Technical analysis of the futures market relies mainly on price movement in the markets as evidenced by charts. It is a very different approach to investing than fundamental analysis, which is more concerned with the relationship of supply versus demand of the physical commodity.
A fundamentalist takes trading positions based off the imbalance between supply and demand while a technical analyst trades off of price action, which is the reaction of price to volume at certain points on a chart. If crude trades down to $40.00 on light trading volume, then begins to rebound on very high volume, this gives the technical analyst clues as to overall price movement and direction of the market. He doesn’t care that there is a glut of crude at Cushing. The market is telling him $40.00 is the price everyone wants to buy. When this is the case, supply versus demand in the futures market takes over. When everyone wants to buy a finite amount of contracts, price goes up, despite the supply of the physical commodity.
The appeal, and some would say trap, of technical analysis is chart patterns. The belief is that history repeats itself, and to the technical analyst, price action repeats itself over and over. Such repetition is memorialized in recognizable chart patterns. The more familiar patterns are the cup and saucer, the double top and double bottom and the head and shoulders, among numerous others.
The head and shoulders pattern is a reversal pattern and when formed indicates a reversal in trend. It looks exactly as you think it would: two similar price points form the shoulders, and one higher or lower price point in between forms the head. The pattern is completed when price breaks through the neckline and continues in the reversal direction. Such a break is most favorable when accompanied by high volume. Often, price will break out, then retest the neck area. If the pattern holds true, the neck area that was once resistance will now become support.
Crude oil is currently attempting a head and shoulders reversal (see above). A look at the weekly five-year chart shows a pronounced downtrend beginning July 2014. Price attempted to rally in early 2015, only to make new lows in August of 2015. Ultimately the rally up to the $50.00 mark failed, thus creating the first shoulder and the neckline of the pattern. Price then made a new low in February of 2016, forming the head of the pattern. The rally of 2016 back to the $50.00 mark and then it’s failure back to $40.00 created the second shoulder. Currently we are awaiting confirmation of the pattern as price is hovering around the neckline at approximately the $50.00 level.
In the weeks to come we’d like to see a break above $50.00 on high volume to confirm the pattern. A move back down to the neckline at around $50.00 followed by a move higher will fully confirm the trend reversal. Being an optimist, I see higher prices ahead. Only time will tell.