The Smart Way to Trade Oil Now

11/16/2011 9:00 am EST

Focus: COMMODITIES

With crude oil nearing the all-important $100 level, the charts suggest a reversal lower may soon unfold, and traders who are ready to play the short side using leveraged ETFs may profit significantly.

Crude oil was the commodity to trade back in 2007-2008, when prices rocketed above $145 per barrel then dropped like a rock all the way back down to $35 per barrel, leaving many investors and traders either greatly rewarded or dead broke.

Since then, the focus of the world has moved to gold and silver while currencies spiral out of control and more and more reasons emerge as to why individuals and entire countries should focus on owning physical metals rather than eroding currencies.

Just because a commodity is not under the direct spotlight does not mean you can’t trade it or make money from it. With that said, here is my analysis on how to trade oil if $100 per barrel is reached in the coming trading days.

Let’s first take a look at the charts.

Here on the weekly chart, you can see how oil is trading around the $100 level. When the price is trading below it, then $100 will act as resistance, and when oil is above that level, then $100 becomes support.

chart
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And now a daily chart:

chart
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Notice how oil has moved higher for an entire month without any real pullbacks and that it has a clean support trend line underneath. If oil sees some big sellers step in here at the $100-$104 level, then I expect the green support trend line to be broken. If that takes place, oil could quickly and easily drop back down to the $90-$92 area.

NEXT: Best ETFs for Trading Oil's Next Move

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On the ETF side, this chart of the ProShares Ultra DJ-UBS Crude Oil ETF (UCO) shows a recent rally of price accompanied by strong volume:

chart
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I like to review the price by volume analysis from time to time when nearing a major support or resistance level on a chart. For those who have difficulty finding support and resistance levels, this indicator/volume analysis tool will take most of your guesswork out of the equation.

To make a long story short, the longer the volume bars on the left side of the chart are, the more people either bought or sold crude oil at that price. Keep in mind that it does not matter if they bought or sold here. The key to remember is that there are a lot of new positions here and that is where people exit their positions at breakeven because they held such a large drawdown over the past few months and just want their money back.

Most traders and investors who trade off pure emotions (fear/greed) would have held a losing position through the August-to-October selloff and are now going to be more than happy to exit the trade at breakeven and move on to the next emotional rollercoaster.

See related: Year-End Oil Event Few See Coming 

It’s this type of trading which allows the non-emotional traders who thrive off of price action and mass psychology to catch price swings in the oil market.

The chart below clearly shows that oil is entering a resistance level and a pullback is becoming more likely each day. Those looking for leveraged ETFs for trading oil should look at UCO or its inverse, the ProShares UltraShort DJ-UBS Crude Oil ETF (SCO). The inverse ETF goes up in value when oil loses value.

In short, oil is becoming overbought, meaning it has moved up to far too fast and should have some profit taking shortly. Given the fact that oil is reaching the century number ($100), I feel there will be a couple days of selling starting soon. Aggressive short-term traders looking to play this support trend line breakdown should look at trading oil ETFs like SCO. 

By Chris Vermuelen, trader and blogger, The Gold and Oil Guy

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