Exploiting Natural Gas Volatility

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.

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.

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:

Buy UNG. The ETF is trading for just under 38 per share. There is no dividend, but potential capital gains implied by the market could make this a lucrative bet.

Buy UNG calls; however, given that implied volatilities are so high, you’ll end up paying hefty premiums. To minimize this loss, I recommend buying deep in-the-money (ITM) contracts with a long time to expiration. The January, 2010 contracts look particularly enticing.

Try one of the more complicated, but less risky, option combinations. By simultaneously buying and selling contracts with different strikes you can limit maximum exposure and position yourself on either the credit or debit side of the trade. I personally like bull put spreads or skewed iron condors for making long bets on an asset.

Options markets are by no means magic balls into the future, but they do tell us where the majority of investor sentiment lays. In this case, we know the market expects natural gas to launch into a bull rally. Given how badly it’s been slaughtered in the last two months, this makes sense; however, nothing is certain but death and taxes. I offer this observation in a position of complete humility, only so that you can determine for yourself if you want to adopt any of the recommendations. By how badly I just got my butt kicked in the recent US dollar bull run, I truly mean my disclaimer of “humility.