Wednesday, September 20, 2006

Oil: Capitulation?

This is a big question and by the sound of it it seems to require a big answer. I am sure that with enough research of the sector's and the commodity's fundamentals, analysis of market order flows, comparisons to the past, etc., several strong, "big answer" views can be formed.

As a trader and by no means a well-equipped analyst, I will offer a small one:

December futures are trading at 61.70 and we are betting a large sum of money that we will be seeing this price again.

"Great!", you say. "You call that a view?"

Well, from my perspective, which has an extremely shallow, admittedly singular basis called "making money", it absolutely is. If I told you that there was at least a 95% chance that 61.70 was a price that we will be seeing in the future, would you consider that information as a tradable view?

To be fair, this really boils down to your trading methodology. One of the methods sometimes applied at Cadence is bottom fiishing (feel free to read my recent article posted at that describes the strategy). In a nutshell, when an asset falls hard and fast after a prolonged decline (I am oversimplifying) chances of a near bottom being formed are very high. Obviously, a glace at the Oil chart that includes today's close will show a nearly perfect example of such scenario.

Now, knowing that the bottom is near, how is my trading view relevant?

It's less than immediately obvious. The easy part is of course that I am dead on right and Oil will go higher from here. If you believe me then you'll run out and buy a pile of Globex futures right now and enjoy your profits as soon as you decide that you've made enough. Now, the not so easy part is that I may be wrong, at which point the issue of risk management comes into play.

Well, here's the clue: I said that I have a high degree of confidence that 61.70 is a price we'll be seeing again. What I didn't say was that most likely, we'll be seeing it on the way up from below. Your profitability will be determined by how much lower we go before we revert to (and likely above) the 61.70 level.

This means that as long as your cost is not much higher than this price, you have a very high chance of being "safe". So, while you may not necessarily make money in the end, the truth is that you're very unlikely to lose much, if any. And, on average, you'll make ok profits.

Word of caution: there is that 5% chance that I am completely, obnoxiously wrong and we won't be seeing 61.70 any time soon. What to do?

The answer is simple if you reaize that this 5% chance quantifies an outlier. And, as all outliers go, the best you can do is cap it with a stop (just like you would with a long leg of a short options spread). Just keep in mind that your stop should respect the increased volatility levels.

Overall, I do happen to think that Oil is capitulating in the short term. I am also fairly confident that once it bottoms somewhere near here it has an upside of $6-8. But this particular statement is just for fun, because we won't be there waiting for the $6 profit to materialize.

That's just not how the game is played.



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