Why I'm Bullish on Crude Oil (In the Short-term)

I discussed being bullish on Crude Oil today on my social media stream and it opened up quite a discussion. I mean, how does a trend trader become bullish on an asset one day after it set a multi-year low? Seems odd right? I agree this is not my normal trade, but I try to observe trends on all timeframes and am an open-minded market participant that tries to remain objective to the evidence in front of me. So here we go...

I emphasize that this is a short-term trade. I don't expect oil to recover to $60/barrel in the near future. But by my estimation it doesn't have to for there to be a very strong risk/reward trade. First I want to start with my immediate reasoning for opening a Long Crude Oil position this morning (1/21).

USO 30 minute bars

The short-term trend is looking constructive. The downtrend line that has been in place for all of 2016 was broken today and held on a mid-day consolidation. Price was also able to hold above the 50 SMA on the 30-min chart. We also saw a higher low established after the early morning pullback at the open today.

Zooming in on the same chart, this morning's action was quite bullish in my opinion. After a strong rally to end the day yesterday, oil gapped lower at the open today. The gap was filled within the first hour of trading and despite an attempt to roll the market over after the gap fill, buyers came in and cleared both the gap level and yesterday's high on the largest trading volume we've seen in more than 4-months.

This was my entry signal following yesterday's late day reversal. The surge of buying suggested yesterday's reversal rally was more than just Shorts taking profits and that a substantial upside move may actually be in process.

Looking at my indicators going back to the beginning of the year we can see rotation coming into USO on the short-term charts as it broke its relative downtrend vs. the SP500. The MACD line is now > 0 and will need to hold in that position to maintain the uptrend momentum. So far so good.

The risk management of this trade is easy. With today's rally and confirmation of yesterday's reversal, we can use the low at 7.92 as our stop going forward. Basically if oil makes a lower low from here we will be done. No questions asked, no justifying holding a losing trade.

Apart from the short-term execution of this trade, the greater evidence lies in the longer-term charts and price action I've observed over the past year.

USO Daily chart

Looking at the daily chart the first thing I see is a classic two bar reversal setup. On 1/20 oil gapped lower after an 11-day -30% decline, but closed near the highs of the day creating a "hammer" candle. Today's trading engulfed the body of yesterday's hammer and closed above the gap resistance from 1/19. This to me shows exhaustion and is likely to lead to a reversal of some kind.

The other thing I notice is the dramatic increase in trading volume that has occurred over the last two weeks. The 50-day average trading volume going back the last 2-years has been between 20-35 million shares traded daily. 6 of the last 8 trading days have seen more than 80 million shares traded while price declined substantially. Heavy selling doesn't necessarily mark lows in a downtrend, but a capitulation of worn out bulls does tend to occur near major turning points.

The more telling volume move I've noticed is on the weekly chart of USO

This is the volume trend of USO going back to 2007. As you can see last week saw the largest weekly volume EVER and 150 million more shares traded than the next closest weekly total.

This spike in weekly volume has occurred after an 18-month and -80% decline in the price of oil. 

3x Inverse Crude Oil ETF (DWTI) sees uptrend reversal and potential blow-off move

 I often find it helpful to look at a chart from the opposite perspective. If I want to go Long Crude, what does the inverse of that chart look like? Seeing the position of DWTI causes me to be more confident in taking a Long trade here.

The time to be a buyer of DWTI or to short Crude was near the $150 area. This particular vehicle traded more than 200% higher in less than 2 months. The last two trading days suggest a substantial trend reversal is in motion. This is basically the exact opposite of what we are seeing in the USO. Here we had a parabolic rally from the beginning of January (+150% in 12 trading days) that then gapped higher and closed near the lows of the session on 1/20. This can be a signal of exhaustion of a rally and is called a "shooting star" formation. This single candle needs confirmation to be a viable trade signal and today we saw a bearish engulfing candle emerge and close below the prior gap from 1/19. This is a highly bearish indication, especially following such a strong rally in a short period of time. The setup suggested by DWTI is that a Long Oil trade is now a viable and high probability option.


A question I was asked by several traders today was how can oil have a bottom if companies haven't been going bankrupt yet? Where is the real pain, the blood in the streets? My answer to this is oil companies are hurting currently and many have high debt levels. But the fall in the price of Crude has been relatively fast. WTI was trading at $55/barrel in mid-October. I've been told that even most marginal oil players can break even near the $50-$60/barrel price. OPEC I've been told can operate profitably at under $10/barrel. We have seen a decline of nearly 50% in just over 3-months. This is likely not enough time for the price to impact credit obligations just yet.

Where I believe the trouble lies for oil company bankruptcies is in the "lower for longer" scenario. If the more fringe oil producers can't make money below $50/barrel, then the longer prices stay below that level the more issues they will have. 

As I stated above I don't think we see $60/barrel prices in the near future. But the price of Crude could bounce around between the 20's-40's for an extended period of time. It is also my belief that the time to short the commodity itself has come to an ending point or is very close. From this point forward, should the price of oil remain below $40/barrel, shorting the high debt oil companies could still be a very viable strategy.

For this immediate trade I'm looking for a recovery to near the $35/barrel price. That would be just under 20% from the current closing price on 1/21 and would setup a move in USO to the $10 area. Granted this is not my normal strategy to trade for mean reversion, but I do take short-term swing trades from time to time. I usually don't share those trades on social media simply due to their rapid changes being on such a fast timeframe. This particular trade I felt like sharing as so many have been obsessively following the price of oil. I hope this thought process helps you understand how I build and construct a trade in a different manner than my normal long-term trend strategies.

There are many ways to make money in the markets. The most important concept to understand is whatever method you choose to follow be sure to always manage risk first. If you know your exit point and size your positions appropriately you will come out ahead regardless of the particular entry strategy you use. 

Thanks for reading
-ZT