How to Play the Oil Bounce

Last month, I looked at the energy sector and raised the likelihood that crude oil would drop to 50 in order to complete a large-scale bearish pattern set into motion in July. The futures contract has now breached that target, which has been acting as a price magnet since a recovery attempt failed two weeks ago just above $70.

This price level marks technical and psychological support and should yield a basing pattern for a strong countertrend rally. However, it's unlikely that a single touch of the magic number will bring in waves of new buying interest. More likely, we'll see a few probes under that level, perhaps into the low 40s, to shake out remaining longs.

Notice I use the term "countertrend." The broad pattern in play since July raises the possibility of a climactic selloff wave after we get the expected rally. So I'm not looking for a full recovery that returns the contract to its parabolic glory. However, the upside should offer good trades for all things energy before the downside resumes control.

Seasonality is also an issue, because the contract is in a negative period until the start of 2009. Historically, traders bid up crude oil in the first quarter as they anticipate demand during the summer driving season. Of course, the coming year might be a different animal if the recession keeps folks from taking their annual vacations.

The price of crude oil in the next 12 months will also be tied closely to the twin forces of falling Asian demand and the strengthening dollar. However, despite those influences, I expect that crude oil has fallen about as far as its going to fall on this leg of the downtrend and will soon begin a firm recovery that lasts into the middle of 2009.

Crude Oil Futures -- Weekly

Click here for larger image.

Source: eSignal

How high will crude oil bounce during the next rally? In looking at the weekly chart, you'll notice the current selloff is nearly equal in length to the July-to-September down leg. This tells us that the decline is most likely a third-wave impulse in a broader downtrend. The pattern predicts a countertrend move up to 50% of the wavelength.

So, if the decline ended this morning, retracement math would yield a bounce up to $81. Of course, we still don't the actual terminal point for the down wave starting in September. However, I think we're getting guidance from price action that took place before the 2007 rally. Specifically, look at the placement of the July 2006 swing high.

Technicians rely on proportionality and past events to make predictions about future activity. In this regard, the 2006 high near $78 would correspond closely with a 50% retracement if crude oil finally bottoms out in the mid- to upper $40s. While it doesn't sound like a big move, a run to that price level would yield a rally in excess of 60%.

In any case, it will be difficult for any crude bounce to reach into the $90s, because major resistance has developed between $87 and $100. In fact, we may not see that price zone traded in the energy pits for the next five years. So, let's stay realistic and time our positions to the painful reality of the larger-scale bear market.

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At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Farley is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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