A Head And Shoulders Bottom In Natural Gas

08/25/03 10:30:03 AM

by David Penn

Countertrend bounce or new bull market, natural gas is poised to move higher.

Security: NGU3
Position: N/A

I've spent much of the summer proposing a contrarian alternative to those spellbound by the prospect of shortages in natural gas: namely, that from a technical perspective, natural gas futures topped in early June were likely headed for steep declines (see my articles "Is it 'Now Time' for Natural Gas?," Traders.com Advantage, June 19, 2003 and "The Summer Correction in Natural Gas," Traders.com Advantage, July 24, 2003). Since June, natural gas futures (basis September) have fallen from more than 6.500 to just north of 4.500 by mid-July. This collapse of more than 30% in about six weeks was a true windfall for natural gas bears.

But rebounding natural gas prices in late July and into August may be the first signal for the short sellers that while it is fine to be a bear, no smart trader wants to be a pig. After all, what good are gains from a June to mid-July decline if they are taken away by a mid-July to September advance?

What mid-July to September advance? Since bottoming late in July at about 4.580 (again, basis September), natural gas futures have moved up significantly if not dramatically to as high as 5.340. This retracement of the June to mid-July decline is tantalizingly close to 38%--a Fibonacci ratio many traders use to determine not only the extent of retracements, but also to determine potential support and resistance points.

While this may suggest that the nascent rally in natural gas has reached a "stopping point" at 5.340, it is also quite possible that any resistance at 5.340 will prove temporary. Part of this thinking involves the small head and shoulders bottom that has formed from July to mid-August -- a bullish reversal chart pattern that here suggests a possible rally in natural gas futures to as high as 5.780 in an initial move to the upside.

An upside breakout from this head and shoulders bottom could have prices retracing as much as 60% of the June-July decline.

Graphic provided by: TradeStation.

The head and shoulders bottom in natural gas is not without arguments against it. The right side of the formation -- actually from the "top" (read: bottom) of the head to most recent price action -- has been moving in a fairly well defined trend channel. And given the position of prices shown above, it is more than possible that, instead of breaking out to the upside, prices will sag and shrink back to the lower edge of the channel. Even if prices were eventually to move higher in such a scenario, the argument for the head and shoulders bottom would be lost. I have not included volume in this chart, but it too could be considered a mitigating factor against the head and shoulders bottom insofar as the volume trend is rising throughout the duration of the pattern. This is in contrast to the general habit of volume being higher on the left side of the formation, lower moving through the formation, and then again higher (and sometimes dramatically) on the right side as prices break out.

Nevertheless, the case for the bullish reversal is compelling. The moving average convergence/divergence indicator is moving up to test the zero line and has been tracking the upward movement of natural gas well since late July. Also the 20-day exponential moving average has flattened and begun to curl upward. One other excellent analytic tool for determining a trend change is Dave Landry's 2/20 EMA breakout system, which looks for two bars above a rising or falling 20-bar exponential moving average as a signal to enter long (or short) above (or below) the higher (or lower) of the two bars. Depending on how aggressively this system is deployed, there could have been an early, losing long entry back at the beginning of the month.

However, after falling back beneath the 20-day EMA (a signal for exiting a long per the 2/20 EMA breakout system), natural gas is back above the 20-day EMA. Not only that, but the called for "two bars" above the moving average are also in evidence. A third bar above the higher of the two would be an additional signal that natural gas futures were likely to move higher. I've found in my brief experience with Landry's 2/20 EMA breakout system that often the second time prices make a two-bar break vis-a-vis the 20-bar EMA is a better indicator of trend change than the initial break. Current price action in natural gas affords another opportunity to test this observation.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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A Head And Shoulders Bottom In Natural Gas

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