Sunday, February 23, 2014

UNG: A risky bull play

The exchange-traded fund that tracks natural gas prices (UNG) broke above its 20-day price channel on Friday. If it continues to trade above the breakout level, $27.58, on Monday, then it will have sent a bull signal and, under my rules, be a candidate for a possible bull play.

UNG has reached its present level in a rise from $14.25 on April 19, 2012, the end of an epic decline from a pre-recession peak of $511.12 on July 1, 2008.

The present rise of nearly two years can be seen as a new uptrend or as a countrend rally within the long-running downtrend from 2008 peak. In either case, the chart shows UNG to be in the final stages of its rise, ushering in the near-term likelihood of a downward correction of significant proportions.

The Chart

By my Elliott wave count, I see UNG as being in the final leg up of the final leg up of its rise from April 19, 2012. I've labelled the wave as 5 {+2} of 5 {+3}.

Within wave 5 {+2}, which began Jan. 9 from $19.47, UNG is in the final stages of its middle wave, labelled wave 5 of wave 3 {+1}.

Click on chart to enlarge.
UNG 2 years daily bars (left), 30 days hourly bars (right)
Wave 5 exceeded the end of wave 3 on Feb. 21, when it peaked at $27.75. That satisfied the minimum requirement for wave 5 under the Elliott wave rules. However, there is nothing under the rules to hinder wave 5 from continuing upward for quite some time.

The prior uptrending wave at that degree, wave 3, began on Feb. 12 and lasted a week. A similar lifespan would bring wave 5 into the end of February before it reaches its completion.

If wave 5 has peaked, the correction now beginning will take back a portion of the $5.25 rise from Feb. 10. Fibonacci retracement analysis suggests typical endpoints of $26.51, $25.13 or $24.51, although the correction could be more or less than those levels.

Looking at the very long term, I find to possible counts:

Case 1: the decline from 2008 to 2012 was possibly an A wave to the downside, which would make the present rise of nearly four years part of the first wave of a B wave upside correction.

Case 2: Or, the decline from 2008 to 2012 can be seen as the first wave to the downside, making the present rise since 2012 an A wave within a second wave counter-trend move upward.

In either case, the 2012 low of $14.25 will eventually be broken in a further decline, a C wave in Case 1 or a third wave in case 2.

UNG began trading in April 2007, so there is insufficient history to sort out the matter. Neither case makes a difference in my present trading decision but is of interest to afficionados of Elliott wave analysis.

Odds and Yields

The present wave 5 {+3}, which began Aug. 8, 2013 from $16.60, has seen three bull signals completed. Two were successful, yielding 2.8% over 22 days on average, compared to a 3.3% loss over 16 days for the unsuccessful signal.

The most recent completed signal came a degree lower, in wave 5 {+2}. It was successful, but barely so, yielding a paltry 0.7% over 13 days and suggesting a sharp lessening of upside momentum.

The Fund

United States Natural Gas Fund LP aims at matching percentage change in the spot price of natural gas delivered at the Henry Hub in Louisiana, using mainly the near-month NYMEX futures contract as the underlying asset.

The expense ratio is 0.85%, compared to 0.09% for the S&P 500 fund SPY.

Liquidity and Volatility

UNG on average trades 25.7 million shares a day and supports a wide selection of option strike prices spaced a dollar apart, with open interest running mainly to four figures near the money.

The front-month at-the-money bid/ask spread on calls is 4.9%, a bit more than double that of the S&P 500 fund SPY.

Implied volatility stands at 56% and is rising again after having fallen from its Jan. 29 peak of 69%. Volatility is at the 68th percentile of the one-year range and is 4% above historical volatility.

That high level of volatility suggests the bull plays are best structured as short vertical options structures, as as bull put spreads, sold for credit and expiring in March.

Options are pricing in confidence that 68.2% of trades will fall between $23.21 and $32.17 over the next month, for a potential gain or loss of 16.2%, and between $25.54 and $29.84 over the next week.

Contracts were trading actively on Friday, with calls running at 64% above their five-day average volume and puts at 35% above average.

Decision for My Account

My chart analysis shows UNG as likely being in the final weeks of its upward run, to be followed by a decline of significant proportions, perhaps greater than 10%. As I noted, there is no limit on the present upward rise, but on balance, especially given the high volatility, I judge the potential reward of further rise to be outweighed by the risk of a sudden downturn.

Therefore, I am passing on UNG. I won't be opening a bull position at this point. The final wave 5 {+1} to the upside, following the correction, should provide a significant opportunity for a bull play.


My shorter-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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