A Counter-trend Opportunity?

I have had a lot of interest over the past few months from investors wanting to invest in oil stocks because most have fallen 1/3 – 2/3 of their value from last year’s highs. To me this represents an opportunity for profit or on the flip side catching a falling knife!  It took me a while to learn that investing with the trend is the key to long term financial success. I had always felt that if I could get in at the bottom of a downtrend I was going to reap huge profits. While the logic behind the thought is true, being able to pick bottoms (or tops for that matter) may be simple in theory it is almost impossible in practice.  But there are times when the signals are numerous enough, the potential rewards great enough and the risk low enough that it is worth a try.  The key to minimizing damage of attempting to pick a bottom is to manage the risk through position size. For example, invest only ½ what you normally would.  The other key is to find an objective entry and manage it very tightly so that in case you are wrong, any loss incurred is minimized.

This blog post is going to look at how one might do this on a real-life example. The first step is to look at a longer term chart and determine direction. Oil and its related companies have been in a severe downtrend since mid-2014 as you can see in OIH (oil services ETF) chart below. I would like to call your attention to 3 things of major importance 1) all the moving averages pointing down is all the confirmation one needs to validate the current direction 2) Price reversed to the upside last week bouncing off the red horizontal line which has provided support 3 other times over the past 3 years. This tells us this price is IMPORTANT 3) since November of last year price has made 3 lower lows (marked by red arrows) while momentum has made 3 higher lows (marked by 3 green arrows). This 3 push pattern on a weekly chart is pretty rare and provides what I consider an objective reason to contemplate investing against the trend.

Once you have the longer term confirmation you need, it’s time to switch to a shorter time frame by looking at daily or hourly charts depending upon your investment time frame. On the daily OIH chart below we can see price has bottomed 3 times at the $32 level this year.  As with the weekly chart I want to draw your attention to 3 key things; 1) only two of the 4 moving averages are not pointing down (2 are moving sideways), marking the potential for a reversal; 2) price has been rejected twice at the upper red horizontal resistance $37 indicating this level of resistance is important; 3) since the most recent $37 rejection, price has formed a bullish falling expanding wedge.

For those with the appropriate risk tolerance, I find this opportunity presents an objective set of circumstances to nibble at OIH under the following conditions 1) price needs to break above the upper blue expanding falling wedge line 2) Position size should be reduced 3) a stop order should be placed at a level just under the lower red horizontal support line. On a break higher, I would expect this move to find initial resistance at the prior $37 level.  If it breaks that, there is a gap above which should create a vacuum to propel up the to $43-$44 prior congestion level.

In summary and why this is an opportunity for the nimble and risk tolerant is because you are risking ~$2 (~$33.5 entry with a $31.5 stop) to make $11.5. Any risk-reward ratio over 3:1 is worth considering and this one provides an outstanding 5:1 or more.

As always, this is not a recommendation to buy but rather an illustration on how one would, if their risk was appropriate, invest counter-trend.