Why Shorting NatGas Makes Sense Now

That rare and wonderful thing, the regular reader of my ramblings in these pages, may remember that four weeks ago I wrote that, while natural gas may have further to drop from the levels at that time, it was a solid buy once there was a sign of slowing momentum and a turnaround. I try not to toot my own horn too much, but here is what happened in that market since then.

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That was, I guess, not a bad call, but it is now time to reverse it. The things that partially drove that call, higher WTI prices, increased natural gas exports, cold weather forecasts and a small but persistent reduction in stockpiles have all continued and are still happening to some extent now. The main reason for it though, that markets have a tendency to overshoot, particularly in times of volatility, now applies in the other direction.

It is not that natural gas cannot go higher from here over the long term; it obviously can as it was up around $5 just a couple of years ago. The fact that it can, though, doesn’t mean that it will. The history of natural gas pricing since the lows were hit back in March of this year has been wild, but consistent. It is one of upward momentum, but with volatility. Each strong run up has been followed by a mostly quick and steep retracement, especially since August. Most of the time the strongest gains have been in the day or two before the drop came, so this morning’s backing off after a big gain yesterday should be taken as a sign.

I do fully understand that all of the fundamental factors listed above are still working in natural gas’s favor, and I have frequently said in the past that, in the longer term, fundamentals always outweigh technical factors. Despite that, though, shorting natural gas now that there is a sign of a turnaround makes sense. The market has been trading on technicals recently, and the start of a reversal sets up a trade nicely. That is always the case on these overshoot and retrace patterns because the recent high (or low in last month’s trade) provides a logical level on which to base a stop loss.

For these medium-term, swing trades in energy I generally prefer to use leveraged ETFs rather than futures. While these products will lose value over time due to fees and rollover costs those effects are not significant when used for an expected 10-15 percent swing over a period that could be days, but is most likely a few weeks. The leverage is enough to turn that into a 30-45 percent potential profit, but, unlike futures, not so much that a stop has to be set close to entry. In this case DGAZ, a 3x leveraged bearish Nat Gas ETF (It moves in the opposite direction to nat gas prices and moves 3 percent for every 1 percent move in the underlying price) would be my choice.

The trade would involve buying DGAZ at market (4.30 at the time of writing) with a stop at around 3.80, which is below yesterday’s low, or yesterday’s high in terms of the price of gas. That means risking around 12% of capital invested, but if prices return to where they were just two weeks ago you stand to make around 35 percent profit. That is the kind of risk/reward ratio that appeals to me and it certainly looks worth 12 percent of a small investment to sell now, flying in the face of conventional wisdom, rather than wait until a retracement is confirmed.