Natural gas has been one of the most aggressive assets lately. The ETF that is associated with natural gas (UNG) has gone through three 30% moves in only two and a half months. My opinion is that the rally will not be sustainable, as I wrote in a recent article (Natural Gas: How I Got The Pullback Exactly Right With A Simple Analysis).
However, this article is not about that. The recent wild swings in UNG suggest to me that the price of natural gas is very unstable. Trying to determine the direction of the next move for UNG is simply "unwise" to say the least. But one thing about the next move is rather predictable, and that is the fact that it's going to be quite large -- even by natural gas' standards. In my opinion, natural gas will either go through a severe correction (as was the case in late May 2012), or the rally will accelerate, causing a stampede of bulls and a short squeeze.
As of this writing, the most profitable trade for natural gas is to take advantage of the size of the next move rather than trying to determine the direction of it. A good trade would be the following:
Buy UNG August 17th' 12 17 Call Options for $3.45 and UNG August 17th' 12 22 Put Options for $2.35
Here are some properties of this trade and how it will perform based on the moves of UNG:
- The net out-of-the-money premium an investor pays in this trade is $0.83. The total invested capital is $5.83. The maximum loss on this trade is 14% of invested capital (the loss of the $0.83).
- In order for this trade to be profitable, UNG should trade outside of the $16.2 - $22.8 range, which amounts to about a 15% move for UNG in little more than a month. Each 6% move in excess of the 15% will give this trade an extra 20% profit (650% annualized) on the invested capital. Such a move is a very high probability, in my opinion. And the fact that the maximum loss on the trade is capped at 14% gives this trade a good risk profile.
- Investors who want a higher profit potential and are willing to assume the higher risk can narrow the strike price range. In such an adjustment, the profit potential would greatly increase, but so would the risk and amount of the loss of the invested capital.
- If UNG makes an extraordinarily large move in one direction, the part of the trade that turns very profitable should be sold to realize the profits. The other part should be kept, in case UNG retraces its move and the other side of the trade becomes profitable also.
- While the size of the move necessary for this trade to turn profitable might seem outrageous, and investors might find selling options a better trade, there is a tradeoff to selling options that should be taken into consideration. When an investor goes short an option, the loss on that trade has no cap, and the investor can easily lose a few multiples of the invested capital if the underlying asset makes a large move. That is a risk not worth taking, in my opinion.
I will try to post a follow-up article about how this trade performs and how to adjust it if the expected large move in UNG occurs early on. Investors who find this trade interesting can use the "Follow" feature on Seeking Alpha to get that article.
Disclosure: I am short UNG.