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Oil Retreat Leads to Short Covering Rally
The same themes of the past two months continue to drive stock prices (oil and financials). After touching fresh highs almost daily for the past week, oil finally came off significantly on Tuesday - more than $4.00 a barrel - spurring a sharp rally in equities. The stock market had become extremely oversold just as crude had been equally overbought - so something had to give. Interestingly, the sizeable move to the upside came just a few days after the official proclamation by the financial media that stocks had entered a bear market (down 20% from peak-to-trough). Also of note was the fact that the Russell 2000 small cap index, was the best performer with an almost 4% gain for the day. I attribute this to the lack of oil and gas related stocks in this index, which were hard hit that day.
Just like all the prior rally attempts since a year ago, the question will arise again whether this is the bottom, or just another correction in an ongoing bear phase. Of course nobody knows for sure, as tops and bottoms are always seen in the rear-view mirror. Perhaps, this question is of more importance to investors, and not so much to traders. Most E-Mini traders are usually trying to profit from intraday moves, and thus, the primary focus ought to be on short-term trends and patterns.
The opportunities afforded an E-Mini trader on a daily basis are ample. This is in large part due to the leverage and volatility that is inherent in these markets. As an example: the intraday move of the E-Mini Russell on the aforementioned Tuesday was 30 points, that's $3000 per contract. Now granted, this day was an outlier, but with the current level of volatility, a 15-point move is more common.
Futures contracts work differently from stocks. For one, unlike when you purchase shares of a company, or a basket of stocks in the way of an ETF (exchange traded fund), a futures contract is a derivative. Simply put, a derivative is a financial instrument whose price movement is predicated on an underlying cash index (Russell 2000, S&P 500 etc) or a commodity, such as crude oil, gold, or wheat. In order to control one contract of the Russell 2k E-Mini, which has a value of 68,000 (underlying index 682 X $100=$68,000) all that's required is a $5000 deposit (initial margin), also known as the performance bond. Some brokers will allow you to day trade with half that amount ($2500). Although this is appealing to many novice traders, I would not recommend starting this way, as this is analogous to stepping up to the $100 blackjack table with $300 in your pocket.
As you can see, there is a tremendous amount of leverage in futures, and it can be a beautiful thing - if used with an ironclad risk discipline. Moreover, the risk incurred is not the nominal value of the contract ($68,000), but rather the tick movement of the particular contract you're trading. In the example of the Russell, the minimum price movement – referred to as a "tick" – is $10. There are 10 ticks in one point, also known as a "handle". For instance, if you went long the ER2 (Russell 2k E-Mini) at a price of 680, and exited at 685.20, your realized profit would be $520.00 (52 ticks or 5.2 points). If on the other hand, the trade worked against you, and you were stopped out at a price of 678.30, you would incur a loss of $170 or 17 ticks.
I often get asked, "What are futures, and how do they work?" I hope this at least gives some of you not familiar with E-Minis, a better understanding. As an aside, I believe that E-Minis are the best pure trading vehicles out there. After all, what more can a trader ask for? You have maximum leverage, abundant liquidity, and great volatility.
Let's move on to our technical review of the ER2 for the week. First, we'll peruse the daily chart of the ER2. A lot has changed since my last newsletter. We easily see that that market could no longer bear the brunt of climbing oil prices and the relentless havoc in the financial sector as it clearly broke down.
Despite the huge rally on Tuesday, the bad news for the bulls is that we're still in a downtrend. Notice that this move took the price up against the 8-day exponential moving average. In addition, you can see that the 50-day EMA is 30 points away, and to break above it will take some work.
Turning our attention now to the short-term 5 min chart, (shown below) we see that day traders had all afternoon Tuesday to get long with impunity. This is a rare occasion as the rally was so relentless that it cut through four distinct resistance levels like a hot knife through butter.
This is also a reminder that when everyone is on one side of the market, one should watch out when it unwinds.
The bottom line: Once again, the earnings season is upon us. The focus for this week will be GE reporting its quarterly results on Friday. If you recall, last quarter the market didn't take very kindly to its disappointing profit outlook. In addition, tomorrow's crude-inventory report will be watched very closely since the market is still fixated on oil prices. The market is not out of the woods yet. These sharp rallies are common in bear markets, and just as was the case in the previous rally, they can last weeks. Bear markets provide all sorts of opportunities, both for the long-term investor seeking value and for the day trader in search of volatility. Unfortunately, bear markets also exact plenty of pain to those that don't exercise risk controls, and hold on to hope, until it turns into fear.
Until next time, I hope everyone has a profitable week.
If you have questions, comments or you'd like a specific topic covered, please email me at gvelazquez@tradingacademy.com |
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Gabe Velazquez is a professional
trader with 14 years of experience. His focus is intra-day and swing trading the
ER2 (Russell 2000 e-mini) using technical analysis as his primary tool. Gabe has
managed both stocks and futures accounts as well as conducted educational seminars
on technical analysis for the past ten years. He is a frequent guest on Biz radio,
where he shares his market knowledge and utilization of technical indicators.
Gabe also teaches the
