How to Profit from Natural Gas
Changes in natural gas volatility are pointing to a potentially lucrative time to trade the commodity. Prices have fallen nearly 60% in the last two months amid a changing currency environment, supply/demand revisions, and a general bursting of commodities expectations.
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.
Long-term natural gas volatiliy has an average of 45%, whereas short-term (3 month) volatility is currently up to 54%. That information, alone, points to market expectations of more future movement than we’ve seen in the past. However, taking this a step further and analyzing specific contract implied volatilies for UNG, tells us something slightly more profound: the market expects natural gas to move upward..sharply! Looking at September 2008 puts (strike 30) shows implied volatility of 48%, while the same maturity calls (strike 42) show a crazily high implied volatility of 63%! Markets definitely favor higher natural gas movements in the near term.
To play this information we have several options:
Buying UNG is the simplest way to bet on higher natural gas prices.
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.
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