I bet that many are looking at that very tempting hammer candlestick pattern which printed last Friday and thinking that it is a bullish omen. Well, not always. But I do think this pullback presents an opportunity for the long side in the energy sector. Here’s why:
Let’s take a look at the AMEX Oil Index (XOI). It is off its recent high by 12.5% and closed last week at 998.28 - just under the psychologically important round number, 1000. As well, the Oil Index has fallen to support because 1000 is a previous resistance level at which the index struggled for about 11 months (from October 2008 to September 2009). The long term moving average (200 day simple) is right around this level and rising. Finally, like many sectors and stocks, there is a beautifully formed hammer candlestick. So we have a confluence of different technical events, making this level a significant one to monitor:
Taking a look under the hood, so to speak, the bullish percent index has fallen to 41% - exactly where it was in December 2009 when the sector bounced +7% to its October 2009 highs. But notice that this was and is a rather shallow pull back. A real washed out level is around 20% or lower as we’ve seen numerous times, especially during the severe bear market in 2008:
Also, keep in mind that the other major oil index, the Oil Services Index (OSX), is showing a similar pattern but with more relative strength. The AMEX Oil Index is even weaker when we look at it relative to the general market (S&P 500). While energy stocks did rise from their bear market lows in late 2008 and early 2009, they peaked ahead of the crude oil spike and in the aftermath have not kept pace with the bounce in crude oil either. In brief, they have really not been an engine propelling this cyclical bull market. Not at all. The technology sector (especially the semiconductors) have worn that mantle. So I wouldn’t necessarily be expecting fireworks here for the oil sector. But still, I think there is an opportunity.
Fail to Plan? Plan to Fail
One of the most important aspects of a trading plan is to not just define a thesis but also to establish how to know you were wrong. And believe me, you will be wrong. If you are willing to put aside ego and accept a little bit of humility into your life, you can be wrong most of the time and still make money. If you’re new to trading and have no real grasp of money management that will sound silly. But don’t worry, you’ve just discovered the Holy Grail of trading. You’ll thank me later.
In this scenario, the convergence of all these technical characteristics outlined above creates not only a reason to look for the long side but also provides us with a logical rational to place stop losses. For each individual stock in the sector you analyse, you can set its own stop loss based on the support and resistance on its own chart or another method would be to make the exit from individual stocks conditional on the AMEX Oil Index not breaching a certain level.
Just be careful because this is not a forgiving market. The tape is acting rather weak and I could very well be wrong in looking for a bounce in this (or any other) sector. The good thing is that because it is so tightly defined, the tape will telegraph it rather clearly.
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