In volatile markets, keep focused on risk management.

- Chad Butler

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May 18, 2007

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One of the most difficult sectors to trade right now is the energy sector. Crude oil, unleaded gas, natural gas--they all have made large swings. In this sector, trading crude oil has probably been the most perplexing. One of the problems with it is the tendency for traders to have an opinion on market direction that opposes their market analysis.

The Fundamentals

To begin with, a case could be made for both the bears and the bulls using fundamental analysis. Current inventories of gasoline are tight due to refinery issues. This lightens the strain on crude inventories as they are not being distilled as quickly. Even excluding the crude that is being added to the Strategic Petroleum Reserve, crude stocks are increasing. The shortage of crude oil is a perception that watching the inventory numbers does not support. That’s bearish.

However, there is still an economic boom demanding crude in Asia, and the majority of the world’s crude oil comes from areas that are less than politically stable--Venezuela, Nigeria, the Middle East, and Eastern Europe. So, although it is unlikely that the world will tap crude oil dry, we have fierce competition for supplies that are, shall we say, less than reliable. That’s bullish.

(For more on the fundamentals of this market, call in for supply and inventory data.)

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The Technicals

If you have followed my material for any period of time, you know that I have a very simple trend-following approach to the markets. At the core of this methodology is the relationship between the nine-day simple moving average (9MA) and the 50-day simple moving average (50MA). If the 9MA is above the 50MA, we have a bullish bias; if the 9MA is below the 50MA, we have a bearish bias.

As of 5/11/2007, the 9MA has crossed below the 50MA, giving us a bearish bias on crude oil. We are, however, sitting right around another favorite indicator, the 20-day exponential moving average (20EMA). For a long entry, I am watching for the market to settle above the high of the day that broke the 20EMA. That was 64.67 on 5/2/2007.

If you cannot view the above chart, go here.
Chart © 2007 FutureSource

But isn’t this in opposition to our bearish bias on the 9/50 relationship? Yes, and that is what makes this a difficult market to trade at this time.

Some Caveats

At this point you might be thinking that I’ve told you absolutely nothing. I’ve told you the market is both bullish and bearish, both fundamentally and technically. But, that is the way the market works. Remember that trading is a zero-sum game. For every winner, there is a loser. To paraphrase a favorite quote from the movie Wall Street: Money isn’t lost or made. It’s simply transferred. The bottom line is that you MUST be aware of what is coming at you from the opposition. If you are long, there is a seller betting that you are wrong. If you are short, there is a buyer on the other side of that trade that thinks he knows more than you. Never forget to watch your back and know where you are vulnerable. That means trade with a plan. It’s cliché, but failing to plan is planning to fail. And trading without a plan is a recipe for losing money.

What’s the Trade?

Keeping in mind that the market needs to define direction, there are two possible trades that I see. I will give one for the bulls and one for the bears, but you will need to make up your own mind as to which side you are on (or you could be on both sides and let the market tell you where it’s going).

For the bulls, the 20EMA setup that I mentioned earlier is the long trade. That trade would buy the open of the following day if we settle above 64.67. The risk is the lows of the current range–your stop would need to be below 61.47 (the low close on 5/7/2007). That’s a risk of more than $3,200, depending on the entry, but the objective would be a run at the highs of last summer–the $75 area. Not a bad risk reward ratio.

For the bears, a break below 61.47 sets up a test of the January lows near $51. That is a profit objective of $10,000. The stop would have to be above 66.70, making the risk at least $5,230. But that could be tightened fairly quickly with any significant break.

Either way, crude has some very large risk requirements, but also has the opportunity for large rewards–if you are right. If the risk is too large, you have some alternatives. You could trade a mini-sized contract, use an option strategy, or stay away altogether. If you are undercapitalized, I recommend staying away from crude for now. It is better to stand aside and wait for a lower-risk entry than to risk a total washout.

If you are an option trader, or need a defined risk position, bull call spreads or bear put spreads deserve a look. With high volatility, simply buying a call or put outright can be expensive, but the spread can reduce your cost of entry and provide you with a higher probability trade closer to the money. Call in to discuss this with an RJOFutures trading strategist, since this type of position is best custom tailored to the investor’s risk tolerance, account size, and investment objective.

THE RISK OF LOSS IN TRADING FUTURES AND OPTIONS CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER TRADING FUTURES AND OPTIONS FITS WITH YOUR INVESTMENT OBJECTIVES.

Chad Butler is a Senior Market Strategist with R.J. O'Brien. His market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs. Chad's published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, SFO Magazine, and other trade publications. He currently writes market research for RJOFutures and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

Special research offer: Get 6 months access to The Hightower Report's Total Commodity Research Center, without cost to you. It’s a value of $480. Tap into 20+ years of experience that can help you design trade strategies to capture the market’s potential.