Copper, like gold and most other metals, has endured a long decline after peaking in early 2011. And it’s made for a great trend-following trade for bears… really any investors who have been willing to trade on the short side of these markets.
The trouble is, many of the price drops happen over very short periods of time. And, intermittent rallies have tested the nerves of anyone holding short positions.
These rallies are actually gifts to traders who know what to do with them.
Copper is a textbook example of a relief rally that’s giving bears another shorting opportunity. Here’s a chart of daily copper futures prices, with the relative strength index (RSI) at the bottom.
Most novice traders ignore RSI unless it’s showing extreme values. They sell when it hits 80 (overbought) and buy when it hits 20 (oversold).
But ignoring all the other signals – the ones between 20 and 80 – is a big mistake. There’s much more useful information, and profit potential, between the RSI extremes… if you know what to look for. The buy/sell signals aren’t as obvious as they are at the 80/20 levels… but they’re there.
Let me walk you through an example…
Extreme overbought conditions usually indicate buyer exhaustion. That was the case in September 2012, when the copper market showed an RSI value of 80 (these are the red circles in the chart above). Price went on to lose more than 11% in just seven weeks. That, of course, relieved some pressure… sending RSI back down to around 30.
Copper’s next rally was more telling…
As copper prices rose into February 2013, so too did RSI values. But… the rally failed to push RSI back above 80 – an important sign of inherent weakness (see the purple lines in the chart above).
The market cracked lower again in late February, losing a full 20% in three months. RSI was pinned to the floor… well into oversold territory.
That meant it was time for a relief rally, otherwise known as a dead cat bounce. These rallies are common after vicious drops, like the one copper has recently endured. Most of them share common traits:
1) They begin with sharp advance over just a few days.
2) They stall out once RSI hits the 55 – 60 range.
3) They roll over, falling back into the downward trend.
These rallies give bears perfect opportunities to short the market.
Now, I’m telling you all of this because the good news is, there’s still time to get in on this one…
With copper futures trading around $3.24, I recommend targeting the $3.21 to $3.25 range for sell short entries. Based on the extent of copper’s last decline, I’m expecting the next leg down to go as low as $2.65. This could happen in just a few months.
A stop loss order at $3.35 is a good idea for tactical money management. With about 60-cents in potential profit, and just 10-cents of potential risk, this gives us a quite favorable risk-to-return ratio of 6:1.
For another way to play copper’s trend, sign up for Boom & Bust to find out which copper stock we’ve recently bet against. It’s already handing us gains, but I’m expecting much more… and there’s still time to get in.