How I Knew the Crude Oil Run Was Over

Crude oil, from a technical perspective, has been trading in a rather narrow sideways range since it fell back to earth (from a ridiculous $190/barrel) in late 2008. So there’s no clear trade to make today – but that doesn’t stop me from studying the charts for patternrns and for plotting out the next potential opportunity.

First, let’s look at the bubble-like run-up, and collapse, crude oil experienced as the financial crisis of 2007/08 was unfolding. Two distinct candlestick patternrns occurred – one at the very top and one at the very bottom – each alerting me to the reversal in trend that would follow.

Here’s a long-term chart of crude oil futures – with each candlestick representing a full month’s worth of trading:

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In the run-up, crude nearly doubled, shooting from $100 in January 2007 to a high of $194.59 in July 2008. But July was unequivocally the time to get out of oil and I knew this because of the Bearish Engulfing Candlestick patternrn that emerged at the end of the month.

There are a few criteria for a Bearish Engulfing Candlestick patternrn to form:

1) It must occur after a meaningful price advance
2) The candle’s high must be higher than the previous candle’s high
3) The candle’s low must be lower than the previous candle’s low
4) The closing price of the candle must be in the bottom half of the candle

All four criteria were met on the July 2008 candle, signaling the run-up was over.

There’s a psychological component to this candle patternrn. Investors get overconfident when something goes up consistently for some time. The early birds get greedier and the newcomers pile in to ensure they don’t miss out. Invariably, investors keep buying as new highs are made.

In July 2008, new highs were made and investors kept buying oil. But by the end of the same month, all of these new buyers had lost money – a lot of it. They either sold their positions at a major loss, or got margin calls and had to sink more cash into the investment to keep it alive.

That’s why the Bearish Engulfing Candlestick patternrn is so powerful. It signals a painful month for the latecomer-buyers, whose liquidation selling triggers a cascade of sell orders, ultimately sending the price much lower.

And just as July 2008 clearly marked the top of the trend, February 2009 clearly marked the bottom of the sell-off. The market made this known through a candlestick patternrn that we call a “hammer” or a “dragonfly doji.”

This patternrn unfolds when price continues to move lower after the month opens, continuing the downward trend investors are now accustomed to. After a meaningful price decline, prices climb back up and close near the very top of the monthly range.

You can see for the February 2009 candle, the open and closing prices were identical and at the very top of the month’s range. This signals clearly that the downtrend is likely over.

Moving forward, I’ll be looking for patternrns like these to tell me when oil’s trend is about to reverse.

With crude in a narrow range, now is not the time to buy or sell. But if crude creeps up to between $110 and $120 – and if I see a clear bearish candlestick patternrn – I’ll be looking to get short crude in this range.

For now, we wait and watch… and dream about sub-$3 gas and big cars!

If you haven’t done so already read the Survive & Prosper issue on “The Upside and Downside to Lower Fuel Prices“.



Adam O’Dell

Using his perfect blend of technical and fundamental analysis, Adam uncovers investment opportunities that return the maximum profit with minimum risk.