Natural Gas: Trading The June Top With The 8-wave Pattern

07/25/03 01:47:07 PM

by Nabeel Qadir

A basic 8-wave pattern, along with the Fibonacci ratios and a few other indicators, can be used to trade a market top. In this example, I will use the NYMEX August 2003 futures contract to show how the June 6 market top could have been traded.

Security: NGQ03
Position: N/A

A quick refresher on the basic 8-wave pattern: Impulse waves 1, 3 and 5 will be in the direction of the long-term trend (bullish in this case) whereas corrective waves 2 and 4 will be against the trend. Waves a and c are the main corrective waves (against the trend) and wave b is in the direction of the main trend.

Natural gas futures have been in a bull market since December 2002 on concerns about supply. Prices pulled back towards the $5.00 level in early April when natural gas storage was at a record low at the start of the injection season. Consequently, prices rallied to $5.92, completing wave 1. Wave 1 is difficult to interpret since it is unclear if a corrective phase is continuing or a new impulse pattern is developing.

The August 2003 contract pulled back, retracing 78.6% to a low of $5.24 and ending wave 2. Since the bears see this type of rally as a chance to sell, the corrective wave 2 usually gives back 50% or more of the wave 1 gain.

Wave 3 ends with the market rallying to the $6.53 level on further concerns on warm weather and low storage levels, extending 161.8% off wave 2. Wave 3 is usually the largest impulse wave, as the bulls waiting on the sides see higher momentum and start taking long positions. The MACD makes a higher high, confirming a wave 3.

Wave 4 then corrects back to $5.93 or 50% off wave 3, finding support at the $5.92 level (which is also the high of wave 1). Some speculators start to take profits, pushing prices lower. On the other hand, some of the bulls who missed out on the initial rally jump in, leading to wave 5.

Despite milder than normal weather, strong injections into storage and improving inventory levels, price rallies to a contract high of $6.75, which is 127.2% off the wave 4 move. Since a lot of bulls have already taken profits from wave 3, this rally lacks the power of wave 3 and momentum subsides. The MACD shows a negative divergence on June 6, as price makes a higher high whereas the MACD makes a lower high, ending wave 5.

Figure 1: Daily chart for Natural Gas futures.

Graphic provided by: www.nymex.com.

As a trader, you should have noticed this chart pattern would be a potential short sale candidate once it had confirmed that wave 4 had ended and wave 5 was under way. The doji on July 6, along with the MACD negative divergence reiterate that a near-term top is close. On July 7, the MACD posts a lower bar, confirming the negative divergence. The last confirmation for the trade would be to wait for price to break below the 10-day exponential moving average. The price breaks below the 10-day EMA on June 10, and a trade can be executed to go short, with a buy-stop on the June 6 close of $6.58.

A record injection into storage leads to a huge price drop and wave a retraces 161.8% off the wave 5 gain at $5.56. Another negative divergence on the MACD is confirmed on June 19 as price makes higher lows (April 4 and June 19) whereas the MACD makes lower lows. Wave b corrects to take prices back up to $6.17, a 50% increase off the wave a correction. A simple bull market zigzag correction is obvious with wave c expected to take prices lower and complete the 8-wave pattern. Price falls as an unexpectedly large injection into storage once again acts as a catalyst for the sell-off. Wave c has so far retraced to the $5.38 level, which is 127.2% off the wave b gain. A conservative trader might have taken some profits after wave a and should be taking most of his profits at current price levels. An aggressive trader can take at least half of his profits at these price levels and lower his buy stops to the $5.79 levels for the rest of the position. If prices break through the 127.2% level, the next target is the 161.8% retracement level of $5.17.

Some interesting observations:

The waves retrace or extend almost exactly at the Fibonacci ratios 0.5, 0.618, 0.786, 1.272 and 1.618 (using the highs and lows of the waves).

Understanding market fundamentals is extremely beneficial as chart patterns and technical indicators can be used as leading indicators.

The basic wave pattern can be similar to the head and shoulders top formation.

A similar, albeit a somewhat complicated wave pattern/head and shoulders formation appeared on the November 2002 contract from March to August 2002.

One criticism of the Elliott wave theory is that it is extremely difficult to keep wave counts and break down the waves into waves of lower degree. I certainly agree. I'm not an Elliottician and I certainly do not have in depth knowledge of the wave theory; I have just developed an eye for the 8-wave pattern. Understanding the basic eight wave pattern and combining that with other indicators such as fundamental information, the MACD, Fibonacci ratios and short & long-term moving averages help me set up a high probability trade such as this. Trading off only one indicator is risky business and I like to have at least three indicators (including chart patterns) lining up before taking a position. Nonetheless, no matter how many indicators line up, there is always a chance that the market may move against you; especially a highly volatile market like natural gas where the weekly storage reports from the Department of Energy can have an immense effect on prices. It is therefore imperative to place your stops correctly and use them religiously as soon as you enter into a trade.

References: Technical Analysis Course, Canadian Securities Institute

Nabeel Qadir

Nabeel Qadir works as an Energy Analyst for Aegent Energy Advisors Inc. in Toronto, Canada, providing market analysis and risk management services to large end-users of energy. Nabeel completed his undergraduate business degree from York University, Toronto in 2001 and has attained the Derivatives Market Specialist designation from the Canadian Securities Institute. He is also a candidate in the Chartered Financial Analyst program.

Title:	Energy Analyst
Company:	Aegent Energy Advisors Inc.
	Toronto, ON Canada
Website:	www.aegent.ca
E-mail address:	nqadir@aegent.ca
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