We’ve recently looked at the tools used to gauge petroleum fundamentals (“Oil Market Indicators Explained: Part 2“). Now it’s time to turn our attention to the technical side: chart reading.
Technical analysis—examining charts to discern patterns predictive of future price trajectories—is gospel to some investors, anathema to others. We’re not going to wade into that dispute here. Whether you’re a fan of technical analysis or feel it’s bunk, a price chart can help you quickly surmise a commodity’s history.
Fundamental and technical analysis aren’t mutually exclusive. Many investors use both types of indicators to interpret the market and pinpoint potential entry and exit points. It’s for these investors that our Wednesday oil reviews are most useful.
So, what can a price chart tell you? Let’s look at the markers most often employed when analyzing crude oil.
The chart embedded in our weekly oil column tracks the settlement prices of the nearby West Texas Intermediate contract traded on the New York Mercantile Exchange. Unlike bar or candlestick charts, just one price is assigned for each trading day. The inherent assumption is that the settlement value is the most important price of the day.
You can argue the merits of that notion if you like, but one thing is certain: Using the settlement price simplifies the chart, making it look less cluttered.
Nearby WTI Crude Oil
Support And Resistance
Often our price chart will include yellow lines denoting areas of support and resistance.
Support levels are typically drawn below the current market price and represent areas where demand is strong enough to overcome downward price pressure. Buyers are more aggressive at support levels, while sellers become more timid.
Support levels can be discerned in a number of ways. Most commonly, support lines can be drawn from the market’s previous reaction lows—places from which prices have bounced back from a downturn to trade higher. In our chart above, an upward-sloping support line—in this case, the baseline for oil’s current uptrend channel—was established in midyear 2010.
Moving averages, too, can represent support levels. Typically, longer-term averages are more reliable as support. We’ll examine moving averages more in a minute
Retracement levels can also be considered areas of potential support, but we’ll cover those separately.
Consider resistance as the polar opposite of support—a price level where sellers are emboldened enough to keep prices from rising further. Supply emerges as prices advance toward resistance, eventually swamping demand.
Resistance levels are most often painted above the market’s current price, typically extending from the market’s previous reaction highs. The upper boundary of crude oil’s up-channel, for example, was drawn from a series of 2009-10 reaction highs.
Support and resistance levels aren’t immutable; in fact, they’re often transmutable. Support, once broken to the downside, can turn into resistance, and vice versa.
A break in support signals that supply has managed to overwhelm demand. Should prices subsequently return to the level of previous support, an outpouring of supply is likely to tamp down further price advances, and presto-change-o, that level becomes new resistance.
The flip side is a breaking of resistance when aggressive buying overpowers sellers. Here, demand strips supply. A fallback to that level will drive demand, supporting the price.
Retracement levels—areas of potential support and resistance—can be drawn from the market’s previous advances and declines. The levels at which these are drawn are derived from a Fibonacci series.
A bounce can be expected to retrace some portion of a prior decline. The height of that bounce can be predicted by retracement levels.
For example, we’re now in a reactive phase following crude oil’s 2008-09 nose dive. Chartists are most keenly interested in the 38- and 62 percent retracement levels. For the nearby contract, the $103-$104 level represents a 62 percent retracement of the Great Deleveraging. Oil’s clearance of this resistance level bespeaks the market’s current bullish strength. Once definitively cleared, the retracement level—once resistance—then becomes support.
Moving averages are lagging price histories whose purpose is to filter out trading “noise.” Calculating a moving average is pretty straightforward: Settlement prices for a given number of days are averaged to arrive at an arithmetic mean for the day and then plotted. As we move forward in time, the oldest point in the data set is dropped and the newest is added.
Areas of support and resistance within trends—and, indeed, trends themselves—are often easier to spot when moving averages are plotted.
We track three moving averages in our Wednesday recaps: 20-day, 50-day and 200-day. As you might expect, longer-term averages exhibit less volatility. The 200-day average—covering roughly 10 months—constitutes the long-term trend (for our purposes, anyway). It’s a major event when the settlement price graph penetrates the 200-day moving average. Such excursions typically herald significant trend changes.
Crossovers of the 20-day and the 50-day averages are also tracked for clues to the oil market’s medium- and short-term momentum. When the 20-day average crosses above the 50-day, for example, the bulls have mojo. Bears flex their muscles when the faster average crosses to the downside.
Some traders use the faster line to identify possible trend changes and then rely on the slower line for confirmation to enter or exit a trade.
Moving Average Convergence Divergence (MACD)
MACD is a widely used indicator that can help uncover shorter-term trends within a background trend. MACD is used to confirm trend changes drawn on the price chart and to identify areas where traders are likely to enter and exit the market.
Basically, the MACD indicator is a plot of two lines: a relatively fast MACD graph and a slower signal line. Traders look at crossovers of the two lines as trading signals. Bulls get a green light when an upward-moving MACD line intersects the signal line. A sell signal is flashed when the intersection occurs with the MACD line moving downward.
Relative Strength Index (RSI)
RSI is a momentum oscillator that compares the magnitude of a commodity’s recent gains with the magnitude of its recent losses to arrive at an index reading between 0 and 100. A higher RSI value results when the commodity’s price advances; lower RSIs are engendered by price declines.
We look at the last 14 days’ trading history in our RSI calculation.
Day-to-day RSI readings will most often oscillate between 25 and 75. However, when there’s a large number of consecutive “up” days—days in which the settlement price is higher than the previous days’—the RSI may move above 75, indicating an overbought condition. Traders consider this a good time to sell. Whenever a string of “down” days pushes the RSI index below 25, the market’s deemed oversold, piquing buyers’ interest.
Wrapping It Up
This compendium of analytic tools is by no means exhaustive. It’s merely a recap of the most commonly employed indicators in our weekly oil column. From time to time, additional tools—chart patterns, oscillators or volatility metrics—may be referenced, but this primer represents the bulk of what you’re likely to see when oil’s technical picture is painted each week.
ETF Daily News Notes Some Oil Related ETFs: United States Oil ETF (NYSE:USO), iPath S&P GSCI Crude Oil (NYSE:OIL), PowerShares DB Oil (NYSE:DBO), ProShares Ultra DJ-UBS Crude (NYSE:UCO), PowerShares DB Energy (NYSE:DBE), United States 12 Month Oil (NYSE:USL), PowerShares DB Crude Oil Dble (NYSE:DTO), ProShares UltraShort DJ-UBS (NYSE:SCO), United States Short Oil (NYSE:DNO), PowerShares DB Crude Oil Long (NYSE:OLO), United States Brent Oil (NYSE:BNO), PowerShares DB Crude Oil Short (NYSE:SZO), United States Heating Oil (NYSE:UHN), Oil Services HOLDRs (NYSE:OIH).
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