Of course, a lot depends on the rig count number later, but that only has to be as expected to maintain that look for today’s candle.

The second reason is a little more esoteric, but valid nonetheless. Over the last couple of days, we have been treated to an ever-growing chorus of pundits, both on TV and on financial websites, telling us that this it is just the beginning, and that oil is headed much higher. I hate to be too cynical, but that is, more often than not, a sign that a rally is coming to an end. I was told early in my forex career that every currency pair almost looked most bid at the top and most offered at the bottom, and the same applies to commodities. Once the scramble to cover wrong positions is underway things move quickly, in this case in an upward direction and give an appearance of serious strength. Once the shorts are covered, however, those that wanted to buy probably already have and a turnaround is just about assured.

The second thing to do is to accept that as good as your case for a contrarian trade is, it can still be wrong. A strategy to keep losses manageable is therefore essential. Stop loss orders are the obvious and best way to do that, but this type of trade demands that they not be too close to your entry point. The difficulty of picking the exact level that will spark a turnaround means that stop losses should be further away than you might normally consider, so it is best to keep positions small initially. Remember, you can always sell some more if oil does turn over the next few days.

All that makes a small short position in WTI futures look like a decent trade. The size of such a position depends on your own risk and loss tolerances, but it should be at most half of your normal position size. That would enable a stop to be set up close to $51, above yesterday’s high. I would also look to add to my short somewhere just below $49 if we get there, and then run with a trailing stop to see how far we go. However you do it though, shorting WTI at these levels with a stop loss in place looks like a smart move.

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