ETFs: Trading the Phase Change - Natural Gas (UNG)

July 6, 2010

Mish's Daily Articles

By Mish Schneider

An essential piece of knowledge for all traders to have in their tool belt is an understanding of the different phases of the market. All markets are cyclical. Savvy investors who recognize the different parts of a market phase are more likely to profit during any market cycle. They are also less likely to get caught buying at the worst possible time. This is a fundamental part of the syllabus in Marketgauge's course, The Complete Trading System. All financial instruments go through phases. We outline 6 different phases of the market, based upon where the 50 and 200 day moving averages line up in relation to one another plus, the direction of their slope. The greatest opportunities to make money is when a phase changes. A comprehension of phases is critical if you want to maximize investment or trading returns.

Furthermore, before execution, all traders should analyze a trade using a top down approach by considering the phase of the overall market indices (QQQQ DIA SPY IWM), the particular Exchange Traded Fund, which relates to a sector and group, followed by the individual instrument (stock or future.)

Looking specifically at UNG, the ETF for the United States Natural Gas Fund, the famous "Death Cross" happened in September 2008, when the 50 day moving average dropped below the 200 day moving average. We refer to this phase as a "Bearish Phase" or one where the 50 crosses underneath the 200 and both with a downward slope. We also use a 2 day close below the moving averages to confirm the phase has indeed changed.

UNG Chart

Since 2008, UNG has remained in a bearish phase with only temporary blips into a recovery phase or when the price closes for two days back above the 50 day moving average, but remains far away from trading above the 200 day moving average. So, why care now that UNG is once again, back in a recovery phase? From a fundamental viewpoint, Natural Gas, compared to other energy sources, has been undervalued. We watch for technical patterns and particularly, a phase change, usually the best time to catch momentum. On June 2nd, (see chart) UNG crossed the 50 day moving average yet again, only this time, the slope of the moving average began to flatten. Plus, since we like to see 2 days of closes above the key moving average to signal the phase change confirmation, the next day, a long entry was established over the prior day high or 7.58.

Third, yet perhaps even more compelling, is that the risk is nominal as we simply use a close under the 50 day moving average for our stop loss or that day, under 7.26. For a swing trade, risking 1 to 1.5 ATRs is reasonable. UNG's average true range is $.32. Now, depending on your personal trading timeframe, you can either stay with the trade until the 50 day moving average is penetrated for a position trade (you would still be long) or take partial profits at 3 or more ATRs (8.54, which traded on June 14th), then go to a no loss stop for the balance for a swing trade or (our choice) use a close under the adaptive moving average to exit and re evaluate(therefore making $.96 on some, then exiting on June 22nd under prior day's low of 8.20 locking in another $.62). Position traders, who would still be long, make a small profit using the 50 day moving average for their exit regardless, as it is now rising.

On July 1st, another opportunity to go long presented itself when the 50 day moving average was tested for 2 days in a row. Equally significant is that on June 30th, the second day, UNG had an inside day (see article on Inside Days). Therefore, on July 1st, a break of the range for the 2 days prior was the perfect re entry price with a continued low risk to under the 50 day moving average or about $.20 from entry as of July 2nd. Now, if UNG sustains its rally, the next hurdle is the 200 day moving average, coming in at 9.09. Watch for 2 things for a phase change to accumulation (when the price goes over both the 50 and 200 day moving averages and the time to buy or add because values have stopped falling and everyone else is still bearish). First, wait for 2 closes above the 200 day moving average as confirmation. Second, notice if the slope of the 200 day moving average turns up. If so, that is a good indication of the power of the phase change and how much follow through you might expect. These guidelines give traders a clear roadmap for identifying phase changes and catching substantial shifts in the market or individual instrument.