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DGAZ Risk Analysis

Feb. 01, 2014 1:47 PM ETUGAZF, DGAZ24 Comments
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Yesterday I wrote an article on my DGAZ Investment thesis. In follow up, this article will focus on more exploration and analysis on the risk and opportunity associated with investment in DGAZ. First, it should be noted that leveraged ETF funds carry a high degree of risk and volatility and are not for all investors. 3X leveraged funds can move substantially in a short period of time, which means investors can lose capital or make gains very rapidly.

Lets first explore some assumptions associated with my investment thesis. As with any thesis, if assumptions turn out not to be true, then a thesis can fail or a model can turn out to be invalid. I will work on this analysis using past performance patterns as the best indicative view of how performance could play out in the future if these assumptions turn out to be true.

1) Past performance patterns associated with UGAZ/DGAZ behavior will be indicative of future performance patterns.

2) Natural Gas prices within the next 3 months will revert to the target range of 3.4 to 3.8/mmbtu.

3) Winter severe weather has mostly passed and temperatures on average should continue to moderate during the next few months.

Starting with the 2nd assumption, lets look at Natural Gas prices.

Considering the known proliferation of available NG reserves in US shale zones, my assumption is that we will return to the range bound by the blue horizontal lines on the chart above, between 3.4 and 3.8/mmbtu. The pricing we see at present is based on price spikes associated with peak demand from severe winter storms we have had the past few weeks across the US.

Exploring assumption 3, this is where we have risk and must dynamically watch for any signs of more severe winter storms. With the threat of any storms, it is recommended that one manage this risk, either with options, positions aligned to long Natural Gas (UGAZ or other alternatives) and/or, sell out of some or all of DGAZ positions and re-enter at lower prices in DGAZ. Traders can also adjust based on trading patterns when new resistance levels are hit, there can be a bullish run to allow for pricing adjustment by exiting some positions in DGAZ at the resistance level and re-entering near the end of the bullish push. My anticipation is this opportunity will be in movements of around .4 points in NG. Unless there is a compelling event, I don't anticipate bullish runs from here of greater than .4 points from any resistance hit at key support levels.

Now, lets take a look at Assumption 1. First, I'll include the chart for DGAZ, with UGAZ overlaid for comparison.

Vertical black lines are drawn for the prior cycle of the spread for UGAZ and DGAZ from beginning to end, as well as for the beginning of this current spread and my current assumption on the peak spread (although with another price spike, it would be possible to make new highs in UGAZ and new lows in DGAZ). It is my belief at this time, that we have seen the high, but investors should continue to watch for and manage risk in positions associated with risk of another compelling event.

Below is a table of prices on DGAZ, UGAZ, NG and the NG Index at the dates of the vertical lines. Lets start with the first complete spread early this year.

Pricing at inflection points - Spread Cycle 1
Date DGAZ UGAZ NG/mmbtu NG Index
2/15 22.45 17.19 3.153 54.85
5/1 8.93 36.72 4.025 72.24
8/9 18.82 14.04 3.22 52.99

Price movement behavior from 2/15 to 5/1 max spread:

DGAZ - (60%) UGAZ - 213% NG 27% NGI - 31%

Price movement behavior from the 5/1 spread to the crossover on 8/9:

DGAZ - 210% UGAZ - (38.2%) NG - (20%) NGI - (26.7%)

Pricing at Inflextion Points - Current Spread (with Estimates)
Date DGAZ UGAZ NG/mmbtu NG Index
11/4 17.32 12.34 3.43 52.68
1/29 * 3.29 41.28 5.449 83.28
4/29 ** 11-12 est. 10 est. 3.6 est. 50 est.

* - Assumes that we hit the peak spread of UGAZ and DGAZ on 1/29 and that we will not have another compelling event that drives a new high in UGAZ or, new low in DGAZ. Note that due to slippage in DGAZ in price spikes in NG, it is possible a rally not setting a new high could still drive a new low in DGAZ.

** - Estimates based on my charting and analysis, as well as applying price performance characteristics in line with prior spread cycle.

Price movement behavior from 11/4 to 1/29 * (assumed max spread):

DGAZ - (81%) UGAZ - 335% NG 59% NGI - 58%

Price movement behavior from the 1/29 spread to estimated crossover around 4/29

DGAZ - 335% UGAZ - (76%) NG - (34%) NGI - (40%)

Natural Gas Index Chart UGAZ and DGAZ are predicated upon:

Some conclusions from this analysis:

1) If there are price spikes that drive NG prices and UGAZ to new highs (and DGAZ to new lows), the % increase in UGAZ (from the beginning of the spread cycle) would correlate fairly closely to the % move up anticipated in DGAZ. This would increase from the 335% estimate now. However, this demonstrates what Robert Edwards has been saying. If NG goes to $6/mmbtu, UGAZ goes to new highs and DGAZ to new lows, the % increase expected in DGAZ would go higher, but from a lower price. A 500% increase from a DGAZ low of $1, would give us a high of only $5. So, key to our modeling for 3x ETF leveraged performance is, we have to position our lows and our cost basis carefully!

2) As a result of 1, investors should be prepared to reposition at key support levels and be prepared to exit DGAZ positions if dynamics lead to a belief there will be other significant upwards move, and/or, should hedge position risk appropriately with offsetting UGAZ, options or other positions.

3) If we have seen the top in NG and UGAZ, as well as the bottom in DGAZ, then investors with the right cost basis have some nice upside ahead. However, these positions clearly need to be "managed positions". With the volatility in NG and other commodity prices, these positions are not conducive to buy and hold investing. Investors must either manage very small positions (for managing portfolio risk), or actively manage their position risk.

Happy learning and investing and cheers to profitable investment on the UGAZ/DGAZ spread here in 2014.

Disclosure: I am long DGAZ.

Additional disclosure: I may trade and reposition DGAZ shares based on dynamics associated with the Natural Gas Market. I may also trade in and out of UGAZ, or buy/sell calls and puts on BOIL or KOLD (2X Leveraged ETFs on Natural Gas Index).The thoughts and opinions in this article, along with all stock talk posts made by the Author, are my own and are shared on the basis of helping others learn, to provoke other points of view that help us all on our journey to become better investors. My posts are never intended to provide investment advice. Investors should always view multiple sources of information in their due diligence process.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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