WALKTHROUGH
The following provides a step-by-step trade/analysis walkthrough as an example of how to use the Reduction Reports. The reports and analyses referenced here are not theoretical; they are drawn from the actual reports generated and my views on the cited dates. The descriptive analyses here (“My Views”) are not included with the products. They are provided here as an illustration of the Reports’ functionality.
Please bear in mind, this section is NOT meant to be a definitional guide to or explicit description of the Reports' features. It is meant to provide a window into and visualization of the practical usage of the Reports and connect the concepts discussed in the previous section to a real-world, hands-on example. A complete guide, filled with interpretation tips and rich detail on each of the Reports' features, is available to subscribers.
Asset: NYMEX Henry Hub Natural Gas
Context: Natural gas stocks were drawn to very low levels in 2018 (accounting for seasonality), yet prices did not rise upwards as would normally be expected. The market commentary frequently cited concerns about record production levels, but these were exceeded by record demand levels (resulting in larger inventory draws / smaller injections). The typical narrative was that abnormally strong gas-for-power demand from the hot summer season and nuclear outages would subside, but record production would continue, reducing concern about the low inventories.
Snapshot 1: September 7th, 2018
My View: No Trade (Bullish Fundamentals, Bearish Technicals)
While I respected the market’s view, every price dislocation comes with a myriad of narratives to justify it, so it was important to assess further. As always, the first check was the Reduction Indicator, which showed a reasonably strong reading at 6.2. This was in spite of a fairly negative technical picture (to be discussed further down). The fundamentals were strong with virtually all models showing very high Value readings.
Secondly, there were several bullish factors working in NG’s favor:
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Inventories/Production Balance: Depleting inventories are indicative of a bullish market imbalance, most importantly to the front month contract. At a minimum, the market was underpricing risk of a weather or production issue over the winter, and with such a low amount of gas in storage, I believed there was an asymmetric risk of an upward price spike.
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Substitutes: As evidenced by the Substitutes Factor and the Relative Value Models weighing NG against coal (power source switching) and heating oil (alternative heating fuel), NG was fairly cheap relative to its substitutes, which were on the rise.
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Demand Components: Industrial strength was still strong, but momentum was slowing. Winter weather expectations were relatively warm (bearish for natural gas).
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Sentiment: Sentiment is a double-edged sword. It can be reflective of the smart money correctly getting ahead of the market. At the same time, when sentiment is over-extended, the market is more prone to pullbacks (with exuberance sending prices beyond fair value and jittery longs ready to exit their positions). Further, the market may simply “run out of buyers”. That being said, while the Sentiment Factor was high, the market’s price action / technicals (more on this below) did not show signs of over-extension, so pull-back risk seemed low.
As discussed above, the technicals were weighing down the Reduction Indicator, and were quite bearish short-term. In my view, it is suboptimal and often quite risky to take a trade based purely on fundamentals. However, given the fairly strong fundamental backdrop, I viewed the risk of a significant downward break as minimal, and I was looking more aggressively for technical signals to time a trade entry (which were not here yet!).
Snapshot 2: September 18th, 2018
My View: Buy (Bullish Fundamentals, Technicals Turning Bullish)
With fundamentals still strong and Natural Gas looking cheap, I was waiting for a decent technical setup to buy. After bouncing twice off the 2.770 level, a strong bullish candle on high volume took out both recent swing highs, and some of the indicators were showing signs of a turn in momentum.
Snapshot 3: October 26th, 2018
My View: Hold (Bullish Fundamentals, New Range Establishing: Looking for Break Above, Will Exit on Break Below)
Model Values still imply Natural Gas is very cheap. Entry was approximately 2.890 (adjusting for the contract roll). Market seems to have taken a pause to reevaluate. A new range is establishing itself. I would close out the trade on a break below support, but with a nice profit already and fundamentals still supportive, I am holding and looking for another move upwards. Some may have chosen to already close out the trade with technicals having turned, but these decisions come down to trading styles and risk preferences.
To illustrate some of the risk functionality, let’s look at the Sentiment Factor further. As discussed in the previous section, the estimated price impact of Sentiment returning to neutral was 0.319. Another way to estimate this is through some of the risk features. The approach discussed here can also be applied to perform a scenario/shock analysis of any of the factors.
