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And so the dwarf star called UNG glows ever dimmer

|Includes: The United States Natural Gas ETF, LP (UNG)

The path of UNG is glowing dimmer and dimmer with each passing day.  New 52 week lows have been printed.  Yet natural gas is still well above 2009's lowpoint of $2.40 on prompt.  UNG is below $6.10 per share as of 10/1/10.  NG is at $3.797, just a smidge below the $3.80 support.  Fundamentals are not looking bullish for NG futures pricing AND if one remembers last winters record breaking year, it sets up some nasty YoY comparables.  NASTY.  If you arent trading NG or just looking at charts of NG, your probably out of your league.  I can name a few "articles" floating about that have serious holes in their views.

The options market on UNG are not pricing in the adequate reflections that can happen to UNG.  The put side of the trades are extremely cheap and heck the shares "do appear" cheap.

Are the shares cheap?  No.  Are the options cheap on UNG, yes. 

Why is there discrepancy between the options market for UNG and the stock.  Most likely the reason that UNG keeps sucking in new investors into its path to singularity or reverse stock split kingdom.   

The options market for UNG is not pricing in contango decay at all into its prices.  For me, its great, I hesitate to even bring this up because hey maybe it will erode the advantage offered out there.

Taking a look option pricing.  January 2011 $6 puts trade for $0.50 on the ask, $0.50, thats its a 8.25% premium?  Give me a break.  Given the possibile downside prices out there on NG futures, $3.40 isnt a stretch to reach at all and is 10.29% lower.  If your long, those puts would save you from lower NG prices and you dont have to worry about contango.

However the fundamental flaw and mass destroyer hasnt even been calculated in yet.  Contango.

Right now, UNG has 3 rolls to face between today 10/2/10 and January option expiration.  Nov-Dec $3.79 to $4.077, Dec-Jan $4.077 to $4.261, Jan-Feb $4.261 to $4.283.

That represents a decay of 13.01%.  It could get much worse, it could get slightly better.  I wouldnt expect contango to be less than 7% for the next two rolls.  It could reach 30% but I think thats doubtful.  A 20-25% would be more reasonable.  I cant predict the weather so I cant predict where contango will end up.  My stance would be flat to higher than flat to lower. 

A way of looking at it is UNG owns $3.797 NG as of 10/2/10 at $6.06 NAV or a ratio of 1.595.  If contango were to stay the same.  UNG would own $4.283 NG at $6.06 NAV or a NG ratio of 1.414. 

So if your paying up a 8.25% premium for the Jan 2011 $6 puts, the fact that 10.29% downside in NG prices or $3.40 could exist very quickly and is probably more likely than most market people are thinking (wide variety of reasons briefly mentioned, this isnt a NG fundamental article as that would take about 50 pages to outline all of the reasons).  The contango right now in the market is 13% as well and this is for sure not being priced into those puts.

The point of this is to be aware of whats going on in what your investing into.  If you dont fully understand the situation or are trying to apply an investing concept on Natural Gas Prices based on a hurricane smashing into the GOM or that brrrrrrr its going to be cold I would strongly urge you to bone up on recent history of NG prices since 2000 and the weather factors that impacted them.    If your trying to apply that same investment concept via UNG then you really need to bone up on spreads and contango.

Or if you want to take a shot at higher Natural Gas Prices do this.  Buy the Jan $6 calls for $0.60 and define your risk that way.  The maximum you can lose is $0.60.  If your already long UNG and have some losses or think you timed the bottom, I would suggest you go buy those Jan $2011 $6 puts for $0.50 and have a guaranteed exit at $6 less the debt of $0.50 for the put protection.

I can see the possibility of higher prices but think weather HAS to not only turn bullish but has to stay bullish all winter long for NG to incrementally creep up.  Upside of NG is probably going to be capped in the low $5's if we have a very bullish (think very cold) winter. 

I honestly think even if a winter like last one were to reappear that the fleeting prices of $6 NG would not occur. 

See both sides of the trade, not just what you want to see.

Disclosure: Currently in OTM Bear call spreads in UNG