Speculation in Natural Gas

  • SumoMe

In this article I laid out an “approach” to investing.  Including in that approach was “10% whatever you want”.  In other words, you allocate 10% of your investment capital to whatever idea(s) strike your fancy.  In this manner:

*You are not constrained from acting based on your own knowledge/whims/ideas/etc.

*You can only do so much damage to your portfolio

The idea that follows falls squarely into that 10% – i.e., it represents random speculation.

Ticker UNG

Ticker UNG is an ETF that is intended to track the price of natural gas.  In Figure 1 we see that the Elliott Wave count generated by ProfitSource by HUBB is suggesting that the current downtrend “may” be running its course, i.e., 5 waves down.  To my mind this isn’t something that as a single piece of information would not prompt me to immediately jump into a bullish trade – there could be more downside left to play out, there may be a consolidation and/or a trading range before anything actually “bullish” happens, and so on.1Figure 1 – UNG with Elliot Wave count (Courtesy ProfitSource by HUBB)

In Figure 2 we see that from a seasonal standpoint we are entering what is often a favorable time of year for natural gas.  This adds a little more fuel to the “potentially bullish” fire.3Figure 2 – UNG annual seasonal trend (Courtesy Sentimentrader.com)

If we were to look at establishing a bullish position using options on UNG we can see in Figure 3 that option implied volatility (the black line) is extremely low.  This tells us that there is not a lot of time premium built into UNG options at the moment, i.e., they are “cheap.”  So it might make sense to take a position that can benefit from an increase in volatility.2Figure 3 – UNG with implied volatility at the low end of the range (Courtesy www.OptionsAnalysis.com)

Looking to Trade

First let’s acknowledge the fact that anyone getting bullish on UNG here is clearly fighting the trend, which is bearish.  This type of activity is generally discouraged because, well, it can make you look really stupid to try to pick a bottom in anything.  However, if you allocate a small portion of your capital to “whatever strikes your fancy” then it can make sense.

So let’s consider the following scenario:

*We think UNG’s latest plunge “may” be running its course and that a seasonal rebound is possible (i.e., we’ve got a hankering to pick a bottom)

*We have no idea when this bounce may occur (so we want to have a lot of time for any bullish move to play out)

*We know that option implied volatility is low (so we want to enter a position that can benefit from an increase in volatility)

*We recognize that we are contemplating a trade (going long natural gas in the face of a clearly established downtrend) that can easily blow up in our face, and rather quickly (so we don’t want to risk much)

*UNG is trading at $23.00 a share, and the most significant support level is down at $20.40.

Allocating Capital

Let’s say for sake of example that we have $25,000 in trading capital and we are willing to risk no more than 2% of our capital on “whatever strikes my fancy” trades.  That means that we can risk no more than $500 on this position.  The possibilities are endless.  So let’s just pick one as follows:

*Buy 6 Jan2020 30 UNG calls @ $0.86

*Sell 5 Jul2019 30 UNG calls @ $0.13

What we have is sort of a mutant calendar spread (by virtue of the fact that we are buying one more of the Jan2020 30 calls than we are selling of the Jul2019 30 calls -buying 6, selling 5).

The reason I like this “mutant” approach is that it creates the potential for unlimited profit, unlike a straight calendar spread where the risk curve “rollover” once price reaches the strike price.  Figure 4 displays the and Figure 5 displays the risk curves.4Figure 4 – UNG trade particulars (Courtesy www.OptionsAnalysis.com)

5Figure 5 – UNG trade risk curves (Courtesy www.OptionsAnalysis.com)

Things to note:

*The cost and maximum risk is $451, so less than our allowed 2% risk on $25K.

*The trade will make money if UNG advances enough between now and July 19th expiration (155 days away, so we have some time for things to play out)

*If UNG fails to advance this trade will lose money, plain and simple.  But no more than the $451 we allocated to begin with.  Bottom line, if we aren’t willing to risk $451 then we don’t make the trade in the first place.

The Volatility Factor

Obviously we want – in fact, need – UNG to advance in price sometime between now and mid-July in order to profit.  But there is another factor at play – implied volatility.  As we saw in Figure 3, implied volatility is at the low end of the historical range.  This DOES NOT mean that it is about to spike higher, nor even that it can’t continue to fall even lower.  This has “implications”.

First the short lesson on volatility: An option’s “vega” tells you how much it will rise of fall in price if implied volatility rises by one full percentage point.  Our combined position as shown in Figure 4 has a “vega” of $28.11.  This tells us that if implied volatility:

*Rises by one full percentage point this trade will gain $28.11

*Falls by one full percentage point this trade will lose $28.11

(NOTE: vega values are not static and do change over time)

*Also, the longer the time until expiration the higher the vega.  In other words, the January 2020 call that we bought has a higher vega ($6.80) than the July 2019 call (-$2.60) that we sold.  So, if IV rises one full point, in theory, we will gain $6.80 on the long call and lose $2.60 on the short call.

*A decline in implied volatility from here will reduce the value of our position, however, ultimately our maximum risk is still -$451.

*What we are hoping for is an increase in implied volatility between now and July expiration.  If IV rises 33% (from roughly 30% to roughly 40% – see Figure 3 for the historical IV range) the value of the trade will increase significantly as shown in Figures 6 and 7.6Figure 6 – UNG trade if IV rises 33% (Courtesy www.OptionsAnalysis.com)

In Figure 7 we see that if IV rises the risk curves also rise (on the chart that means they move further to the right, i.e., into higher territory).7Figure 7 – Risk curves if IV rises 33% (Courtesy www.OptionsAnalysis.com)

Summary

Is a bullish calendar spread on UNG a good idea?  It beats me.  In fact, given the typical degree of success enjoyed from “picking bottoms”, I might go as far as to say “probably not.”

Still, am I pounding the table and recommending that you go out and make this trade or a similar one?  Not all all.  The example above is NOT a “recommendation”, it is meant merely to illustrate “one way to play”, assuming a given scenario and a willingness to risk a certain amount of capital on a completely speculative position.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.