One of the most well known adages of all time is “What goes up must come down.”  In fact this old adage has completely buried the corollary adage of “What goes down, must eventually go back up.”  I guess that gravity thing is pretty tough to get around.  In any event, these two thoughts remind me of two of my own “important” trading maxims.

Jay’s Trading Maxim #372: What goes up may eventually go down - but it might also continue to go up and maybe a lot more than you expect and for a really long time. 

Jay’s Trading Maxim #373: What goes down may or may not eventually go back up - but it will probably bounce, at least every once in a while. 

As it turns out Trading Maxim #373 is much more useful when applied to physical commodities than to individual stocks, for as we know, the price of a stock can in fact go to zero.  Virtually any physical commodity – no matter how much in abundance it may be – will maintain a price level somewhere north of zero.

Which brings us to the topic of this week’s piece – natural gas - and to one other “important” trading maxim.

First, Someone else’s Trading Maxim: Never try to pick a bottom.

Now on the face of it this sounds like sage advice, but I would caution you of two things:

1) Never is a long time.

2) Human nature is a tough thing to overcome (so far no one we know has been successful in doing so).

So the bottom line is that anyone who has been in the financial markets for more than about five minutes has felt the urge to “pick a bottom.”  This leads us directly to:

Jay Trading Maxim #112: Go ahead and pick a bottom if you feel the urge – but don’t be stupid about it and do not - I repeat DO NOT - “bet the ranch.”     

With this adage firmly in mind let’s take a look at the current state of affairs in natural gas.

The Long Slide in Natural Gas

In Figure 1 you can see that natural gas (in this case we are using the ETF ticker UNG which trades like shares of stock but tracks the price of natural gas futures) has experienced “a bit of a decline”.  To be more specific, UNG has plunged from $127.88 a share to as low as $4.98 a share since July of 2008.  This represents a "not insignificant" decline of -96% (for the record, spot Natural Gas has declined “only” 86% since peaking in December 2005). 

So for some, the obvious reaction is “hey, it must be due to bounce.”  To which we reply with a resounding “Maybe.”  Of course you could have had the same thought roughly anytime over the past three and a half years as prices plunged lower and lower. 

Figure 1 – Natural Gas prices have experienced a spectacular and steady decline

So why is there any more “hope” for a bounce than at some point in the past?  Figure 2 highlights the fact that while prices have been moving sideways to lower, several key momentum indicators (namely MACD and Rate of Change) have been working higher and forming a bullish divergence. Also, the 3-day RSI just dropped into slightly oversold territory.

Figure 2 – MACD and Rate-of-Change indicators are forming a bullish divergence from price and 3-day RSI is oversold

So does this bullish divergence mean that natural gas is due for a “pop” to higher levels?  Maybe yes, maybe no.  The more important questions are “does it make sense to try to pick a bottom and can I do it without risking alot of money?”

The "Am I Qualified to Speculate in Natural Gas" Quiz     

To find out if a bullish speculation in natural gas makes sense for you, please take the following three question quiz:

1) Do you think that there is a chance that UNG – after falling 96% over 42 months – may at least bounce back up to its recent December 2011 high of about $6 a share? (Hint: Note that the question is not asking you to predict if this will actually happen, only if you think it is possible).

2) Do you have a brokerage account?

3) Do you have $66 bucks?

If you answered “Yes” to all three questions, then congratulations, you are qualified to speculate on a potential bounce in the price of natural gas.  You can now proceed to the next section.  If not, you should in all candor, probably stop reading at this point.

Is "Low Risk Speculation in Natural Gas" an Oxymoron?

Figures 3 and 4 depict a position that involves buying the April UNG 5 strike price call option.  As this is written the option is selling at $0.66 so the cost to buy one contract is a whopping $66. 

Figure 3 – Buying the April 2012 UNG 5 call

Figure 4 – Risk curves for buying the April 2012 UNG 5 call

A few things to note:

-The total dollar risk on a 1-lot position is $66.  The total dollar risk on a 10-lot position is $660.  This is the maximum amount you can lose and would only occur if UNG fell below $5 a share by April option expiration and you held the call until expiration.

-As this is written the option is “in-the-money” and as long as UNG remains above $5 a share, the option will retain some value.

-If UNG were to bounce back up to its December high of about $6 a share, this position would gain 50% to 80% in value, depending on how quickly the move occurred.

Summary

A few key things to note in summation:

-I am not predicting that natural gas “has bottomed” or that it “is due to rally” or that (the ever popular) “you can’t lose trading natural gas options”.  I just think it’s possible that a bounce could take place sometime in the next two months.  Please note also that I am not “pounding the table” or suggesting that anyone contemplate any kind of a sizeable position.

I am merely pointing out that:

-Thanks to the advent of ETFs that track commodities and;

-via options on said ETFs,

-it is possible to “speculate on commodities” without exposing yourself to a great deal of risk.

Is this a good thing?  Let’s answer that with one last Trading Maxim.

Jay’s Trading Maxim #14: When push comes to shove in the financial markets (and come to think of it, life in general), you alone are responsible for your own actions.  So choose wisely.

Jay Kaeppel

Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ Your Options Education Site

NOTES:

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