This Bonfire Night update on our 2021 Natural Gas (NG) position trade explains why our existing NG exposure is being maintained even though the price has run up a lot. We will discuss how the seasonal factors and option pricing skew have persuaded us to add to the position trade and hold through Winter 2021. However due to the high price rise, we will only be adding option trade overlays that take advantage of the higher option volatility on the Natural Gas ETF (UNG). If UNG runs higher then these new option trades will make money up to a target strike – but if UNG stays the same or sells off then they will expire worthless.
Natural Gas Winter 2021 – Existing Position Trade
The existing NG position has already been quite profitable. To recap the existing position trade has two main parts 1) 50 contract Aug/Sept calendar spread – that is short $15 Aug 2021 and long $15 Sept 2021 pair for total cost of $0.22 and 2) 50 contract long underlying LEAP call Jan 2022 $11. See the previous long natural gas since Q1 2021 post (from July of this year) for all of the background to how these UNG positions were traded starting in March 2021 . Anyhow as luck would have it, in August 2021 the NG market pulled back and allowed the short UNG Aug $15 call (the short call in the calendar spread) to expire worthless. Fortunately the market rallied back strongly in Sept 2021 because the only remaining position from the calendar spread was the long Sept $15 Call. This call ended up $2.65 ITM with UNG $17.65 on Sept 17th. This meant that there was a market enforced trading decision to make with following possibilities:
1) Sell to close $15 Sept 2021 call for an immediate profit.
2) Roll into another call in a future month (e.g. Dec 2021 or Jan 2022) further out in time. The term “Rolling” here means sell to close the existing call, then buy to open the new call.
3) Deliberately get assigned UNG at $15 and create a new ETF position
Normally we would consider the original Aug/Sept calendar spread as one self contained trade, and simply close for a nice profit (option 1). However we decided to push the envelope, and keep UNG trade on since it was acting very bullish. Hard to know where the top is in a strongly rallying commodity. Commodities can tend to have blow off tops, when supply/demand move to extremes. This isn’t obviously a guarantee for a similar blow off top high in NG, but the chart pattern is similar. historically NG can rally very fast. So on balance decided to maintain the larger position.
The issue with maintaining position was that option volatility was very high. This meant that rolling (option 2) would have required purchasing $2 or $3 of pure time value to roll to similar $15 strike in Jan 2022. So rolling long calls when volatility is that high is not desirable, even if it is more capital efficient (than just buying the ETF outright). UNG would need to rally about 20% by Jan 2022 just to break even.
Therefore decided to go with getting assigned at $15 and creating a new UNG share position (option 3). Deliberately did nothing until Sept 17th expiration Friday, then as UNG closed over $15 our account got assigned on 5000 shares UNG. As a reminder – one option contracts controls 100 shares, so 50 contracts x 100 shares = 5,000 shares. The trade was already in the money with some profit, so that gives some buffer before losing money on the actual ETF position (if UNG were to pull back). However this requires using $75k cash to buy 5000 shares at $15. The brokerage will assign ITM calls automatically, so on the Monday after expiration will be long 5000 UNG shares. This did not require purchasing any time value with options because a stock or ETF position has no time decay (no theta value). Sometimes it is “ok” to use ETF (or stock) to compliment the overall position, specifically because ETF positions don’t decay with time. It also allows selling options against the stock to bring in some time value.
The overall position is now 5000 UNG and 50 Jan 2022 $11 calls. This combined position has a delta of nearly 100, because the Jan call is so far ITM it is trading almost equivalent to a stock or ETF position. Stock or ETFs always trade with a delta of 100 because they are the actual underlying for any derivative option (and have no time decay). Therefore the overall UNG position here is almost equivalent to 10,000 shares. The average price of the new long UNG 5,000 shares is about $15.22 (including the profit from the expired short Aug call). The average price of the Jan 2022 $11 call was $0.94 so UNG can pull back to about $11.94 before that starts losing money. For simplicity this ignores any time embedded value in the call – in reality there would always be some time value in the call – unless it was the final trading hours into Jan 2022 expiration. Getting back to estimating the breakeven point – this gives us an approximate break even point of $15.22 + $11.94 / 2 = $13.58 for this unrealised long UNG position. This is a very aggressive position sizing, however this is an example of pyramiding into winners – which we are trying to do as improved trading discipline (but it is surprisingly hard to do). We are hoping to get a market top at higher prices, and are willing to let the underlying unrealised profit thrash around. Hopefully it will go higher, because the trend is up. Keeping one very successful unrealised profit trade open is very hard to do physiologically. The pull backs always feel difficult to hold through, because always pricing relative to the latest price peak. For example, “if we’d sold last week, now we’d have $20k more than today”. The issue is that if you sell before a big move is fully realised, then you likely aren’t getting back in – no matter how good your technical analysis is at identifying top and bottoms. We are attempting to apply the trading logic from Reminiscences of a Stock Operator – “The big money was not in the individual fluctuations but in the main movements – that is, not in reading the tape but in sizing up the entire market and its trend.” and “It never was my thinking that made the big money for me. It was always my sitting.”. There is no guarantee that NG will hold up and has a history of huge sell offs, however if don’t hold then are foregoing possibility of very large gains.
Natural Gas Winter 2021 – Call Volatility Skew
In additional to the winter seasonality advantage, the overall position trade is being maintained partially because the near term options skew to the upside. As NG is entering into Q4 2021 there is significantly implied volatility in near month options indicating that potentially a much higher price move is still quite possible. Additionally there is currently an incredible call option upside skew, when compared to put options.
The following is the Dec 2021 UNG option chain on 26th Oct 2021:
With UNG at $20.40 comparing the 30 delta calls and puts for Dec 2021 (53 days time) shows a huge call skew. The option market thinks that UNG has a 30% probability of closing at $18 to downside ($18 put with 0.3067 delta) or $32 to upside ($32 call with 0.2970 delta). To put this another way – UNG options were implying in 53 days time that a $2.40 move lower had the same 30% probability as an $11.60 move higher. That is a 4.8 to 1 upside skew in calls versus puts at the 30 delta option! This level of skew is not normal, so we may be able to structure some short option strategies to take advantage.
Since the main position trade consists of long stock and deep ITM calls, we can change option strategy to take advantage of high volatility. Additionally would like to be greedy and make even more if UNG rallies into winter 2021. However do not want to add significantly more capital into UNG. Therefore will look at very wide 2:1 ratio call spreads, partially financed by way OTM short puts.
Both of these high volatility option strategies are available with option legs a long way OTM because UNG volatility is over 100%. As the following 1 year chart of UNG volatility shows – implied volatility has been over 100% at some points in Oct 2021, peaking around 120% in early October with a low point of around 90% in mid October.
The trade construction is Buy 50 contracts of a call at high OTM strike, then sell 100 contracts at even higher strike. This a 2:1 ratio call spread is called that because the number of call contracts at the higher strike is usually double the lower strike – in this example a 100 contract: 50 contract ratio call spread. The 2:1 ratio call spread is typically placed for small credit or debit, then idea being to get the 100 contracts sold to approximately pay for the 50 purchased contracts. It can be hard to find match the exact strikes for an even money (no credit or debit) so often there is a small debit or credit.
To help pay for any debit incurred and to maintain a small positive theta (time decay) in the position, we will also look to sell an OTM put for a small credit. The 2:1 ratio call spread is better added as a compliment to an existing bullish ETF position in a high volatility environment because the strikes can be placed further apart. The further apart the strikes, the more profit potential.
For example this trade was done in the Nov 19th 2021 option expiration cycle with long 50 call contracts at $30, short 100 call contracts at $38, and short 50 put contracts at $13. Note this option structure means that have to deliver 5000 shares at $38 because of the extra 50 contracts short – however this is fully covered because we already own 5000 shares.
This was repeated on Dec 2021 option expiration cycle with long 50 call contracts at $28, short 100 call contracts at $38 and short 50 put contracts at $12. This option structure was also fully covered because we already own the 50 call contracts Jan 2022 at $11. Should UNG reach $38 at Dec expiration we would be able to deliver the 5000 shares (via the 50 contracts of the Jan 2022 calls).
These are covered positions on the upside, but with an another important kicker. If UNG closes over the $38 at Nov expiration, then profit would be equivalent to a close at $46. The embedded call spread (long $30, short $38) would be worth $8. So having to deliver ETF stock at $38 (from the $38 call), would be give an equivalent exit price of $38 (short call strike) + $8 (embedded call spread max value) = $46.
This logic would also repeat for Dec. If UNG closes over $38 at Dec expiration, then profit would be equivalent to a $48 closing price. The embedded call spread (long $28, short $38) would be worth $10. So having to deliver ETF stock at $38 (from the $38 call), would be equivalent exit of $38 (short call strike) + $10 (embedded call spread max value) = $48.
If this very bullish scenario were to take place, then it could be possible to maintain the position by do some rolling adjustments nearer to Nov or Dec expiration. However if UNG was massively over $38 it would probably just be simpler to let the entire option structure expire and take the full position profit.
On the downside the short put is cash secured, and is definitely a downside risk that would need to managed if NG drops significantly into winder 2021. This is a possibility, because anything can happen in the market, but not likely. However on trade entry the short put had an 11 delta, which means that it has an 89% chance of expiring worthless at Nov or Dec expiration. A short put trade seems worth the risk, since we are bullish on NG price (it should maintain over $13 by Nov option expiration) and bearish on NG volatility (think volatility will decline from current elevated levels). Short 50 contracts in Nov expiration at $13, and short 50 contracts in Dec expiration at $12. These short put credits help finance the slightly debit for the 2:1 call ratio spreads.
One nuance to the put selling approach is that they are diagonal at lower strikes the further out in time they go. The Dec $12 strike is lower than the $13 Nov strike. This is to allow for market probabilities to play out into Dec (50+ trading days to expiration) and Nov (only 30+ trading days to expiration). There is more time for the a down move to occur by Dec, so it makes sense to sell a lower strike in Dec than Nov. Either way the probabilities are similar, because on trade entry both Nov and Dec short puts were around 11 delta.
As the 2:1 ratio calls and short puts have been held for several trading days, the market has moved down from Oct 20th to Oct 26th. However the Nov short put is now almost worthless. The volatility in the calls has reduced, so that the $38 short calls have made money and more or less cancelled out the loss of the $30 call. This entire structure of $30/$38 2:1 call ratio and $13 put short, should expire for an approx $600 profit – if UNG is above $13 by Nov expiration.
Similarly the Dec structure volatility has reduced, however the Dec options still have some bid, because the chances of UNG being able to move to option strikes by Dec is more likely. These Nov and Dec 2:1 call ratios will be maintained until expiration, as they represent a “free shot” at UNG being over $30 in Nov and $38 in Dec (with no incurred cost). If a price near $30 ever happened the calls would jump to life again, even if they have a very low probability and so a low price today. This is “ok” because the market paid the premium of the lower call for us as they were financed by the 2 short calls – which is why it is a “free shot”.
Natural Gas Winter 2021 – Speculative Butterfly
Since there will be a $30 call held until 19th Nov expiration, we wanted to add a small speculative long, but with low risk. So we bought in the Nov 26th weekly cycle a 50 contract butterfly $24.5/$30/$35 for $0.29 – total cost about $1500. Normally don’t pay for premium, but considered it partially financed by the short puts from the earlier Nov/Dec trades. It is total speculation, but would be more likely to hit (as only 20% OTM on trade entry). The maximum theoretical gain for this new speculative trade is exactly $30 on 26th Nov and would be about $28,500. Sometimes added a butterfly in high volatility as a compliment to an existing position gives something to focus on in the next expiration cycle, while waiting for the main underlying UNG position trade to play out. This gives some entertain while waiting for the underlying UNG position trade to hold into Dec 2021 and maybe longer in Jan 2022.
Natural Gas Winter 2021 – Summary
Natural Gas (NG) price has consistent seasonal drawdowns typically in winter for home heating from November to March. In 2021 there are potentially a sharp spike in near term prices, because of recent inventory dropdowns before coming into the typically higher demand winter season.
A good source of fundamental NG news is naturalgasintel.com. Despite fundamentals pointing to warm weather in Nov, NG is flat for October (albeit with huge amount of volatility in a range). The lack of significant decline in October in the face of bearish warmer weather could be seen as bullish for rest of 2021. The following summary chart shows UNG price action and volatility in context of the last year’s trading:
This was an update on how to lever up the existing LEAP call and ETF position, using options to potentially increase position trade return. The aim is to maximize return from a commodity price spike over the next 1 to 3 months over Winter – this is not a forever long term hold. The trade exit for this will possibly be in Dec (to close year end trading nicely) or maybe by Jan 2022 (for 2022 taxes). Not entirely clear if this becomes a structural bull market for NG in next few years (and we accidentally bought the bottom). More likely scenario is that NG supply is tight and demand is up in winter 2021, so better to sell into any major price spikes in Dec or Jan. The underlying NG future (near month Nov) is around $6, so if there was a spike towards $10 then traders would probably look at double figures as a logical point to take profit. When trading UNG it is important to look at underlying /NG futures because that is where the majority of NG trading is done. UNG ETF does trade in a liquid way, but it is not the entire market. Price targets and support/resistance in UNG will not impact trader sentiment as much as price targets being reached in the /NG futures. In short /NG futures drive the NG market, not UNG ETF. UNG can also experience much more volatile trading days leading into monthly /NG future expirations. So knowing the exact monthly /NG future expiration dates can explain UNG moves.
In summary we are maintaining position trade over many months, and complementing it with option strategy overlays to hopefully boost returns. The intent is to be long into year end and re-evaluate along the way. The position is bigger than usual with “high conviction” . The position has been correct for several months now, so some amount of unrealised profit volatility can be tolerated. the position will likely ultimately be stopped out by short calls meeting profit targets.