Dear OGIB Reader,
In Part 2 of his story on the Natural Gas Bull ETF, Guest Writer Cory Mitchell tells you historically WHEN the best time is to make this trade to maximize profits... and it's coming up very soon. He also explains what happens to this short trade if natural gas prices start to rise (Hint: It’s better than you think.)
By Cory Mitchell, CMT
In Part 1, I explained The Best Trade in Natural Gas—shorting the Horizons BetaPro Natural Gas Bull ETF, symbol HNU on the Toronto Stock Exchange. With very little volatility, investors who shorted this ETF in June 2008 would be up more than 99% now—in fact, there is almost no time in the past four years when this trade would not have been profitable.
Most retail investors look to ride a major trend to profits, and the downward slope of natural gas prices for the last three years have provided very steady capital gains.
So when is the BEST time to make this trade—shorting the HNU:TSX?
Charts suggest that the Monday of the last week of January has been a historically good entry point for short positions. Here is what happened the last three years:
- Monday, January 25, 2010—if you shorted and held you would have never seen a loss and would have made 88.95% between that date and December 2, 2011(closing prices).
- Monday, January 24, 2011 was a steep drop day. But if you sold on that day, the price never moved above it again, representing a 63.56% gain as of the close on December 2.
- In 2009 the ETF did manage to move a bit higher after the last week in January, but by mid-February—only three weeks later-- the ETF was dropping once again, never to reach those levels again.
Therefore, the first Monday of the last week in January has been a solid entry point, yet there is possibility that it could fluctuate and move higher from there in the short-term. History indicates this is likely a high probability short position entry point, although history does not always repeat itself so retail investors must be vigilant on managing their own risk and not taking positions which they cannot afford to lose on.
What Happens if Natural Gas Goes Up in Price?
Natural Gas has been sliding this year, as mentioned, down 22.77% YTD as of Friday, December 2. Therefore, if natural gas begins to rise over the long-term will HNU rise?
Given the structure of the ETF, this is extremely unlikely over the long-term. Even if natural gas rises the ETF will continually be paying a higher price for new contracts than it receives for expiring ones. The spot price at expiry will theoretically need to be higher than the futures price paid every time a contract is rolled in order for this ETF to appreciate long-term—a highly unlikely scenario.
The potential exists for a “backwardation” market condition to develop. This would aid HNU in recovering some of the excessive losses it has seen since its inception.
Backwardation occurs when contracts in the future are priced lower than the current spot rate and then rise as they near expiry to converge with the higher spot price. This would occur for example if short-term demand is higher than anticipated demand in the future. The current price is driven up, but contracts for future months are priced lower because demand is expected to decline by then.
This allows the leveraged long position ETF to profit when the spot price increases, remains flat or even if the spot price declines slightly--because the ETF will purchase contracts which expire in the future for cheaper than the current spot price (how much they sell expiring contracts for).
I hope you're still with me!
As the contracts near expiry, its value will increase to the current price, at which point the position is rolled into another contract which is priced lower than the current spot price. This allows the fund to purchase more of the new contract which is likely to provide a positive return even if the spot rate remains flat.
Backwardation rarely occurs in natural gas, which is called a "non-perishable commodity," since there are storage and insurance costs for holding the commodity for delivery in the future. This is why futures contract far away from expiration are priced higher than the spot price—it compensates the seller and holder of the commodity for costs incurred until delivery.
Sustained backwardation is really the only way HNU can recoup losses, and this scenario is highly unlikely. Therefore, it is very implausible HNU will be able to sustain an uptrend even if natural gas were to begin a long-term uptrend.
The daily objective of the fund means it is more suited to day traders, and long-term short sellers than bullish investors. The odds are stacked against the bulls due to the structure of the fund and contango. While bullish investors may be able to exit at a better price on daily gyrations, it is probable that this ETF will continue to decline, as it has done since July of 2008. That provides an opportunity for those open to short selling.
We are approaching a time which was a great entry point in 2009, 2010 and 2011.
2008 saw a sharp rise in natural gas between January and the end of the July. This was the only time the ETF rallied—right after its inception. It responded well to the bull market then mainly because during the first several months, contracts did not have to be rolled. Once the contracts began to roll, the losses mounted as natural gas began its long-term decline. If such a sharp rise occurred again, HNU.TO would likely rise, but the effects would be more muted than in 2008 because of the contango effect and the inefficiencies mentioned in Part 1.
HNU is a product long-term investors should avoid buying as the ETF does not accurately reflect the movement of natural gas beyond a single day. The likelihood of a long-term rise in the ETF which will allow investors to recoup losses, even if natural gas begins a bull run, is slim. The structure of the ETF is not favourable to long term appreciation. In order for long-term appreciation to occur, conditions would need to be perfect, and need to run counter to the norms of the non-perishable commodity.
This makes the ETF a prime candidate for taking a short position as the inefficiencies of the fund create profits for further downside. Couple this with a weak natural gas price and late January of 2012 begins to look like a good short-entry point.
- Cory Mitchell, CMT
EDITOR'S NOTE: Several readers emailed in after reading Part 1 asking, why short the HNU ETF -- why not buy the HND:TSX, the natural gas down ETF? The answer is simple. In terms of being able to capitalize on a trend it has been less reliable.
Since March of 2009 HND has continually pulled back to former price lows (support). HNU has not done this; very rarely on a long-term basis has HNU moved higher to test old resistance levels. This makes HNU far more consistent in making new lows (good for shorts), than HND is at making new highs (tricky for longs). For trend followers and investors who don't want to have to babysit a position, the short in HNU is likely a better option. HND provides great profit potential as well, but entries and exits are harder to pick as the movement is far less uniform than in HNU over the long-run.
Disclaimers: Cory Mitchell nor Keith Schaefer currently hold a position, short or long, in TSX:HNU. Neither Cory Mitchell nor Keith Schaefer are investments advisors; no part of this article should be considered personalized investment advice. As always, investors should consult with a licensed financial planner for help on their particular investment situations.