Natural gas has been utterly decimated since early July, dropping 60% from its high. There are several good reasons for the decline: a strengthening dollar, new supply and demand expectations, and bursting of a commodities bubble. Volatility is a scary thing, but it is the bread and butter of the savvy option investor. There are several ways to play natural gas that can more than pay for your winter heating bills.
My favorite way to play commodities is by using exchange-traded funds (ETF’s); in this case, UNG. Trading futures contracts can be far more lucrative, but comes with a commensurate amount of risk. For the small investor, I recommend sticking to ETF’s. They offer representative price movement with far less risk.
A quick and dirty way to gauge how the market expects an asset to move is to analyze the implied volatility of options contracts. In the case of natural gas (UNG), calls are priced with IV of 63% compared to put IV of 48%. These are both higher than long-term historical volatility, so it’s safe to say the market thinks something’s up. It’s hard to tell what that something is, but with the majority of market participants betting on the call side, guessing that prices will move higher is a decent way to go.
There’s multiple ways to take advantage of this information:
Simply “go long” natural gas and buy UNG.
Buy call options on UNG. I recommend buying longer term calls, starting with Jan10 contracts. Buying options at or in-the-money (ITM) will reduce time premium and contact some element of intrinsic value. I recommend going this route, perhaps looking toward the 37 and below strike calls.
Consider more complicated options strategies, such as ratio spreads, iron condors skewed on the long side, and bull put spreads. These all involve limiting total position exposure by simultaneously selling short and buying long contracts of variable strikes. I’m a fan of credit spreads, in which you are paid up front for opening the position and keep the premium if the asset expires within your desired range.
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.