Here’s how to trade the new ‘bogeyman’ in oil markets

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The new market bogeyman in the oil markets is the flash crash. When we are short of catastrophe, we tend to summon up the potential for such a scenario and this has been applied to trading in Nymex oil.

A flash crash is when algorithms go bad. In previous times, it was often called a fat finger error where a much lower sell order was placed by accident and the market plummeted to meet the sell before rapidly returning to the previous trading level.

We developed 'snatch and grab' trading strategies around these so-called "kangaroo tails." Whilst it's comforting to think that algorithms do not make mistakes, it's useful to remember that programmers do make mistakes.

(Read more: Prince warns US shale could hurt Saudi economy)

In our July 7 column, we flagged a Stop and Reverse (SAR) trade opportunity with oil. It was predicated on the divergence in behavior between the Egyptian Stock Exchange and the developing Egyptian crisis. The "frightened" money flees, and the "confident" money stays. In Egypt it was staying, but foreigners were driving up the price of oil, a slow moving flash crash in reverse.

The trading strategy was to apply an SAR, or stop-and-reverse trade. This is a rally trade. It's not a trend trade. We expect this to be a short-term momentum pop, followed by a retreat back to under $100. It starts with trading from the long side with upward momentum.

Nymex oil peaked at $108.05. There are many ways to set the trailing stop. We prefer to apply the principles of an SAR trade rather than use an SAR parabolic indicator. We use a self-adjusting volatility-based stop loss to set the trailing stop. This is a Guppy count back line (CBL). The stop distance from the current price changes as the significant volatility of price changes. On the day of entry, the count back line is calculated from the high of the previous day. The count back line is the stop loss. The position of the count back line is adjusted whenever a new daily high is made. A close below the count back line is a signal to exit the trade.

The trade with Nymex oil has the long-side stop placed at $99.55 with the entry at $100.80. As the trade develops the CBL is recalculated and follows, or trails, the rising momentum. The long side trade is closed when there is a close below the trailing stop loss level.

(Read more: Why crude will keep cruising)

As soon as the long-side trade is closed we switch to a stop-and-reverse trade. A short side trade is opened. The CBL calculation is also reversed. The new lows are used as the calculation point. The count back line is placed three significant volatility moves above the most recent lowest low. The trailing stop loss follows the downtrend. A close above the stop loss line is a signal to cover shorts.

The count back line sets a stop at $1.06. The stop was hit during the last week, giving an exit at $105.50. Based on the original trade plan entry, this delivers a 4.66 percent profit in the underlying move.

(Read more: Four-week rally in US crude rekindles 'flash crash' fears)

A new short position is opened at $105.50 with a short side stop loss at $107.50 on the day of entry. The stop is now lower at $105.50.

The rally in oil was unsustainable and this was the foundation of the trading strategy. A flash crash may drive prices much lower and very quickly. It's just one factor in the rally-and-retreat environment. The chart cannot tell us what event will drive the trend behavior but the chart does indicate when trend weakness is developing which will make it vulnerable to a change in trend. Our job is not to predict the market. Our job is to trade the market.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at [e-mail]. We welcome all questions, comments and requests.

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