DGAZ Trade Strategy Update

Feb. 26, 2014 7:16 PM ETDGAZ, UGAZF, BOIL, KOLD34 Comments
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Contributor Since 2013

Stock, Options, ETF and Commodities Investor; My educational background is in Computer Science and Accounting with significant entrepreneurial and Fortune 100 Corporate experience in Information Management and Technology services in industries including: Consulting, Oil and Gas, Manufacturing, Financial Services, Chemicals, Petrochemicals, Software, Professional Services and more. For many years, I've learned from experiences as an individual investor. Today, I enjoy sharing my thoughts and collaborating with others to help provoke interesting trade opportunities as well as to learn the tools available to help enhance portfolio performance, manage risk and find performance opportunities under all market conditions. Randy Lawton

Many readers following my last article, "DGAZ - Are We There Yet?", here, have had a number of questions lately. I wrote the article while March contract prices for Natural Gas (NG), were spiking as high as 6.4, DGAZ was trading on the S&P GSCI NG Index that had already rolled over to April which was trading up to 5.2. I had many questions from readers on what would happen, and ventured to share my thoughts that there might be some upward pressure on the Apr NG contract, that the Mar contract would most likely come down some and that we would not be required to close the gap. And further, to the Title of the Article, seeking to determine if we had found the bottom in DGAZ yet.

Well, we did have some upward pressure on the Apr contract, pretty much matching the DGAZ low we had seen from 02/05 of 2.74, hitting a low during normal trading hours of 2.75 on 2/24. Pre-market trading had lows of around 2.50 on both those days, but quickly pulled up as we entered normal trading hours.

From there, times have been good for DGAZ and this has been the action we were looking for. Pre-market today, I watched prices at 3.68 on DGAZ and we closed at 3.61, while after hours, we have seen some prices at levels above the close.

This is great news as we should have put in the bottom on DGAZ and should mostly be working on our uptrend from here - some assumptions and risk factors always associated, of course.

Below, is the latest chart update on the DGAZ/UGAZ spread overlay.

From this chart, notice the comparison of the spread on the left versus where we are today. I drew a flat trend line where DGAZ formed a double bottom in the first spread, and now you see the trend line matching on the current spread mapping our double bottom here. So, all things being equal about the recovery, we should expect to see some similarities going forward to what we saw in the prior spread up cycle for DGAZ.

Notice how the next trend line slopes up a little, then there was a relatively flat line and the last leg up was a very steep upward move in price action for DGAZ. Of course, no guarantee we see this again - but this still is my expectation.

Some early readers on articles mentioned being "stuck" in positions at higher DGAZ prices, while sitting and waiting for prices to come back - and concerns about whether they will. Apparently these readers were not able to follow the trail of articles I put out stating that we need to be actively managing these positions and re-positioning with various approaches suggested for doing this. No one should ever feel stuck in a position, as you can always sell, take losses and move on. So, my recommendation is, just as we saw this week, the rallies do come. If you can read the charts and follow the rallies, there should be clues about where one can sell out, say 1/4 or 1/2 of their position, then seek to buy back at lower prices. This may take a loss on the original basis, but it also earns part of that loss back. For example, this week, I sold off 1/4 of my position at 3.4 and bought back at 3.22. So, I earned back .18 from that reposition.

If you view the prior spread on the chart, the ellipses show on the bull move in DGAZ, there were positions where one could have sold out on the good rallies, then waited for the opportunity to buy back in on lows a week or two later. We should see a similar pattern going forward as we aren't likely to see prices go in a smooth line. Guaranteed, we still have some volatility ahead and we want to make that volatility our friend.

One more thing to mention from the 1st spread is, that from the double bottom, before we got to the price to exit that spread - and the pattern I hope we will see this time around, it took a period of 3 months+ to get there. So, I don't expect to see us hit a big price in DGAZ right away. I expect to see volatility (perhaps more and more extremes than in spread 1 - offering greater repositioning opportunity) along the trail. A buy and hold strategy, unless one was fortunate enough to buy and have a cost basis near the bottom, is not recommended - but, very well could turn out to be quite profitable. Just know that there is more risk to sitting in an original high basis position, then in continuing to work the reposition opportunities. If NG prices don't go back to near mid 3's/mmbtu and only get to a low of 4, we may not see some of the prices we would like.

Lets review a snapshot of an NG chart to look at what transpired to answer some other questions I received from readers relative to why if NG fell from 6.2 to 5.5, asking why DGAZ did not move more.

DGAZ underlying index methodology rolls NG contracts each month on the 5th through 9th business day of each month. Mar and Apr contracts had a very wide spread of over $1 - referred to as the widow maker spread. That spread created a great deal of anxiety for many readers - and even some anxiety for me as no one knows for sure whether a gap will remain or will close, or which contract would move to drive that close. But, one thing I knew is that since 2007, March has been a net injection month to storage and April contract delivery just wasn't likely to have fears of continuing to withdraw 250 bcf from storage as we did from a few weeks ago.

When we rolled from the Mar contract to the Apr contract, we did not lose any value in DGAZ prices. Actually, in my last article, I showed that DGAZ was actually up a little. We did roll into the Apr contract trading at about NG 4.632 at the end of the roll, versus NG 5.223 for the Mar contract. In a way, that meant we lost some high NG price value to drop from (that would result in a rise in DGAZ) some would conclude. However, in my analysis, we came out FAR better via the roll methodology than had we still been in the Mar contract. Mar contract continued to climb to a peak of just under 6.4/mmbtu which would have slammed DGAZ down hard - much lower than our 2.5-2.75 bottom lows. And that, would have been very difficult to recover from. Instead, we were pressured lower in DGAZ while the Apr contract moved up to 5.2 but moving into the shift to show the Apr contract as front month, we got the very nice drop from 5.2 to the 4.5 level we are at now with a nice price increase in DGAZ. One should not be disappointed we didn't get a bigger increase in DGAZ from the fall of the Mar contract. If we had gotten that bigger move, it might have been from a low of $1 and we might not be at the prices we are today. Glad that is all behind us now.

Looking forward:

Tomorrow at 10:30 ET, the EIA will release the storage report findings for last week. Below is a poll on what we are likely to see on that report:

Essentially, 77% of those polled, believe the EIA will report a US-wide Storage draw of 100-109 bcf or less. If the report is in the 100-109 bcf range, I think this will be somewhat bullish for DGAZ - confirming the drop in prices, milder weather patterns and the view that spring is certainly on its way headed into injection season. Believe me though, the bulls are not going to give up and will leverage bad weather, continuing low storage to get behind some rallies when they can in Natural Gas. And, if we are working our repositioning properly, we are going to welcome those opportunities to buy cheaper DGAZ shares to replace shares we sold at higher prices to enhance profits.

If the report shows withdrawal is greater than 109 bcf, then the bulls could make a rally out of this tomorrow. From comments in the forum this poll was taken from however, the expectation seemed to be that estimates actually might be lower which seems to place a low probability for higher draw. If the bulls do manage to get a rally, it may be a good buy opportunity for DGAZ.

In March, we will again roll contracts to the May contract. Below is a snapshot of current contracts:

Notice the spread from Apr to May at last trade is less than a 7.2 cent difference. This roll will not likely create any anxiety as did this last one. The next roll will begin on 3/7 and end on 3/13 and should be uneventful. If we have volatility in prices, it will likely be reflected in both contracts moving together.

Some lessons learned and reflections on future trading of leveraged ETF's - especially when trying to find a bottom or top, and the turn when the trend is working against you.

1) Never get locked into a position. One can always sell a position and move on, or, sell portions and re-position.

2) Consider breaking investment funds for the trade strategy into tranches and average costs in. What we have learned though is, sometimes the bottom can be much worse than what we originally thought. For this reason, when things begin to look worse than expected, always be willing to sell out a portion when you can see prices are headed lower and buy back lower, continuing to reposition.

3) An even better approach is to buy both a long leveraged position and the inverse position. Example, when entering the DGAZ trade early (while the trend was up in NG), we could have bought with initial tranche a position in UGAZ and in DGAZ. Ratios can be worked out such that you have an offset in price movements neutralizing them. As UGAZ moved higher, we could have sold out at profit and added more DGAZ. Then, when we get a rally in DGAZ, we could have sold a little of the DGAZ position and added some UGAZ until we were comfortable we had found the bottom.

Once comfortable the bottom is in, one could just work the DGAZ side of the trade selling out of the UGAZ position, or, could adjust the ratio and say hold 1/5 the amount in UGAZ as in DGAZ and continue to work the rallies and lows in the cycle with the buys and sells.

3) Another approach can be to look to offset a position with opposing options. Sometimes this approach can be done with fewer investment dollars to hedge the risk of price action against one. An earlier article of mine presented a strategy for doing this with NUGT, another 3x leveraged ETF for Gold Miners.

4) Regardless of approach taken a) to average in prices, b) to leverage both long and inverse positions, or c) to leverage options to hedge risk while working on the turn, one should always be prepared to sell on rallies, take losses at opportune times and free up cash to buy lower. It is amazing what it does to a traders psychology when with cash in hand, you are looking for and hoping the price action will rally against you so you can buy some cheap shares and lower your cost basis, rather than sit in a position where you watch your hard-earned dollars disappear on paper.

On investments of course, a loss is never a loss until executed, but don't let the fear of taking losses and repositioning until you get your basis right and the risk out of the trade keep you from maximizing your profit opportunity. Stay flexible and agile in your trading so you can respond to and take advantage of whatever the market brings your way, rather than living with the dread of carrying large losses. It is a very different view of the world when you have some cash and only wish NG would go to 12/mmbtu so you could go all in with remaining cash and ride the train back the other way - rather than having bought when NG was 5 and living in fear while your investment dollars have continued to trend toward zero.

Disclosure: I am long DGAZ.

Additional disclosure: I also am long BOIL puts. 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.

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