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In one of my previous articles, I suggested that the rally we got in natural gas, in May 2012, was not sustainable. I had argued that profits should be taken from that short-term rally because the capitulation event that would mark the real bottom in natural gas prices hadn't occurred yet.

Well, I am proud to state that, I was able to determine the upper range of the rally quite precisely. When that initial article was posted, the natural gas ETF (NYSEARCA:UNG) was trading around the $18.80 level. UNG did increase another 3,7% above that level before it topped out, but it eventually turned down and it almost crashed back to its levels before the May of 2012. As of this writing, the short UNG trade I suggested has produced a profit of about 18%.

It seems that I have been even more accurate on my reasoning for the natural gas rally and why it would have not lasted. I had suggested that the rally in natural gas was not the result of declining supply as many investors suggest, but it was rather the unwinding of pair trades (long stocks, short UNG) during the stock market correction we had in May 2012. As market sentiment turned negative, investors simply closed their pair trades which amounted to closing the short UNG positions also. That caused a mild short squeeze in UNG and hence the rally.

However in late May 2012 the stock market stabilized. As the market sentiment somehow improved, the pair trades were probably put back on and as a result UNG moved decisively lower. The strong negative correlation between the market and UNG proves that UNG has not put its fundamental bottom yet It merely moves on speculation and market sentiment.

For investors that are long UNG, there are the added losses to contango which are definitely not negligible for the natural gas market. In order to be able to profit from UNG, the rise in natural gas prices should compensate for the contango and then rise even more for additional profits. A stagnant natural gas market will surely cause losses for UNG investors.

I should note that my medium-term expectations are different than what might be inferred from this bearish article. In fact, I had argued in one of my most popular articles (Natural Gas: Possibly The Best Trade of 2012 Fast Approaching) that once the capitulation bottom is formed, natural gas would be the best trade of 2012. Such an event would be characterized by a severe downward move (probably in excess of 13% in a single day), followed by very aggressive increases.

The fact still remains though, that the natural gas market is purely pushed around by traders. In such an environment, any rally will not hold unless the capitulation bottom I have articulated in the above article is formed. Until then, UNG will simply be an asset that is negatively correlated to market sentiment, in my opinion.

So is there are trade to be made for UNG until that capitulation bottom?

In my opinion, there are some profits to be made from shorting the UNG because of the contango. However, I would not argue it is a good trade. The risk of another sudden rise in UNG in case of a deterioration in the stock market is too high and it does not justify the possible profits.

In order to make a reasonably good trade on UNG, natural gas should start to move on its own fundamentals and not just as a negatively correlated asset to the stock market. In order to get that fundamental move, natural gas needs to put in that capitulation bottom. That will probably happen after the Eurozone crisis is settled in September of 2012. Until then investors should not get carried away trading UNG.

I will try to post another article, if my analysis shows a bottom formation in natural gas. Investors who find that my trading suggestions and analysis are of good quality can use the "Follow" feature of SA to follow-up on my analysis of UNG.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in UNG over the next 72 hours.

Source: Natural Gas: How I Got The Pullback Exactly Right With A Simple Analysis