Oil Traders’ Losses Could Be Your Gain

As oil prices fall, oil traders can be forced to sell stocks to cover their losses. If enough traders sell, markets suffer as traders surrender.

Analysts at Goldman Sachs expect oil prices to drop. Like OPEC, they blame high production from U.S. shale oil producers for pushing prices down.

The analysts also believe that oil traders have added to the danger of a market decline. Traders at large hedge funds set up a “capitulation” trade that might push stock prices down quickly.

A capitulation trade involves traders being forced to sell stocks quickly, which pushes prices down quickly. Capitulation trades are usually associated with market crashes.

The reason traders capitulate is often related to leverage. For futures trades, it’s easy to become overleveraged. One contract in the futures market offers exposure to 1,000 barrels of oil. At $50 a barrel, that’s a $50,000 investment.

However, to buy one contract, a trader is required to have just $2,970 in their account. If oil falls $3, the trader loses $3,000, which could be a loss of more than 100%.

As prices fall, traders can be forced to sell stocks to cover their losses. If enough traders sell, markets suffer as traders surrender.

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Hedgies Love Oil

One sign that a capitulation trade is possible is an unusually large position in a market. And it looks like hedge funds may have too much exposure to oil. This is shown in the chart below:

As oil prices fall, oil traders can be forced to sell stocks to cover their losses. If enough traders sell, markets suffer as traders surrender.

Oil prices are at the top of the chart. At the bottom, the number of contracts hedge funds own is shown.

This data is published by regulators every week in the Commitment of Traders (CoT) report.

The CoT report details the positions of large speculators, which includes hedge funds, as well as small speculators and commercials. Commercials are the giant companies that know the market the best. They trade futures contracts as part of their business operations.

In the oil market, commercials are the producers and refiners. From the data, we know they’ve been selling futures contracts to hedge funds.

The CoT report shows that hedge funds own about $1.6 billion worth of oil futures, which is their largest position since the end of 2016. If oil turns down, they face losses of about $34 million for each $1 drop in oil prices. It’s unlikely that hedge funds could sustain losses like that for long, so a decline could lead to capitulation.

Black Gold? Not Quite…

After traders capitulate, prices often rise. That’s why the time to buy oil should be after the next sell-off. But that would be a short-term trade. In the long run, supply is still a problem.

Shale oil allows the U.S. to produce more oil than the OPEC nations. OPEC has cut its production to try to boost prices, but U.S. production is near record levels. In addition, states, cities and companies around the country are creating policies that make them more reliant on renewable energy sources.

It looks like high shale oil production and innovations in renewable energy are going to continue. Consumers will enjoy low gas prices while hedge funds face large losses. If the losses from oil are too steep, hedge funds will be forced to sell their other holdings, including stocks.

Goldman analysts see the possibility of a capitulation trade in oil, but it will almost certainly spread to other commodities markets. Stocks are not safe if this happens.

Rapid selling, or even a crash, would be a welcome buying opportunity for stock market investors. If you see prices crash, stay calm and buy. It’s probably just oil traders selling to cover their losses.

Regards,

Michael Carr, CMT
Editor, Peak Velocity Trader

P.S. Paul Mampilly has made a career out of successfully forecasting major moves that Wall Street and the media argued were impossible. His new service, True Momentum, focuses on “down and out” stocks that are ready to take off at any moment. Click here to find out why Paul is confident that his strategy will help you make your account shoot up by more than 300% over the next 12 months.