The Danger Of Round Numbers: WTI’s Rapid Retreat from $50

Yesterday, to much fanfare from the online financial sites and business television stations, WTI, the benchmark for U.S. oil, broke through the $50 level. No sooner had the breathless talk of a complete recovery in oil prices begun, though, than it ended as WTI reacted to the level like a scalded cat and retreated as quickly as possible. This morning brought some attempts to explain why that rapid retracement occurred, but as far as I can see none of them have hit on what I consider to be the real reason.

In some ways it may seem that analyzing and attempting to explain what happened yesterday is a bit pointless; it is all over after all. Usually I would feel that way, but it is important that what happened yesterday is understood by anybody who trades oil, or for that matter any commodity futures from home, as it is not a rare phenomenon. To understand what caused the rapid retreat, you have to first understand what probably caused the run up above $50, and to do that you have to put yourself in the position of a desk or floor trader, a job that I did for nearly twenty years.

(Click to enlarge)

The above chart is for oil futures from 1 AM on Wednesday to early morning Friday U.S. Eastern time. When traders in the U.S. came to their desks at around 6AM they would have seen a chart that showed that oil had been basically flat for the last 6 hours. There had been an attempt to push lower that had failed, which suggested some support at around 49.70, but otherwise 49.76/96 had covered most of the trades. I can assure you that if I had come in in the morning and seen a chart like that, with that level of proximity to a round number, I would have been a buyer straight away, but only to set up a sell.

The round number, in this case $50 per barrel for WTI really means nothing to traders, except in one sense. They will be aware that it does look significant to retail traders and many of their customers, so orders will likely be clustered around the level. Most importantly it is reasonable to assume that there are stop losses just above $50…and that sets up a classic squeeze. In the thin early market it would take a relatively small amount of purchases to push the price up through $50 and trigger those stops. Keep in mind, though, that this is not a move that is in response to any fundamental factors, nor is it done with any conviction by those traders.

Once the price gets to the point where most of those stops have probably been triggered, in this case $50.20, those same traders who bought to drive the price up, sell into the stops that they have triggered. It is a basic, bread and butter play by desk traders and one which, I am sure has hurt most people who trade at some point. It is often done by people who already have long positions in order to squeeze the last little bit of profit out of that position.

What is important in understanding yesterday's action, though, is that other than as a short term, technical play the traders who buy in that situation have no interest in remaining long. They are looking to dump positions as soon as possible. In some cases the whole reason for buying is to sell. It is little wonder then that the first break of a round number such as we saw in WTI yesterday is usually a false one, and once momentum is reached in the other direction, those that misread the situation and bought on what they saw as a breakout above $50 get squeezed out on the way back down. (Incidentally, if you think that this is trading with 20/20 hindsight, I should point out that I advised the Energy Trader Team members to sell at $50.10 yesterday morning).

The lesson here is one that I have preached in these pages before. Round numbers make for easy headlines and may seem significant, but they are dangerous places for retail traders to play unless they understand the thinking and tactics of the big players in the market.