Bears Engulfing Gas

08/19/05 07:40:55 AM

by David Penn

Japanese candlestick patterns and classic indicators can combine for potent results.

Security: NGU5
Position: N/A

Last night, Jim Cramer of Mad Money proclaimed a top in commodity prices. In a typically fascinating opening salvo, Cramer described a scenario in which prices for basic commodities like oil and copper had finally become too high for industrial consumers to bear (no pun intended). Cramer's observations extended beyond this, of course, to speculate on what falling commodity prices--a boon to consumers, at least on the surface--might mean for the economy going forward. But it was his notion, that commodity prices would likely not travel much higher in the near term, that was the key point.

Hours before Cramer's broadcast, I'd been looking at the chart of September natural gas futures shown in Figure 1. As you might guess, my attention was drawn to what appeared to be a bearish engulfing pattern at the close of Wednesday's trading.

Figure 1: Focusing on the "real bodies" of the Japanese candlesticks from the past few days, it is clear that Wednesday's selling created a bearish engulfing day that anticipated a reversal to the downside.

Graphic provided by: Prophet Financial, Inc.

Here's what Steve Nison, an expert in Japanese candlestick analysis, had to say about bearish engulfing patterns in his book Japanese Candlestick Charting Techniques:

There are three criteria for an engulfing pattern: 1. The market has to be in a clearly definable uptrend or downtrend, even if the trend is short term. 2. Two candlesticks comprise the engulfing pattern. The second real body must engulf the prior real body (it need not engulf the shadows). 3. The second real body of the engulfing pattern should be the opposite color of the first real body.

There are other contributing factors that Nison mentions, such as the size of the engulfing candlestick compared to the previous one, or the presence of heavy volume on the second, engulfing candlestick. But even in the absence of these contributing factors, it appears clear that September natural gas has formed a bearish engulfing pattern with Wednesday's closing low. This suggested strongly that a correction--or even a reversal--was imminent.

Figure 2 is what September natural gas futures looked like a day later.

Figure 2: A negative stochastic divergence helps confirm the bearishness of the engulfing candlestick in mid-August.

Graphic provided by: Prophet Financial, Inc.

A close to 5% day-to-day drop in the natural gas futures market is no move to sneeze at.

What is particularly interesting about this bearish engulfing anticipated breakdown is that the bearishness of the engulfing candlestick was supported by bearish portents from the stochastic oscillator. Note how as natural gas prices made a high in early August and then a higher high by mid-month, the stochastic was making lower highs. This negative stochastic divergence developed at exactly the same time as the bearish engulfing pattern. Both were suggesting that the upside in September natural gas was limited and together they provided a real warning for alert traders--whether long the futures and looking to take profits, or on the sidelines watching for a chance to get short a short- to intermediate-term peak.

How could you have taken advantage of this combination of bearish patterns in the price bar/candlesticks and the stochastic? For me, shifts in the moving average convergence/divergence (MACD) histogram serve as triggers to establish entry points. In this case, either of the histogram reversals to the downside--from August 12 to August 15 or from August 16 to August 17--would have provided short entry points at 9.26 and 9.14, respectively, that would have been filled on August 18. As of the close of that day, a short entered at 9.26 was up 33 cents, or $3,300 per contract. A short entered at 9.14 was up 21 cents, or a more modest $2,100 a piece.

David Penn

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

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