Oil prices set for a breakout, but which way will they go?

Oil prices have been relatively strong in recent times despite the economic weakness in Europe and North America.

Oil prices have been relatively strong in recent times despite the economic weakness in Europe and North America. But as this week's monthly oil price futures chart from certified financial technician and councillor with the Australian Technical Analysts Association Mark Umansky shows, it has been trading in an ever-narrowing band since January 2009.

Oil reached a high of $US140 a barrel in June 2008, just before the global financial crisis really hit home with the collapse of Lehman Brothers. Then it fell for seven straight months to reach lows close to $US40 a barrel, under the influence of the intensifying recession and fears that China's economy might collapse.

But the situation turned around strongly, with professional traders pushing the price back up to resistance levels of about $US114 a barrel in April 2011. Since then, the price has been oscillating between narrowing trend lines, indicating that oil is set for a breakout.

Looking to find which direction, investors could use several charting tools that measure momentum and are widely available, such as the stochastic oscillator.

While such tools can be useful, Umansky warns they should be used with great caution as they measure only past performance.

The tightening of the price oscillation indicates that any breakout is likely to be strong and the chart could be described as being in a very long-term congestion pattern. Indeed, the price following the breakout could test either its highs or lows on the chart, he says.

With that in mind, he says, wise traders will be looking for a breakout in either direction while protecting their position with stop losses just below the trend line on the opposing side of the breakout. However, in such situations it pays to be nimble and investors need to keep their eyes out for false breakouts that could be quickly reversed.

Where a position is taken in what turns out to be a false breakout, then the position should be reversed if the oil price re-enters the confines of the trend lines.

This column is not investment advice.

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