Sunday, February 9, 2014

The Petroleum Triangle: A case study

The exchange traded fund that tracks crude oil, USO, gave a bull signal on Friday. Because the chart is problematic, I'll do the analysis now rather than waiting for confirmation.

By problematic, I mean in the sense that J.M. Barrie employed, with some elegance, in the original book version of Peter Pan: "Dreams do come true, if only we wish hard enough for them."

The same can be said for chart formations, especially trendlines and their offspring, triangles.

The Chart

Using Elliott wave analysis, I find that by one reckoning, the bull signal came as the final blip of a massive symmetrical triangle that began to form its lower boundary in 2009 and its upper boundary in 2011. 

The two boundary lines -- in black on the chart below -- form the triangle that is the primary structure of wave 2 {+4}, a sideways correction that will be followed by wave 3 {+4}, a long-running decline.

The question is, when should the trend forming the upper boundary begin?

Click on chart to enlarge.
USO 6-1/2 years weekly bars
I put the start of the upper boundary at May 2011. However, that starting point is more than two years after the wave 1 {+4} low that began the correction. 

Eight months after the low, I would, with complete justification, have drawn the red trend line. Two years and three months after the low, I would have drawn the green line.

Neither is the defensible boundary of a triangle, not at that point at least.

It is only in February 2012, three years after the low, that I would have had enough on the chart to draw the descending upper boundary required for a symmetrical triangle.

Likewise with the lower boundary. In October 2011, two years and eight months after the low, I would have drawn the descending lower boundary (in red). Its angle means that it can't be part of a symmetrical triangle, although an expanding triangle would be a possibility.

Only in July 2012 would the ascending lower boundary have become possible.

What to make of all of this? 

R.N. Elliott developed Elliott wave theory in the 1930s. He grandiloquently titled his final work on the subject, published in 1946, two years before his death, Nature's Law -- The Secret of the Universe

If that is indeed what Elliott wave theory purports to be, then the malleable nature of its analysis, as illustrated so neatly by the long-term USO chart, marks Nature as a lawbreaker with few useful secrets to whisper in the trader's ear.

My approach differs from Elliott's in that I have little faith in secret laws or open laws, at least insofar as the markets are concerned. I've observed many trends in the thousands of charts I've screened. I've also observed many whipsaws.

Historians, professors of English literature, psychologists, politicians, propagandists and journalists have a useful tool in their intellectual kits called framing, a model of sorts that enables discourse about unstructured events.

Write about politics using a class conflict frame and end up with Karl Marx. Using a traditional virtues frame, with Edmond Burke. An heroic individualism frame, with Ayn Rand, or possibly Rand Paul, or Ron Paul. 

A change in the frame changes the discourse.

I use the Elliott counting rules as a frame to bring some order to a chaotic history of price fluctuations. I do so with the full realization that many other frames might be applied. 

The Elliott counts appear to provide useful information about turning points and to match the actual behavior of prices under many circumstances.

Are they perfect? Not at all. If they cease to be useful, then I shall toss them into the trash bin in an instant without regret.

Having done my best to tarnish Elliott wave theory, let me now bring out the polish and put a shine on the important capabilities it provides.

My entire complaint about the USO chart can be boiled down to this: I don't know the future. I don't know what I don't know.

Of course my view of the chart in October 2009 will differ from that of February 2012. My view of life, my prospects, the American economy and health benefits of pizza also changed in that period.

The ability to alter an analysis to accommodate new information, far from being a flaw, is the sign of a robust analytical system.

The world a changeable place, no aspect of it more than the markets. A system that knows that new information means that the prior analysis was wrong and proudly proclaims it is a system imbued with high virtue.

An Elliott wave triangle touches the boundaries five times, with each touch labeled with a letter, a through e. After the final e touch, then the trend continues in whatever direction the triangle's placement in the wave count would dictate.

Sometimes a boundary touch will overshoot somewhat, but if it is a triangle, the reversal will quickly come.

In the case of USO, I would have known around the July 2012 reversal that a triangle was under construction, and the September 2013 reversal would confirm it. Friday's high of $35.75, at the boundary, marks the end of the triangle.

I count the triangle as a correction within a major downtrend, wave 1 {+5} that began in July 2008 from $119.17. Since the enclosing degree is a downtrend, the first, third and fifth waves are declining, and the second and fourth waves are upside corrections of the decline.

The end of wave 2 {+4} with the e leg of the triangle means that wave 3 {+4} is beginning and that it will be a long-running move to the downside.

If instead of reversing, the e leg's rise above the triangle boundaries continues to move higher, then, under the Elliott wave rules, my count is incorrect and I would need to redo the analysis. 

A move below the lower boundary, now at about $32.90, would confirm that the wave 3 {+4} downtrend was underway.

That's what framing does for me. That's why I continue to use Elliott waves in my analysis.

Normally for a bull signal, I wait for the price to continue to trade higher the day after the signal. In this case, a triangle reversal, confirmation suggests that perhaps the count is wrong. A spectacular non-confirmation is the best-case scenario for this analysis.

So in looking at USO, I'm thinking of it as a potential bear play, despite the bull signal. It is a contrarian trade at this point, not a trend following trade.

The Fund, Liquidity and Volatility

USO on average trades 5 million shares a day. Its holdings are in the form of futures contracts on fossil fuels. It seeks to track percentage changes in the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, a major intersection point for U.S. pipelines.

The fund has an awesome selection of option strike prices spaced 50 cents apart, with open interest running to four and five figures near the money. The front-month at-the-money bid/ask spread on puts is 1.9%, a fairly narrow range.

Implied volatility stands at 19% and has been rising since hitting a one-year low of 15% in late December. Volatility is low, standing at the 24th percentile within the annual range.

Options are pricing in confidence that 68.2% of trades will fall between $33.68 and $37.60 over the next month, for a potential gain or loss of 5.5%, and between $34.70 and $36.58 over the next week.

Volatility that low best suits long option spreads sold for credit, such as, in the case of a bear play, a bear put vertical spread.

Decision for My Account

I won't trade USO as a bull play, despite the bull signal, for the reasons given in my chart talk. The lower boundary of the 20-day price channel now stands at $32.68, about 20 cents below the lower boundary of the triangle, and so a bear signal would be a fair indication that the triangle was indeed complete.


My shorter-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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