The chart of West Texas Intermediate Crude (WTI) has formed a bearish rising wedge pattern which typically indicates that a trend reversal is on its way. If the pattern is confirmed by a downside breakout oil could fall by around $11 to $84 representing a decent trading opportunity.
A 4 month chart of crude oil
Chart courtesy of stockcharts.com
The rising wedge is a bearish (negative) pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows.
According to StockCharts.com, “The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely.”
In order to qualify as a reversal pattern there must be a prior trend to reverse. In the case of oil the trend since the June 2012 low of $77.28 has been up. However, the rising wedge, which usually forms over a 3-6 month period, can mark an intermediate or long-term trend reversal.
It takes at least two reaction highs (touch points) to form the upper resistance line, each of which should be higher than the previous one. It also takes at least two reaction lows to form the lower support line. Again, each of these should be higher than the previous one. These lines converge as the pattern develops and the advances from the lower support line become shorter and shorter, which makes the rallies unconvincing.
The pattern is confirmed as bearish when the lower support line is broken in convincing fashion. This indicates that demand has finally been overwhelmed by supply. However there is often a rally that retests the broken support line which then typically becomes overhead resistance. Some traders prefer to wait for this “reaction rally” to occur before they begin to trade the move.
Ideally volume will decline as pattern evolves and it will increase (often dramatically) when the support line is broken. This also helps confirm a bearish breakout.
Another indicator that can be useful is the Chaik in Money Flow indicator (CMF) which often turns negative prior to a bearish confirmation of the pattern, although in this case it remains in positive territory.
If the pattern is confirmed as bearish, oil could fall by around $11 to $84 representing a decent trading opportunity. Those looking to profit from this move could do so via a spread bet – going short either as the lower support line is broken, or upon a retest – with stops paced just above the level of the breakdown.