I recently wrote about the tendency for natural gas to show weakness during the following period:
*The period from the end of January Trading Day #5 through the end of February Trading Day #11 has tended to be bearish for natural gas (1/8/16 through 2/16/16)
Please note the use of the word “tendency” and the lack of the words “You”, “Can’t” or “Lose”.
I am not recommending that anyone go out and play the bearish side of natural gas. However, I am going to offer an example of one way to do just that as an educational example.
Bear Call Spread using Feb UNG Options
Ticker UNG is an ETF that tracks the price of natural gas futures. Instead of betting that UNG “will decline”, we will instead bet that UNG “will not rise more than a certain amount.”
In Figure 1 we see that the implied volatility for options on UNG is near the high end of the historical range:
This tells us that there is a lot of time premium built into the price of UNG options and suggests that selling premium might be a better strategy than buying premium.
Figure 1 – Ticker UNG with high implied volatility (Courtesy www.OptionsAnalysis.com)
Before we look at the specific trade example note in Figure 2 that the example trade I will highlight is essentially a bet that UNG will remain below the level indicated on the chart through February Trading Day #11 (2/16).
Figure 2 – Ticker UNG (Courtesy: AIQ TradingExpert)
A trader who is NOT willing to make that bet should not make the trade highlighted below
Example Bear Call Spread Trade
A “Bear Call Spread” involves selling a lower strike price call option and buying a higher strike price call option. More premium is received for the option sold than is paid out for the option bought. As long as the price of the underlying security remains below the strike price of the option sold the trade makes money.
The example trade using options on ticker UNG highlighted below involves:
*Selling Feb UNG 10 strike price call options
*Buying Feb UNG 11 strike price call options
For arguments sake we will assume a trader is willing to commit $2,000 to the trade. In this case the trader can trade 24 contracts of each option. The resulting position appears in Figure 3 and 4.
Figure 3 – Feb UNG Bear Call Spread (Courtesy www.OptionsAnalysis.com)
Figure 4 – Feb UNG Bear Call Spread Risk Curves (Courtesy www.OptionsAnalysis.com)
As you can see in Figures 3 and 4:
*The maximum profit potential for this trade is $432, or roughly 22% in 42 days IF UNG is at or below $10 a share on 2/16.
*The breakeven price for this trade is $10.01.
*The maximum risk is -$1,968. However, a trader should consider exiting the trade if UNG rises into the $10.03 – $10.63 range. In the worst case of an immediate rally, a trader could limit his or her loss to -$630 to -$960.
*As this is written, UNG is trading at $9.08 a share. This trade will show a profit as long as UNG remains below roughly $10.03 by 2/16.
Summary
Is this a good trade? That’s not for me to answer, as this is only an example and not a recommendation. The key points however are:
*It takes advantage of high implied volatility by selling premium
*It can make money even if UNG rises another 10%. At the same time, given the volatile nature of natural gas prices, it should be remembered that this trade could get blown out of the water in very short order. Therefore a trader MUST sand ready to cut a loss if the worst case transpires.
*There is a fairly objective “Uncle” point (above recent highs above $10 a share) where a trader can say “I am wrong and am getting out.”
I don’t know if it’s a good trade….but it sure is a good example.
Jay Kaeppel
