On our chat, my brother told me he was looking to take advantage of rising oil prices and invest in the USO ETF. I agreed that in the long run, oil prices will continue to climb higher. But my advice to my brother on our chat was:
[11/9/2011 10:55:24 AM] Roy : I think this is a very bad time to buy oil right now
[11/9/2011 10:55:32 AM] Roy : I can tell you that much
[11/9/2011 10:56:19 AM] Roy : I think at least some of the rise in oil prices is due to news from Iran
[11/9/2011 10:56:59 AM] Roy : but technically, this is a very RISKY place to buy oil
[11/9/2011 10:57:11 AM] Roy : and very little potential reward
I was in the middle of work, so our chat was cut short. I promised my brother I will give him a better explanation to support my view. Well.....I've been kind of busy so I'm just getting around to it today. Better late....so here's the explanation:
On November 9th, USO was on a thirty-seven day rally. During that time it went up over 27%. Despite the seemingly unstoppable climb there was a big problem on the chart. The risk/reward ratio was all skewed.
The closing price on Nov. 9 was exactly $37.00 but it was heading straight into a supply (resistance) zone at $39.22. This meant that the potential reward was two dollars and twenty two cents or 6%. But what was the risk? The way I saw it then, the real support for the price was way back at $29.10 or more than 21% below the Nov 9 closing price. So the risk/reward ratio in dollars was about 8 to 2 - which means you would have been risking $8 to gain $2 - terrible odds.
In the month since I chatted with my brother, USO has hit the supply area and pulled back somewhat. That's not to say that it cannot or will not break above $39 - it may very well do that. But if it does, a much lower risk entry would be on a pullback to the $39 area with a tight stop right below to contain risk.
Here's what it looks like on the chart (Click to see bigger image):
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