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Everybody talks. If you stop and listen, you will hear all kinds of different people say all kinds of different things. This is especially true when it comes to the financial markets. Whatever your personal opinion is about anything, you can easily find someone to back you up 100%, or – if the mood strikes – someone who thinks you are completely wrong and is willing to argue with you about it tooth and nail. While all of this may sound like a lot of conflict, the truth is that this conflict is what makes the markets move. If everyone held the same opinion there would be no one to take the other side of your trade. So, ultimately, ongoing conflict is a good thing. Still, it’s a little disconcerting when someone says something that you either don’t agree with or hadn’t thought about, and challenges your “comfort level.” I should know. It happened to me in June.

OASIS 2007

Anyone who was fortunate enough to attend Optionetics 2007 OASIS gathering got to listen to a main stage presentation by Mr. Jim Rogers of Quantum Fund and Investment Biker fame. Mr. Rogers was an astoundingly successful hedge fund manager back in the 1970s and was among the traders profiled in the original Market Wizards book written by Jack Schwager (still required reading for all traders as far as I am concerned). In his presentation, Mr. Rogers spoke on many topics – from his early days, to his three-year driving trek around the globe with his wife, to the fact that his young daughter is learning to speak Chinese. But while I enjoyed the “personal” stuff, I was much more struck by the “professional,” investment-related stuff. Before telling you what he said, let me first tell you where I “live.” To me, crude oil is a commodity, therefore the price will fluctuate over time. Sometimes it will go up, sometimes it will go down, etc, etc. But Mr. Rogers offered a different point of view. Likewise, I am born and bred an American – “God Bless the USA,” “love it or leave it,” “greatest nation on God’s green earth,” and so on and so forth. Yet, Mr. Rogers challenged that notion also.

The primary theme running through Mr. Rogers’ presentation was simply that the opening up of the economies of India and especially China was going to drive the world markets for a long time to come. He argued - quite convincingly - that the price of commodities of all sorts was destined to rise simply as a function of strong demand by literally billions of people who were never able to demand such goods before. And he also argued that while the United States was the dominant country in the world in the 20^th century, the 21^st century would belong to China. Now that notion did not sit particularly well with me. It challenged my notion of “the USA is #1.” But his logical arguments made sense. Supply and demand ultimately rules in the marketplace. Apparently these arguments make sense to a lot of people. To wit, Chart 1 displays the performance of iShares FTSE/Xinhua China 25 Index ETF (FXI) since the time of Mr. Rogers’s talk in June.

Chart 1 – FXI since 6/8/07

Had an investor run out of Mr. Rogers’ presentation and placed an order to buy market on close that day, he would have since enjoyed a +70% gain just under four months. Would it be too much of an understatement if I simply referred to this as a “good call?” Hey, I wonder how you say “show me the money” in Chinese.

For a trader, this type of trend obviously offers lots of opportunities. Chart 2 highlights several occasions when the 3-day RSI for FXI ticked higher after bottoming out below 30. Within a truly meaningful trend, this type of signal can highlight some excellent buying opportunities.

Chart 2 – FXI pullbacks since 6/8/07

Since the last RSI signal marked on Chart 2 (August 17), the FXI has rallied +58 in just 34 trading days. These types of moneymaking opportunities don’t come along all that often. And they never come around if: 

• You are unwilling to consider a point of view that simply does not agree with your own preconceived notion of “the way things are.”
• You recognize but fail to take advantages of a prevailing trend.

So, where to from here?  More on that topic in moment. First, lets go back to the other main theme from Mr. Rogers’s presentation.

Regarding Crude Oil

According to Mr. Rogers, the people of China and India – in an apparent case of “let the U.S. worry about global warming” – are buying cars in droves (I also read somewhere that a lot of them are buying American-made cars. Go figure. Gee, they sell us toys with lead paint, we sell them cars destined to break down and clog their highways. Heck, who needs nuclear weapons?). As a result, he foresees an ever-increasing demand for crude oil, even as we continue to deplete the earth’s supply. As I walked out the door from Mr. Rogers’s presentation, the one question that was stuck in my head was simply, “How is crude oil NOT going to go up in price?”  So far, no one – particularly the crude oil market itself – has offered a compelling counter argument. Chart 3 displays the action of the crude oil tracking ETF (USO) since Mr. Rogers’s presentation in June. Also marked on the chart are several oversold buying opportunities that an alert trader might have taken advantage of.

Chart 3 – Crude Oil ETF since 6/8/07

For the record, since the close on the day of Mr. Rogers’ presentation, Spot crude oil has advanced from $64.77 a barrel to $81.22. That’s about a $16,500 move for a crude oil futures contract.

Now I hate to rain on Mr. Rogers’ parade – actually it is more of a case of “I fear taking the side opposite his” – but I believe that at least a near-term correction in crude oil is possible. Chart 4 displays the action of December crude oil futures through 10/5/07. On the chart you see marked one of my favorite “a short-term reversal may be in the offing” signals. The crude market made three new highs; however, the second and third new high were accompanied by lower highs by the 3-day RSI (marked 1, 2 and 3 on the lower clip in the chart).

Chart 4 – Bearish Divergence for Crude Oil RSI

This pattern was completed on 9/28 when crude oil ticked down and the RSI formed the second lower high (labeled #3 on the chart). On that date the December crude oil futures contract closed at 80.48. A trader concerned about the unlimited risk associated with shorting crude oil futures could have considered a bear put spread as follows: 

• Buy 3 Dec07 8000 puts
• Sell 3 Dec07 7800 puts

Figure 1 – Crude Oil options bear put spread

Chart 5 – Risk Curves for Crude Oil Bear Put Spread

The maximum risk on this trade is $2,490, however the idea would be to exit the trade if crude were to break out much above its recent high of 82.45. In that case, the loss would be somewhere between $600 and $1,700 depending on how soon the breakout occurred. On the flip side, if December crude oil futures are at any price below 78 at the time of option expiration, this trade would show a profit of $3,510.

And what of FXI?  As you can see in Chart 6, FXI just completed the same three-step price/RSI divergence that I just described for Crude Oil. So there is a potential for a pullback in the near-term.

Chart 6 - Bearish Divergence for FXI RSI

Summary

So does all of this mean that the bull markets in crude oil Chinese stocks are over and that Jim Rogers had better just climb back on his Harley and motor off into the sunset?  Not necessarily. There are macro trends and there are short-term movements within those larger trends. Learning which you are best suited to pursue is key. For example, back in July, despite being a slightly detached but still long-suffering Cubs fan (is there another kind?), I actually predicted that the Cubs would go to the World Series this year.

Guess I’ll leave the macro trends to Jimmy Rogers.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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