Commodity ETFs as a Contrarian Play

Within the past several days, overall market sentiment has reversed quickly. Though the Fed said nothing shocking during Wednesday's announcement on economic policy, traders sold into strength of the anticipatory rally. Since then, the major indices have been trending steadily lower, and the S&P 500 has registered two consecutive sessions of higher-volume losses (a.k.a. "distribution days").

In the short term, until I see how the major indices react near pivotal support of their 20-day EMAs, I prefer to avoid trading in ETFs that have a high correlation to the direction of the broad market. This works suitably well, as there are currently some interesting setups with commodity and currency ETFs.

On Wednesday, Sept. 23, crude oil sold off sharply after the weekly inventory report showed a large, unexpected surplus of the sticky commodity. This caused the U.S. Oil Fund (USO - commentary - Trade Now) to slice through support of an uptrend line that had been in place for the past five months. It also fell through a significant area of horizontal price support, as well as its 20- and 50-day moving averages. The following day, USO sold off again, bringing its two-day loss to just over 8%. The daily chart of USO is annotated below:

U.S. Oil Fund (USO) -- Daily Source: TradeStation

In my fund, I had already entered a short position in USO when it broke below support of its uptrend line. However, any bounce into new resistance of the prior uptrend line would present a secondary entry point. Alternatively, traders could consider buying the inversely correlated PowerShares Crude Oil Double Long (DTO - commentary - Trade Now) on a pullback, rather than selling short USO.

As USO weakens, the U.S. Natural Gas Fund (UNG - commentary - Trade Now) is finally setting up for a short-to-intermediate-term trend reversal. After apparently exhausting the sellers earlier this month, UNG rallied back to reclaim support of its 20-day exponential moving average (EMA). For more than the past week, UNG has been holding above that 20-day EMA, and its trading range has tightened up significantly.

---

At the time of publication, Wagner was long UUP and UNG, and short USO.

Deron Wagner is the founder and head trader of Morpheus Trading Group. His daily focus is managing and trading the Morpheus Capital Hedge Fund, which he founded in April of 2004. He also teaches his trading methodology with The Wagner Daily, The MTG Stalk Sheet, and The Wagner Weekly newsletters.