Oil's Descent: Triangles, Elliott, Reversion, & BackwardationIn this analysis, we will delve into the oil market’s current state and explain why a significant reversal is imminent.
Contracting Triangle
Oil has been forming a contracting triangle since the beginning of May. The lead-up to the triangle was bearish, so statistically, the breakout should also be bearish. The upper extreme of the triangle is at $84.45, but prices could advance up to $87.67 before invalidating the bearish breakout.
Wave C of E of X
According to Elliott Wave analysis, contracting triangles form five waves (i.e., A, B, C, D, E). Typically, each of those five waves subdivides into a zigzag (i.e., A, B, C). We can clearly count five waves of the triangle and three waves of the final zigzag, indicating that the reversal should occur at any moment.
Mean Reversion
On the daily timeframe, oil has approached the overbought level on three different mean reversion indicators. It has been overbought since June 17, according to the Stochastic Oscillator, and it will be overbought according to RSI and Bollinger Bands at $85.09.
Backwardation
Backwardation, where forward contracts are traded below the expected spot value at maturity, often signifies a bullish outlook for crude oil. However, it can also indicate short-term market stress caused by buyers' panic over excess demand or insufficient supply. This scenario often results from an overreaction, and as future supply and demand expectations come into balance, the oil market tends to experience a selloff towards more rational pricing. Given the current strong state of backwardation in oil futures, this dynamic could unfold, contributing to the next market downturn.
Executing the Bearish Strategy
As this is a countertrend trade, risk should be tight, and one’s stop loss should be adhered to religiously. While unlikely, if prices were to continue their ascent, and you have a wide or flexible stop loss, you could experience a substantial loss.
I believe the best place for a stop loss would be just beyond the end of intermediate wave C at $87.68. If prices move beyond this level, it would invalidate the Elliott analysis and offer a strong indication of a bullish breakout from the triangle. As long as prices hold below this level, the outlook would remain bearish, unless a strong consolidation pattern forms near these highs.
If the analysis is correct and we do see a bearish breakout, prices could easily decline to $65, possibly lower. This would be a reasonably conservative target, but I am planning a discretionary exit as price action develops.
As for entry, this is a personal decision. I see three possible options:
Wait for prices to climb a little higher (less risk at entry if successful, with a chance of entering lower with more risk if unsuccessful).
Wait for prices to decline a bit to confirm the analysis (higher probability of a winning trade, with greater initial risk at entry).
Enter now (somewhere in between options 1 and 2).
Good luck, everyone!
