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Kaeppel's Corner: Is Natural Gas About to Break Wind?

By Jay Kaeppel, Optionetics.com | Tue June 12, 2012 10:02AM PT

 

If you are an ardent believer in the phrase “if something looks too good to be true it probably is”, then you’d better brace yourself.  Because a “sure-fire, can’t miss, you can’t lose” thing is about to happen in natural gas.  Well OK, at least that’s the theory.

 

A Bearish Seasonal Trend in Natural Gas

The time period in question extends from the close of trading on the 11th trading day of June (Friday, June 15 in this case) through the close of the 14th trading day of July (Friday, July 20th). 

Natural gas futures started trading back in April 1990.  During that year, a short position in natural gas futures would have generated a profit of $790.  During 1991 and 1992 however, a short position held during this period would have generated losses of -$200 and -$1,850, respectively.  That’s the bad news.  

The good (or at least the “interesting”) news is that a short position in natural gas futures held during this period during the ensuing 19 years (1993 through 2011) would have generated a gain each year.  Yes, you read that right - 19 consecutive years of profit. 

So for the record, since 1990, a short position in natural gas futures during the June TD 11 through the July TD 14 period showed:

-A gain 20 times (90.9% of the time)

-A loss 2 times (9.1% of the time)

The cumulative equity curve generated by holding a short position in natural gas futures only during this time period from 1990 through 2011 appears in Figure 1.

 

Figure 1 – Cumulative gain from holding a short position in Natural Gas futures during bearish time period (1990-2011)

Now let’s be honest, that’s a pretty good track record no matter how you cut it.  Of course, that’s the good news.  The bad news is that these historical results in no way “guarantee” that a short position in natural gas during this bearish period this time around will actually make money. 

Plus, let’s be even more honest – skipping all rational, mathematical analysis, after 19 consecutive years of profit doesn’t it just seem like Murphy’s Law and the Law of Averages is just sitting there waiting to pounce on anyone who dares to sell short natural gas futures during this period this time around?  

Of course, I suppose you could have said the same thing after 14 consecutive years, or 15, or 16 and so on.

Still, in the immortal words of Crosby, Stills, Nash and Young – paranoia, it strikes deep.

 

What to Do, What to Do?

Now some might still be inclined to throw caution to the wind and consider a short position in natural gas futures based solely on this historically bearish seasonal trend.  However, the other approximately 99.99% of all investors are highly unlikely to do so.  But that doesn’t mean they are necessarily shut out of this play, as clearly elucidated in:

Jay’s Trading Maxim #24: If it “looks too good to be true” (but might still turn out to be true anyway), consider a limited dollar risk trade using options. 

Ticker UNG tracks the price of natural gas futures.  At the moment the 5-day average of daily options volume on UNG is roughly 20,000 contracts.  To put it another way, there is a great deal of liquidity in UNG options.  So it makes a lot of sense to consider a limited risk option position in UNG as a way to play this potentially bearish trend. 

Now as it turns out, it is a little soon to talk about specific possibilities.  This is so for a couple of reasons:

-First, natural gas has showed a tendency to rally in the days leading up to June trading day 11.  So we don’t want to “jump the gun.”

-Second, as of the close on Friday June 15, there will be July options trading and October options trading.  The problem with July options is that they expire on the last day of our bearish period for natural gas (July 20), therefore any time premium that you pay to enter a position in July options will be lost.  

So if you were going to buy a July put you would likely want to consider something deep-in-the-money (i.e., a strike price well above the current price of UNG).  The problem with October options is that because there is so much time left until expiration they will be less sensitive to price movement. 

-So one other possibility is to consider waiting until Monday morning on June 18th because starting on that day August UNG put options will begin trading. 

 

An Example

As I mentioned, it is too soon to make this play, however, the trade shown in Figure 2 and 3 are displayed to illustrate the concept of buying a deep-in-the-money July put option in order to minimize the effect of time decay. 

Figure 2 – Deep-in-the-money July UNG Put option

Figure 3 – Deep-in-the-money July UNG Put option

As you can see in these Figures, the price of UNG is 15.61 and the breakeven price is 15.40.  In other words this position only entails only $0.21 of time premium.  Once UNG drops below 15.40 then the put option position will move point for point with the shares of UNG (of course the put option will be gaining ground as the underlying security is losing ground).  This is essentially like taking a short position in UNG, however, instead of putting up margin and incurring the threat of unlimited risk, the risk in this case is limited to the amount of the premium paid to buy the option ($360).

 

Summary

So this week’s idea almost seems like something of a “dare”.  “Go ahead, bet on a 20th consecutive year of profitability – I dare you!”  Given the tenuous nature of any seasonal trend the prudent thing to do seems to be to use a limited risk options position to play.  At this moment the best bets appear to be a deep-in-the-money (based on the price of UNG near the close on June 15th) July put option or a position in August put options (that don’t start trading until Monday 6/18).

As always, time will tell.

Jay Kaeppel

Staff Writer and Trading Strategist

Optionetics.com ~ Your Options Education Site

 

NOTES:

Interested in covered call writing? Log onto www.MoneySteps.com for a free trial.  Course videos by Tom Gentile and Monday/Wednesday/Thursday Case Study updates by Jay Kaeppel.

 


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