How to Profit from Natural Gas
by: RobViglione |
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In the last two months, natural gas has fallen by 60%! This can be largely attributed to the burst of a nat gas bubble, a stronger US dollar, and revised market expectations on inventory, short-term supply, and global demand. Despite these strong reasons for a sharp pull-back in price, markets are constantly providing opportunities to profit from short-term disparities in market efficiency.
Outright futures trading is risky business, with the potential for losing more than you have. I don't recommend going this route for the amateur investor. Rather, commodities exchange-traded funds (ETF's) provide exposure to price movements sans the big risks.
My thesis on natural gas is that it has dropped sufficiently to expect future volatility to level off and return to historical levels. Three month volatility is currently up to 54%, while the long-term average is 45%. Looking at market implied volatilities shows that aggregate investor sentiment is that downside volatility will decrease in the near term; in fact, implied volatility for Sep08 strike 30 puts is 48.17%. On the flip side, strike 42 calls have an implied volatility of 63.17%, which is remarkeably high. The invisible hand of the market is telling us that natural gas has a higher probability of moving higher than lower.
There's multiple ways to take advantage of this information:
Buy UNG. The ETF is trading for just under 38 per share. There is no dividend, but potential capital gains implied by the market could make this a lucrative bet.
Buy UNG calls; however, given that implied volatilities are so high, you'll end up paying hefty premiums. To minimize this loss, I recommend buying deep in-the-money (ITM) contracts with a long time to expiration. The January, 2010 contracts look particularly enticing.
Ratio spreads, skewed iron condors, and bull put spreads. These are more complicated, but less risky option combinations. As an example, VPAG just opened an iron condor with a 30/35/42/47 profile. This means we sold 35 strike puts and 42 strike calls, and bought 30 strike puts and 47 strike calls. This limits our downside if UNG falls below 30 or rises above 47. We received a 1.58 credit per share on each spread sold, or $158 per contract spread.
The only right or wrong when it comes to markets is what works in the end. The only thing I know from my short vantage point is that natural gas has moved a lot in the recent past, more than it has historically. Implied volatilities are high, but coming down on the put side and increasing on the call side. This means market participants expect prices to rise in the future, disrupting a significant two month downward spiral for the commodity. Stick to what you're comfortable with, but consider alternatives in a limited fashion.
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About the Author
If you liked this discussion visit others written by Rob Viglione and his team at The Freedom Factory. The site is dedicated to political and economic freedom, two concepts which cannot be decoupled.
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