Structuring A Trade For The Top Of The Channel

For any trader, a perfect and clear chart pattern is a wonderful thing to behold. Even those like me who understand that technical and chart analysis has its limitations and will always be overpowered by shifts in fundamental factors finds it difficult to resist the obvious trade in such circumstances. The chart for WTI futures right now shows just such a pattern. In fact, the setup is so perfect that even that obvious trade can be structured in such a way as to guard against the possibility of being wrong.

(Click to enlarge)

I am sure that even if I hadn't added the trend lines to the above chart, most of you would immediately spot the downward sloping channel in QM, the E-Mini WTI futures contract. Since the end of April oil has exhibited volatility, but in a pattern of lower highs and lower lows that is text book perfect.

The obvious trade now that we are right at the top of that channel is to sell. Even if we don't continue the pattern and drop to the lower trend line, a retracement back to the next support level at around $45.50 would offer a very nice profit. The problem is that, as is usually the case, there are very good reasons for WTI being at the top of the range.

The two main bullish influences are global growth and OPEC. The strong rally in stocks around the world over the last few months has opened up the possibility of increased oil demand, which would take care of the glut of oil that has kept prices relatively depressed. That is especially so if the production cuts agreed by OPEC and a few influential non-OPEC producing countries are adhered to or even extended. Over time it is reasonable to expect both of those things, particularly the prospect of increased demand, to lend support to oil.

The short-term bear case, however, does not rest solely on the chart pattern. Increasing worry about the effects of Fed tightening and the tapering of QE by the ECB have stalled the stock rally for now, so it appears that the degree of confidence in global growth is diminishing. From a more oil specific perspective too, there must be some doubt. The OPEC led meeting in St. Petersburg last weekend produced a lot of supportive words, but the buzz going in was all about some nations' failure to observe production caps. The history of OPEC and the current level of mistrust among some prominent members of the cartel suggest that that problem is not going to go away.

So the fundamental factors look to be well balanced, which brings us back to the technical pattern. Range and channel trading are the bread and butter of a trader's method, but at the extremes there are serious risks that must be accounted for. Because selling at the top of a channel like this is so obvious the trade can easily become crowded, and when it does any break out above the level that can cause a sharp move on up. While that poses a danger, though, it can be used to protect your trade. Setting a stop loss to cover against a breakout would be standard operating procedure for any trader, but making that order for double the size of your original position in a situation like this is a good tactic. That way, if the breakout does come you can use the exaggerated nature of the move to recover losses from the original position.

There is a common misconception that success in trading always depends on getting the next move right. In actuality, understanding that that is not always possible and devising a strategy to protect against getting it wrong is just as important. WTI futures currently offer an opportunity to do that, so a small short position at these levels with a double sized stop just above $50 represents a potentially profitable trade with controlled risk, and that is, by definition, a good trade.