Unlocking natural gas’ downside risk with options

Natural gas (NYMEX:NGQ13) is one of the most popular types of fuels in generating electricity to power homes and factories, and the summer is usually the commodity’s peak as individuals and businesses use the fuel to power their air conditioning to battle typically high summer temperatures. For example, last summer much of the United States experienced a massive heat wave and some of the hottest temperatures in recent years. This caused natural gas prices to rally by more than $1.00.

However, this has not been the case so far this summer. The majority of America and Europe have been experiencing relatively mild weather, and natural gas prices have taken a beating as a result.  The commodity, which is largely used for gas-fired electricity to cool homes and businesses, has had a drastic decline recently with prices falling by 7.27% this past month to current levels of $3.62. While natural gas prices are up almost 30% on the year, it has been a very disappointing summer for investors in natural gas related stocks as prices have fallen considerably since reaching a 52-week high of $4.52 in late April. The current price of natural gas is just above its 52-week low of $3.35, which was reached in February.

The temperature forecast doesn’t look like it is going to change either as many weather outlets are predicting further cooling toward the end of July. The cooler temperatures will be felt strongest in the Northeast, which will hurt demand for the commodity even more due to the high population concentration in that region. With lower demand for natural gas, expect a continued decline in the price of the commodity in the foreseeable future.

So how can a trader speculate on a lower natural gas price?

  1. Trade the ETFs. UGAZ, DGAZ, UNL, UNG and NAGS are all exchange-traded products meant to track the price of natural gas. These products do not track the price of the commodity as well as futures and are also capital intensive positions to take on.
  2. Natural Gas stocks. Trading stocks that have exposure to the price of natural gas can allow a trader to take a view on forward prices, this, however, is capital intensive and has the lowest correlation.
  3. Natural Gas futures and options. The cleanest way to trade the price of natural gas. This is also the most capital efficient way to take a view on prices.

With October options implying a move of around .40 we can calculate a downside target. With futures trading at $3.68 this gives a target of $3.28 by October expiration.

Trade: Buying the /NG Oct 3.4-3.35 Put Spread for 0.013

Risk: $130 per 1 lot

Reward: $370 per 1 lot

Breakeven: 3.387

The trade sets up for an almost 3 to 1 return on invested capital with a more conservative target than what the options market is implying.

Click to enlarge.

About the Author
James Ramelli

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.

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