Why is that people are always so surprised…..when the stock market declines, that is?

We’ve had a rip-roaring bull market for years on end (granted, thanks primarily to an orgy of printed money, borrowed money and artificially low interest rates, all of which is almost certain to end badly at some point, but I digress), the market averages have been building classic multiple top formations for months (See Figure 1) and seasonally we are smack dab in the worst time of the year.

And then just as it has always done, the stock market experiences a decline and lots of people freak out!  Oh well, same as it ever was I guess.Figure 1 – Major long-term advance followed by an extended topping formation, followed by, well, what else?

Now I make no claims to have “called the top”, nor am I in the “wildly bearish” camp.  My only point is that there has been ample warning that a pullback was quite possible.  Investors and hedgers have had ample opportunity to act (to sell or hedge) and ample warning as the major averages struggled to make any real headway.

If you are new to the financial markets, I advise you to memorize the following.  Look at Figure 2 and repeat after me:

Jays Trading Maxim #77: If price tries to breakout multiple times but fails, something bad usually follows.  So don’t just sit around and wait for the “something bad.”

Figure 2 – When price tries time and again to breakout but cannot the market is (usually) telling you something important

Where we are Now, Seasonally Speaking

Figures 3 and 4 are from www.EquityClock.com.

Figure 3 shows the seasonal annual trend for the S&P 500.  Simply note that as I have written about in the past, the end of May into September and October period is not typically “High Season” for the stock market.

In Figure 3 note the relative performance for the S&P 500 Index during the summer months compared to the rest of the year.

Figure 3 – Seasonal annual trend for S&P 500 Index (Courtesy: www.EquityClock.com)

Also note in Figure 4 that stock market volatility has showed a historically seasonal tendency to spike higher starting at the end of June.Figure 4 – Volatility “spikes” are not uncommon during the summer months (Courtesy: www.EquityClock.com)

Summary

The bottom line is threefold:

1) It pays to learn to recognize “the warning signs” and to act to hedge (or to do some selling) before the scary stuff starts to happen.

2) Given that it is a pre-election year (which tend to be bullish), I am willing to give the bullish case the benefit of the doubt.

3) In the meantime you might want to “strap yourself in”, it could be an interesting few months.

Jay Kaeppel

I learned yesterday that one of my contemporaries – for whom I had the utmost respect – passed away in his sleep the other night.  Nelson Freeburg was for as long as I can remember the editor of Formula Research, a newsletter he published which detailed any and all manner of objective trading methods.

Although I considered him my friend, the odd truth is that we never once managed to actually meet in person.  But we had mutual respect or one another’s work, and communicated by email and phone fairly often a number of years ago.  Nelson took a few “obscure” ideas I wrote about many years ago and turned them into actual systems with full-fledged objective buy and sell signals.  He gave me full credit for the initial idea and allowed me to gain a little notoriety primarily by virtue of his work.  He also took the time to help me flesh out and improve upon a number of ideas on my own.  In truth, we didn’t have much contact in recent years, but I remained and remain ever grateful for his selfless input.

Beyond all that, my recurring thought regarding Nelson was that when it came to developing well thought out, objective (not mention kicka#$) trading systems – in my opinion he was simply the best.  And I know for certain – because I have seen and heard comments to the effect over the years – that I am not the only person who believes that statement to be true.

As I mentioned, we never met in person.  But I have heard from many others that he was an excellent speaker and a heck of nice guy.

Nelson, thank you for the vast contributions that you shared so generously with us.  You will be sorely missed.

Jay Kaeppel

IMPORTANT NOTES:

In case you missed my updates to Part 1 and Part 2: the data that I had for ticker ULPIX (which is a ProFunds mutual fund that tracks the S&P 500 Index times 2) contained bad days of data, which as it turned out, overstated the returns that I showed in the articles.

That’s the Bad News.  The Good News is that the goal of the articles was to ultimately demonstrate that “combining” two different methods can oftentimes prove very worthwhile.  As it turns out, that is the case here – granted, not as dramatically so as I had originally thought, but, well see for yourself………

In Part 1 and Part 2 I detailed two separate methods for trading a stock index mutual fund (or ETF) using the relationship between the S&P 500 Index and junk bonds as the catalyst.

The natural question that might pop into most people’s head is “so which one is best?”  In this case, I think the proper response is “why choose?”  For here’s the interesting thing when it comes to trading.  Sometimes (though granted, not always) “combining” two systems can offer a better tradeoff between reward and risk than simply “choosing” one or the other.  So in this article let’s take a look at what might have happened had a trader combined the methods I detailed in Parts 1 and 2.

The Premise

We will combine the “44-Day SPY/HYG Ratio System” (System 1 for short) and the “252-Day Rate-of-Change System” (System 2 for short) and measure the results.

The Particulars

*For our “stock” component we will use ticker SPY (the ETF that tracks the S&P 500 Index”

*For our junk bond component we will use ticker HYG (the iShares high yield corporate bond ETF, which started trading in April of 2007)

*Because we are shooting for maximum returns I originally used data ticker ULPIX (which is the leveraged ProFunds mutual fund that seeks to track the daily change for the S&P 500 Index times 2).  Unfortunately, the data that I have for ULPIX contains errors on enough days to make a difference.  So for performance purposes I will simply multiply the daily return for ticker SPY times 2 as a proxy for ULPIX.

*When we are out of ULPIX we will simply hold cash.  For our purposes, an annual rate of 1% of interest is used.

We will start our test on 4/11/2008 (rather than 12/31/2007 for the test in Part 1) because HYG started trading on 4/11/2007 and we need 252 trading days to make our first 252-day rate-of-change calculation.

The Calculations

System 1: The 44-day Ratio Moving Average

A = SPY / HYG (each trading day)

B = 44-day simple moving average of A

C = (A – B)

If C > 0 then at the next close Buy (or continue to hold if already long) ticker ULPIX

If C< 0 then at the next close Sell ticker ULPIX and move to cash (or remain in cash if C was previously less than 0).

System 2: The 252-day Rate-of-Change

A = SPY today / SPY 252 trading days ago

B = HYG today / HYG 252 trading days ago

C = (A – B)

If C > 0 then at the next close Buy (or continue to hold if already long) ticker ULPIX

If C < 0 then at the next close Sell ticker ULPIX and move to cash (or remain in cash if C was previously less than 0.

Combined Model:

*If System 1 is”bullish” we will add +1 point to the Combined Model.

*If System 2 is “bullish” we will add +1 point to the Combined Model

*If the Combined Model reading is greater than 0 (i.e., if EITHER system is bullish) then at the next close Buy (or continue to hold if already long) ticker ULPIX.

*If the combined reading is equal to 0 (i.e., if NEITHER of the systems are bullish at the same time) then at the next close Sell ticker ULPIX and move to cash (or remain in cash if the combined reading was previously 0).

Figure 1 displays the growth of $1,000 achieved by holding SPY times 2 when System 1 is bullish and cash when it is bearish versus buying and holding SPY (no leverage).  $1,000 using System 1 grew to $1,635 versus $1,581 for buying and holding SPY.

Figure 1 – Growth of $1,000 using System 1 (blue) versus SPY (red); 4/11/2008-6/19/2015

Figure 2 displays the growth of $1,000 achieved by holding SPY times 2 when System 2 is bullish and cash when it is bearish versus buying and holding SPY (no leverage).  $1,000 using System 1 grew to $2,921 versus $1,581 for buying and holding SPY.Figure 2 – Growth of $1,000 using System 2 (blue) versus SPY (red); 4/11/2008-6/19/2015

Now let’s look at market performance when we combine the two systems.

Figure 3 displays the daily combine reading for all days from 4/11/2008 through 6/19/2015.

Figure 3 – Combined Model Readings;  4/11/2008 – 6/19/2015

When the blue line in Figure 1 is greater than 0 then the system is long ULPIX and when the blue line is at 0 the system is in cash.

The Results

*As you can see in Figure 3, throughout most of 2008 and much of 2009 the system was in cash.  Since that time the Combined Model has been above 0 with one brief exception. Given that the stock market fell hard in 2008 and has mostly advanced steadily since this is about what you would hope to see.

Figure 4 displays:

*The growth of $1,000 achieved by holding SPYx2 when the Combined Model reads +1 or +2 and holding cash when the combined model is 0 (red);

*The growth of $1,000 achieved by holding SPYx2 when the Combined Model reads) 0 (blue);

Figure 4 – Growth of $1,000 holding SPYx2 when Combined Model > 0 (red line) versus growth of $1,000 holding SPYx2 when Combined Model = 0 (blue line); 4/11/2008 – 6/19/2105

Finally, Figure 5 displays:

*The growth of $1,000 achieved by holding SPYx2 when the Combined Model reads +1 or +2 and holding cash when the combined model is 0 (red);

*The growth of $1,000 achieved by holding SPY on a buy-and-hold basis

Figure 5 – Growth of $1,000 holding SPYx2 when Combined Model > 0 (red line) versus growth of $1,000 buying and holding SPY  (blue line); 4/11/2008 – 6/19/2105

In sum;

*A original $1,000 invested in SPYx2 when the Combined Model is > 0 and in cash when the Combined Model is 0  grew to $3,305, or +230%.

*A original $1,000 invested in SPYx2 when the Combined Model is = 0 and in cash when the Combined Model is > 0 declined to $566, or a loss of -43%.

*For comparison sake, $1,000 invested in ticker SPY on a buy-and-hold basis grew to $1,581, or +58.1% during the same time.

As I am wont to say, the difference between +230% and -43% is what we “quantitative analysis types” refer to as “statistically significant.”

Figure 3 displays the annual returns based on:

*Holding SPYx2 when the Combined Model > 0 versus

*Holding SPYx2 when the Combined Model is = 0 verus

*Buying and holding SPY (no leverage)

Figure 6 – Annual Returns for Combined Model Readings of > 0 versus Combined Model readings of 0 and buying and holding SPY

*- Starting on 4/11/2008

** – through 6/19/2015

***Average annual return 2008 through 2014

Summary

So is this SPY/HYG Combined Model a “World Beater” system that everybody should adopt?  Probably not.  The test period is short (7+ years), the maximum drawdown was large (-42%) and much of the outperformance was based on using leverage and so on.

But the real purpose of this article is not to convince you to use this particular system.  The real purpose is simply to illustrate how combining two methods (one that gained +64% and the other that gained +192% can improve the overall net result (+230%).

The fact that this method produced an annual return of +22.7% versus +8.3% for the S&P 500 suggests that there may (at times) be some truth to the notion that “two ideas are better than one”.

Jay Kaeppel

IMPORTANT NOTE: PLEASE READ THIS FIRST!  

I was alerted (by alert reader Satish) that the data that I have for ticker ULPIX is incorrect!

There is Bad News and Good News

The Bad News is that – and yes, this is embarrassing but – an alert reader noticed that the data that I have for ticker ULPIX is incorrect on several dates and as a result the performance numbers in the article below are incorrect.

The Good News is that there is still “a Happy Ending” in Part 3 which appears here.  So while you can read the article below for the calculations that will ultimately be used in Part 3, remember that the performance numbers are incorrect.

For the record, here is what happened: Under the category of “from sources believed to be reliable” I have not reviewed the data that I have for ticker ULPIX in some time.  Which is a shame because as it turns out the data that I have for ticker ULPIX and appears to contain random dates with incorrect prices.  This ended up having the effect of mathematically improving performance, but did not reflect reality.  Instead of using SPY data in my initial test, I went straight to the ULPIX data.  Had I tested the results initially using SPY data instead of ULPIX data I would have noticed the discrepancy when I then went to use ULPIX data.

So two takeaways:

1) Yes, this is embarrassing and I should have verified that the data I was using was accurate before “going to press”.  So I apologize for that.

2) Don’t give up on this whole “Trading Stocks using Bonds” thing until you read Part 3.

Jay Kaeppel

IMPORTANT NOTE: PLEASE READ THIS FIRST!  

I was alerted (by alert reader Satish) that the data that I have for ticker ULPIX is incorrect!

There is Bad News and Good News

The Bad News is that – and yes, this is embarrassing but – an alert reader noticed that the data that I have for ticker ULPIX is incorrect on several dates and as a result the performance numbers in the article below are incorrect.

The Good News is that there is still “a Happy Ending” in Part 3 which appears here.  So while you can read the article below for the calculations that will ultimately be used in Part 3, remember that the performance numbers are incorrect.

For the record, here is what happened: Under the category of “from sources believed to be reliable” I have not reviewed the data that I have for ticker ULPIX in some time.  Which is a shame because as it turns out the data that I have for ticker ULPIX and appears to contain random dates with incorrect prices.  This ended up having the effect of mathematically improving performance, but did not reflect reality.  Instead of using SPY data in my initial test, I went straight to the ULPIX data.  Had I tested the results initially using SPY data instead of ULPIX data I would have noticed the discrepancy when I then went to use ULPIX data.

So two takeaways:

1) Yes, this is embarrassing and I should have verified that the data I was using was accurate before “going to press”.  So I apologize for that.

2) Don’t give up on this whole “Trading Stocks using Bonds” thing until you read Part 3.

Jay Kaeppel

I have a pretty hard and fast rule about not being critical of other analyst’s work.  The reality of the markets is that no one ever really knows for sure what will happen next.  Sure some people get it right a lot more often than others (hence the reason some people get filthy rich in the markets and others do not).  But at any given point in time, two people can disagree on the outlook for a given stock, sector, commodity, etc. and only time will tell who is right.

See also An Example Commodity Play in SLV

OK, with all of that as a preface I saw an article recently titled (something like) “Is Now the Time for Housing Stocks?”  Truth be told I only read a small portion of the article but I think the gist of it was to suggest that now is a good time to buy housing stocks.  And if so, the author may ultimately prove to be correct.  But from my own analysis, I think I would have to answer the question posed in that article’s title as follows:

“Maybe, but Probably Not”

OK, granted that doesn’t exactly qualify as a “gutsy” call.  But historically the summer into fall months have not been kind to stocks in general and especially not to housing stocks.

Housing Stocks by Month

For our purposes we will us ticker FSHOX (Fidelity Select Construction & Housing Portfolio) as our proxy for housing stocks.  Figure 1 displays the percentage gain or loss achieved by FSHOX by month starting on 9/30/1988.Figure 1 – % Gained or Lost by month (ticker FSHOX; 9/88 to present)

As you can see in Figure 1, June and September have seen net losses of roughly -35% and -34% respectively.  July showed a modest net gain and August was basically a wash but with a small loss.  The rest of the months showed a net gain.

So let’s sum it up this way:

*June through September = (-53.1%)

*October through May = +2,336%

Figures 2 and 3 display the growth of equity during these two distinct bullish and bearish periods.Figure 2 – Growth of $1,000 holding FSHOX October through May (9/88-present)Figure 3 – Growth of $1,000 holding FSHOX June through September (9/88-present)

Clearly it is not as though housing stocks always rise between October and May, nor do they always decline between June and September.  Likewise, the “bullish” period clearly suffered a significant drawdown in the 2006-2008 period.  Still, even with that the net result was far superior to the “bearish” period results as displayed in Figure 3.

to put is as succinctly as possible,  a gain of +2,336% versus a loss of -53.1% is what we “quantitative types” refer to as “statistically significant.”

Figure 4 displays the annual gain/loss for the “bullish” months versus the “bearish” months.

Figure 4 – Annual Results for FSHOX (bullish periods versus bearish periods)

A few things to note appear in Figure 5:

Figure 5 – Comparative Results – Bullish Periods versus Bearish Periods for Housing stocks

Summary

It is important to note that none of the data presented in this article precludes the possibility that housing stocks will advance between now and the end of October this year.  Still if the question posed is “is now the time to buy housing stocks”, history suggests that the proper answer is:

“Maybe, but Probably Not”

So as a “Rule of Thumb”:

*Buy a house in the summer?  OK

*Sell a house in the summer?  OK

*Buy housing stocks in the summer?  Maybe not so much

Jay Kaeppel

Please note the use of the word “Example” in this article’s title.  Note also the lack of the word “Recommendation” and note especially the lack of words such as “You”, “Can’t” and “Lose”.

In my last article I noted that much of the commodity world seems to be at a fairly critical juncture.  After years of declines many commodities have been moving sideways to slightly higher and a number have touched multi-year support levels.  One such commodity is silver.  Now the truth is that I personally cannot make much of a bullish or bearish argument regarding where silver might be headed next.  But I do see some indications that it may be “moving” in a meaningful way soon.  So let’s look at why I say that and one example play on ticker SLV, the ETF that tracks the price of silver.

See also: A “Creative Play” in Natural Gas

Conflicting Elliott Waves

In Figure 1 we see that the weekly Elliott Wave count (as calculated by ProfitSource by HUBB) is pointing to the potential for lower prices in the months ahead.Figure 1 – SLV with Weekly Elliott Wave count (Courtesy: ProfitSource by HUBB)

On the other hand, in Figure 2 we see that the daily Elliott Wave count is pointing to the potential for higher prices in the weeks ahead.Figure 2 – SLV with Daily Elliott Wave count (Courtesy: ProfitSource by HUBB)

So which count is right – daily or weekly?  Unfortunately I have to go with my standard answer of “it beats the heck out of me.”  Still – adn interestingly – this does not preclude a trader from entering a position that can make money regardless of which Elliott Wave count proves to be correct (but which, alas, can lose money if neither wave count proves to be correct and silver remains in a trading range).

Example Trade

So to take it from “Soup to Nuts” so to speak, let’s assume that a trader:

*Has a $20,000 trading account

*Is willing to commit 5% to a single trade

*Would prefer not to risk the entire 5%

*Isn’t sure which way silver might move but is reasonably confident that SLV will break out of its recent trading range sometime in the not too distant future.

This sounds like a potential scenario for entering a long straddle using options, using no more than $1,000 ($20,000 x 5%).  Figure 3 displays the particulars for buying:

*8 August SLV 15.5 Calls @ $0.61

*8 August SLV 15.5 Puts @ $0.63

Figure 3 – Long SLV August 15.5 straddle (Courtesy www.OptionsAnalysis.com)

Figure 4 displays the risk curves for this trade, with each line representing the expected profit or loss based on the price for SLV as of a given date.  The distance between the black line and the green line at a price of $15.50 highlights the negative effect of option price time decay as option expiration draws near (i.e, if SLV is unchanged in price as expiration draws near both the call and the put will lose time premium at an accelerating rate which would increase the loss on the trade).

We can use this knowledge to help us plan how to manage this trade.Figure 4 – Risk curve for SLV straddle held to expiration (Courtesy www.OptionsAnalysis.com)

What we see in Figure 4 is the following:

*If this trade is held until expiration on 8/21 and SLV closes that day at $15.50 both options will expire worthless and the trade will lose $992.

*If SLV is between $14.26 and $16.74 on 8/21 this trade will show a loss.

*If SLV is above $16.74 or below $14.26 on 8/21 this trade will show a profit.

However, we do not have to hold this position until expiration if the opportunity arises to take an early profit.

Planning Trade Management

To zero in on “where this trade lives” let’s do the following:

*We will set the upper and lower price targets to the upper and lower Elliott Wave price targets that appear in Figures 2 and 1 respectively – in other words, an upper target of $17.31 and a lower target of $13.26.

*We will plan on exiting the trade no later than 8/7, which is 14 days prior to August expiration.  This will limit the potential damage due to time decay.

This plan gives us the scenarios that appear in Figures 5 and 6.Figure 5 – SLV Straddle held through 2 weeks prior to expiration (Courtesy www.OptionsAnalysis.com)Figure 6 – Risk curves for SLV straddle through 2 weeks prior to expiration(Courtesy www.OptionsAnalysis.com)

*In Figure 5 we see that although we still have to put up the full $992 to enter the trade, if we exit by 8/7 the likely “worst case” scenario is a loss of roughly -$538.  The bottom line is that if SLV remains inits recent trading range then this trade will lose money.

In Figure 6 we see that:

*If price hits the upper target of $17.31 then the profit will range from roughly $490 to $600, depending on how soon that price is hit.

*If price hits the lower target of $13.26 then the profit will be in the $750 range.

Summary

I cannot state that this will turn out to be a good trade. It sure is a pretty example though of one way to play a market that:

*Has been consolidating and/or bouncing off of support

*Has some expectation of making a move in some direction (based on daily and weekly Elliott Wave counts in this example)

*Offers a decent tradeoff between reward and risk if traded using options.

There may be more opportunities shaping up within the “exciting world of commodities.”  With many commodities markets at critical junctures now seems like a good time to start exploring other similar opportunities.

Jay Kaeppel

See also A “Creative Play” in Natural Gas

Commodity prices overall have taken a significant tumble over the past several years.  At the moment a number of commodity markets appear to be at least attempting to “form a bottom.”

I should probably point out up front that there is no “prediction” built into the comments above.  I don’t really have a firm opinion as to whether commodity prices are in the process of “bottoming out”, or if another round of “breakdowns” are in the offing.  The one thing I do sense is that there is a lot “hanging in the balance” in the near future.  To wit, please see Figure 1.

The charts in Figure 1 display:

DBA – which tracks agricultural commodities

DBC – which tracks an index of commodities

DBP – which tracks precious metals

JO – which tracks the price of coffee (also referred to by my wife as the “World’s Most Important Commodity”)

(click to enlarge)Figure 1 – Which way for Commodities?; tickers DBA, DBC, DBP, JO (Courtesy: ProfitSource by HUBB)

As you can see in Figure 1, all four of these commodity related ETFs have:

A) Declined significantly in recent year

B) Are attempting to form a bottom

As I mentioned I can’t really offer a meaningful opinion here as to “which way next”.  The one thing I do know is that traders looking for opportunities should be watching to see if these (and other commodity related assets) “bottom out” or “break down” again.  For now we need to sit and wait and see how this plays out.

For those of us who like “action”, we must currently heed the immortal words of that great philosopher Tom Petty, “the waiting is the hardest part.”

Jay Kaeppel

In a recent article I highlighted the fact that natural gas has showed a tendency to advance during a particular 3-day period in June.  Well, thanks to a strong rally on Day 3 this trend technically rang up another “success” in 2015.  But in reality, it was basically a wash to a small loss, depending on how one chose to play.

*July Natural gas futures declined $20 in value from 2.891 to 2.889.

*Ticker UNG advanced (such as it is) from $14.02 to $14.03.

*The June UNG 13 strike price call – if bought and sold at the market – was bought at $1.10 and sold at $1.07, or a $3 loss per contract.

Now onto the “Seasonally Unfavorable” period.

Jay Kaeppel

Well I hate to repeat myself, but the close of trading on 6/15 signals the start of one of the most consistently bearish seasonal periods in any market.  It marks the beginning of a bearish seasonal period for natural gas which extends through the end of July Trading Day #14 (July 21st in this case).

Figure 1 displays the net performance that a trader would have “achieved” by holding a long position in natural gas futures during this period every year since natural gas futures started trading in 1990 (and let be honest, “achieved” may not be exactly the best choice of words).Figure 1 – Long natural gas futures during bearish June/July period (1990-2014)

To note:

*Natural gas lost ground 19 years in a row from 1993 through 2011.

*Natural gas has lost ground in 21 out of the last 22 years during this period

*The one time it showed a significant gain was during the only previous year in which I actually mentioned this trend, 2012 (proving once again that Murphy’s Law is alive and well).

So forget all that, the real question is “what happens this time around?”  I can tell you that I have spent (wasted?) a significant amount of time trying to come up with a good “confirming” indicator to help suggest whether the trend will play out as expected during a given year but to no avail.  So let’s just consider the trading possibilities.

The Possibilities

So either you put some faith in the fact that natural gas has been down 21 out of 22 years during this period, or you don’t.  All of this leads to a variety of possibilities:

*Do Nothing: If you think seasonal trends are not to be trusted then by all means you should simply steer clear.  No harm, no foul.

*Short Natural Gas Futures: If you are well capitalized, willing to accept a certain degree of risk (and are not terribly frightened regarding what happened the last time I mentioned this trend, i.e., a sharp rally for natural gas rather than a decline), then the “purest play” is to sell short natural gas futures.  But make no mistake, selling short any futures contract involves an above average degree of risk.  As I write, July NG futures are trading at roughly $2.800.  With NG futures a $0.001 move in price is worth $10.  So if a trader sold short a futures contract at $2.800 and NG happened to advance to $3.000, the trader would lose $2,000.  So clearly selling short futures contracts is not for the faint of heart nor the under capitalized.Figure 2 – September Natural Gas Futures (Courtesy: ProfitSource by HUBB)

*Sell Short Shares of UNG: Another choice for non-futures traders is to sell short shares of ticker UNG, the ETF that (ostensibly) tracks the price of natural gas.  Selling short shares of any ETF is also generally considered to be a “risky” strategy.  There are margin requirements for maintaining the position not to mention that pesky little “unlimited risk” thing associated with selling short.  Still, for a trader willing to assume the risks, selling short shares of UNG is a “direct play” on lower natural gas prices.Figure 3 – ETF ticker UNG  (Courtesy: ProfitSource by HUBB)

*Buy an Inverse ETF: Ticker DGAZ is a triple-leveraged inverse ETF that tracks natural gas and trades roughly 9 million shares a day.  This sounds like a great choice for playing the bearish side of natural gas, but one needs to consider the potential “bad” along worth the potential “good.”  During the June/July “bearish” period in 2014 DGAZ gained +74.9%.  However, during the June/July bearish period in 2012 DGAZ lost -53.6%.  So if things “go wrong” with a triple-leveraged inverse ETF, things go “very wrong.”Figure 4 – ETF ticker DGAZ  (Courtesy: ProfitSource by HUBB)

*Put puts on UNG: This seems like a natural choice to play a potentially bearish trend.  The problem is that UNG options often have relatively wide bid/ask spreads.  For example, as I write the July Week 4 14 strike price put trades at $0.66 bid/$0.79 ask.  The bottom line is that if you buy a UNG put option and UNG only declines a few percent the trade will probably not make money.

*Use Options “Creatively”:  I mentioned in a recent article that traders often need to “get creative” in order to make money during the summer months, so let’s look at one “creative way” to play the short side of natural gas (without the risk associated with selling short futures or ETF shares).

The trade we will consider involves:

*Buying 3 October UNG 13 strike price puts

*Selling 2 July UNG 13 strike price puts

Note: For illustrative purposes we will use a “market order” (i.e., buying at the ask price and selling at the bid price).  Because of the width of the bid/ask spreads traders may consider using a limit order instead.  But for our purposes we are essentially assuming a “worst case” fill.

Figure 6 displays the particulars of the trade and Figure 7 displays the risk curves.Figure 6 – UNG Oct/Jul Directional Bear Put Spread (Courtesy www.OptionsAnalysis.com)

Figure 7 – UNG Oct/Jul Directional Bear Put Spread (Courtesy www.OptionsAnalysis.com)

Important things to note:

*The key factor in this trade is that fact that the July options will expire on 7/17, i.e., near the end of the bearish period (July 21^st).  This allows time decay to work for us as the July options will lose time premium at an accelerating rate as expiration nears.

*The October puts will not lose time premium as quickly. Note in Figure 2 that the July 13 put shows a Theta of -$0.90 – meaning it will lose roughly $0.90 a day due to time decay; the October 13 put shows a Theta of only -$0.50.  This explains the “bulge” in the purple risk curve line in Figure 3.  As July expiration draws near, accelerated time decay increases the profit potential.

*By buying in 3×2 ratio we retain unlimited profit potential in the event that natural gas does in fact decline sharply.

*If Murphy decides to invoke his dreaded Law and whack me upside the head again for daring to mention this bearish seasonal trend in natural gas again, the most that this trade can lose by July 21^st is $220 (and that is only if UNG rallies roughly 50%; if UNG rises roughly one standard deviation to around $16 a share, the loss on this trade is roughly -$150.

Summary

As always, none of this constitutes a “recommendation”, only “possibilities”.  In any event, a trader first must decide if they really want to risk their hard-earned money on a seasonal trend.  Then they must decide how they want to go about making the play.  As you have seen there are “high risk/high reward” possibilities, and there are other not high risk/high reward ideas.

In most cases I prefer taking a limited risk using a reasonable amount of trading capital and hoping for a high percentage rate of return on the capital invested.  What you may choose to do is of course entirely up to you.

But whatever you decide to do, DO NOT breathe a word of this to Murphy…

Jay Kaeppel