A New Way to Trade Natural Gas

Includes: GAZ, UNG, UNL
by: Ananthan Thangavel

For the past year, natural gas has been caught in a tight range, trading between 3.2 and 5.25. With all the talk of rising commodity prices and the upward march in energy prices, natural gas prices have not recovered at all since the depths of the financial crisis. Shown below is a five-year chart of natural gas prices:

[Click to enlarge]

Natural Gas 5 Year Price Chart

While natural gas peaked out just under $14, it currently stands around $4.6 and remains mired in the tight trading range of the last year. With no apparent downside or upside breakouts in the price of natural gas, it can be difficult to make money trading the commodity.

At Lakshmi Capital, natural gas has been one of our primary contributors to profit in our global macroeconomic portfolio. How have we achieved this? We successfully implemented an options strategy known as a short strangle.

In a short strangle, the options trader simultaneously sells an out-of-the-money call option and an out-of-the-money put option. To use the current situation in natural gas as an example, a trader would simultaneously sell a March 3.95 put option for $.021 and a March 5.25 call option for $.045. As long as natural gas expires between $3.95 and $5.25 on February 23, the trader keeps the $.066 (or $660) per contract. The trade is profitable as long as natural gas is between $3.884 and $5.316 on expiration.

The advantages of the trade are multi-faceted. Since natural gas is a volatile commodity, options on it are expensive. Since the options have a high implied volatility, selling options can be a profitable strategy. The range required for profitability on this trade is wide, and at least one side of the trade must be profitable. The downside of the trade is if natural gas breaks out beyond the range of the options. Given the $4 level as a psychologically important support level for natural gas, along with the fact that we are in the midst of a frigid winter for many parts of the country, a return to $4 natural gas in the next month seems highly unlikely.

On the flip side, a sustained rally above the $5 level within the next 30 days would also seem improbable. If the trade were to break to the $3.95 put strike price or the $5.25 call strike price, the trader would need to sell or purchase, respectively, a futures contract in order to hedge. Finally, the amount of margin required to implement this trade is lower than would be implementing either side independently because of the fact that one side of the trade must win.

Trading Recommendation

Utilizing a short strangle strategy can help traders take advantage of the increased volatility in markets left over from the financial crisis, and can be particularly profitable given natural gas' range-bound trading. Our recommendation is to leg into this trade by selling calls on days when natural gas rallies hard, and selling puts on days when natural gas falls.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Short natural gas calls and puts