Tuesday, December 30, 2014

Crude oil: are we in yet another cycle?

We often hear that the oil industry is a cyclical one. This partly due oil prices' dependence on GDP growth and global economies. Several times, we have seen how recessions have affected prices and created most "cycles" for this industry. Some of these cycles have lasted for months and some longer  have lasted even years. However, these are demand driven cycles characterized by an "oversold" condition in the market and a subsequent sharp recovery of prices. Pretty much as we saw after the last financial crisis in 2008-2009.

We have had supply driven cycles twice before once in 1986 (prices from 30USD/bbl to 12USD/bbl) and lasted for 4 years. The second time was in 1998, due to a supply glut created by non-compliant OPEC members, but this was short-lived. 

Today there is oil everywhere, but the most significant difference is that this new oil (i.e. shale oil) its safe and reliable oil (unlike most OPECs). It does not bring any geopolitical risk. It does not need to be transported long distances to the consumer (e.g. refineries in USA) and it can be produced almost as you would produce a car in an assembly line. This is really, high volume, low risk cheap energy.

If you ask a veteran oil man, you might hear, yes, this is another cycle. why? well, the demand for energy only goes up as there is more people in this planet, and oil provides an efficient way to solve this issue. This is what I call the "standard demand" (no allegations to Standard oil". On the other hand, the supply is limited and will eventually decline. What can be different this time around: cell phones!

Only a few years ago, we all had different technologies in our hands and I remember asking my friends what kind of phone they had to compare. Those days are gone, we all have smartphones now, they are all touch, made with the same materials and pretty much the same functionality.

This off-road story is to highlight the demand side of this picture. We are entering a supply driven "cycle" while being on a relatively high oil-related-energy demand period. But this might change in a few years, maybe in only a couple of years. What if we get a demand shock while we are still at this supply driven cycle? say China's economy, Eurozone crisis, or even more unlikely but yet more shocking, a transformation of the OECD countries' car fleet. A massive move towards cheaper, safer, reliable and extremely powerful electric cars which by the way come with an incentive. Alternatively, a war-like scenario, Russia-Ukraine, Libya disruptions, could offer a breather to the bearish giant, but don't get fooled. People are trading the future volumes now, the supply glut needs to be sorted out by the market itself, forget OPEC, only a visible reduction in shale oil could make this market bounce back hard. CAPEX cuts by majors only delay projects out in time, they don't necessarily cut production. What is happening now looks less and less like a cycle, and more and more like a change in the way the world of energy is set to work from now on. We only need the demand reduction to fill the gap. Sorry bulls...

Monday, December 29, 2014

The Milky-Way Trading System

This strategy is not only applicable to Forex. In fact, all the charts I am going to show you are from commodities. Brent and Gold to be more specific. My task to you is that you set up this into any currency pair and see for yourself.  

The first thing you need to know, and mark my words: Trading is not about position size, it is about timing. In other words, you can make lots of money with a small position if you time your entry well. Big positions only add unwanted pressure.

Set up:

  • Hourly chart or beyond – candle sticks
  • 5 period moving average
  • 9 period moving average
  • Stop and Reversal (SAR) : default settings
  • Volume: 1 unit +3 units

*  By 1 unit we mean, your minimum position, with the maximum of 4 units at one point.


Long: 1 unit

  • Once you see a SAR dot below the prices, you wait until there is a crossover (5 thru 9) and the price action comes back to your moving average. Enter the position as close as possible to that moving average. Here we start “milking” the trend (if the trend unfolds of course).  The way you make money is by taking profit at a defined target that is no larger than the size of the previous candles (including its shadow). If your target is too far, you will not be able to milk it. So, you are basically, taking profit at parity with the volatility at that moment. Once you have taken profit, you would wait for another retracement to the moving average and enter a fresh 1xunit.  Repeat this process for as long as you see the trend. 

Stop Loss:

Below the previous SAR dot to the current candle. Since there is a long way to that level, the risk/reward is quite elevated for this trade, therefore respecting the 1 unit volume mandate is important.  In the picture above, the trade is successful and you can carry that as long as the SAR allows you to.

On a short trade, apply the same principle. Sell 1 unit at a retracement towards the two moving averages with the SAR above prices.

When to max the position?

Entry: 3xunits

Let’s say it is a very volatile day and the nice trend shown in the pictures above is not quite what you see in the market. Instead you see the picture below:

  • This is where you make the money. This is all about measuring your risk and taking advantage of an existing trend that is well developed.
  • In this case, you are very close to your stop level and you can take more risk. If you get stopped, well too bad, you lost a little bit, but if the trade succeeds, you will remember this strategy for the rest of your life.  Remember, you can continue to milk the trade afterwards, and you are free to exit your 3xunits whenever it suits you best. 
  • Another example follows:

The trend here is coming to an end; however it will try to stay alive and here is where you come in. Seeing that you are close to the reversal point, buy your 3 units and set your stop below the average of the SAR dots. This is a short term trade, as opposed to the first one.

The conditions to enter this trade are simple:

1.- You need a well-developed trend, basically, many red dots. A new trend giving you this signal will only play you for a fool.

2.- Your stop is very important. If the trend is dying, you will see lots of SAR dots horizontally aligned. Your stop should be easy to set just below the dots for a long entry (as seen above).

3.- Choose a stop loss level that makes sense. In the case below, look at our stop, it is set above the previous high and also above the current SAR dot.

It is only common sense to give yourself some room, while still keeping a good risk/reward ratio. See on another example below. The second stop obviates the previous dot because its horizontally aligned to the latest one. Again, some common sense will protect you from getting whipped:

Pitfalls:  (pay attention because I fell into all of them, that’s how I know they exist)

1.- New born trend with prices on the wrong side of the moving averages.

2. Divergence: The SAR is telling you something but prices are obviously going in the opposite direction. The SAR is supposed to be parabolic. You will recognize divergence because the SAR shows no bulge. Stay out of that trade.

You are not supposed to win all. I am going to end this post with a losing trade. Can you identify where the trade has gone wrong?

Look again: In this case, you would have entered a 1 unit long at the first green bubble, then prices move against us, we add 3 units at the second green bubble and not long after that we get stopped!  Not long after that, we enter a new short position and recover some of that loss.