Successful trading rule No.1: do not enter any significant position until you have worked out an eventual exit strategy.
Rule No.1 is especially important if the position is large relative to the overall market or a large number of traders are all trying to put on the same position at the same time because the position could strain available liquidity.
The question of an exit strategy has become pressing in the oil market because of the enormous short positions accumulated by investors in the expectation oil prices are about to fall further.
Hedge funds and other money managers had amassed short positions amounting to 172 million barrels of crude oil in the main futures and options contract on the New York Mercantile Exchange (NYMEX) by Dec. 1.
It was the third-largest short position ever recorded, after the 178 million barrel short positions reported earlier this year on March 24 and 31 (tmsnrt.rs/1SIArx4).
Short positions on NYMEX have almost doubled over the last seven weeks from a recent low of just 90 million barrels on Oct. 13.
If short positions in Brent are included, hedge funds have a combined short position of around 300 million barrels.
CARRY ON PUMPING
Oil ministers from the Organisation of the Petroleum Exporting Countries (OPEC) ended their meeting on Friday without any agreement on production.
The meeting had not been expected to agree on output cuts but failure to agree on any production target at all, even a fictional one, took the cartel to new levels of disarray.
Saudi Arabia, Iran and Iraq are all now set to produce as much as they can in a bid to defend their market share and maximize revenues.
Russia has already increased its output to a record level and is expected to continue pumping as much as it can during 2016.
U.S. shale producers have seen output decline, but only modestly, while production from the Gulf of Mexico is actually increasing.
OPEC is relying on strong consumption growth in 2016 to absorb the resumption of Iran’s oil exports and all the other sources of extra supply.
OPEC’s economic projections show global economic growth accelerating from 3.1 percent in 2015 to 3.4 percent in 2016.
In the meantime, however, the market remains oversupplied, with rising stockpiles of both crude oil and refined products.
Most market analysts believe oil prices will now head even lower until U.S. oil producers stop drilling, stripper wells are shut in, or there is a change of heart in Riyadh, Teheran and Moscow.
WHAT NOW FOR PRICES?
The critical question is how that bearish outlook interacts with the enormous short position amassed by the hedge funds.
The simple answer is oil prices will fall and the hedge funds will gradually be able to close out their positions in a falling market.
Prices have already slipped modestly by 50 cents on both WTI and Brent since the OPEC meeting ended without agreement.
But the large number of short positions to be bought back and closed out could provide some support for prices in the near term.
If prices do not fall as the hedge funds expect, at least some of them will probably try to trim their positions and book profits.
In both March and August this year the establishment of large short positions preceded sharp short-covering rallies.
In both cases, the initial short covering was relatively small scale and had little impact on prices; the main short covering rally arrived two to three weeks later, and saw prices leap by more than $10 per barrel.
Uncertainty about what happens next explains why implied volatility in oil options has soared: fundamentals point to a further drop in oil prices while market positioning points to a sharp rally.
(Editing by Susan Thomas)