A Time to Buy UNG?

Brace yourself but I am about to discuss an investment. Don’t be too alarmed though because we will be doing some trading around this investment in attempts to generate some alpha.

Investing in Natural Gas is more or less a play on the idea that our global economy will start(continue) to recover and generate organic demand. However, the other ideal thing is if we do enter into an inflationary environment the price of natural gas should benefit. Let’s take a long-term look at the ETF UNG and see what the market is telling us.

This is a three-year monthly chart of UNG. We can see that it has basically been in a downtrend for the past year and a half since we saw crude oil peak in July of 2008 and subsequently entered into recession. Note that the downtrend seems to be breaking. Traders and investors have found value around the 8.75 area for the past few months. Bottoming takes time but I think it makes sense to be a buyer here especially when we can still manage risk and use options to help us generate money while we wait.

You may ask why are we using an ETF that doesn’t even correctly track the actual commodity. The answer is for simplicity. If we wanted we could do this same strategy on natural gas futures themselves and structure our own futures pair trades depending on how we thought the gas would trade from month to month but this makes it much easier. All we have to worry about is buying and holding and our managing of our options positions.

Instead of simply buying the ETF we are going to buy UNG and use some covered calls to help our return. In addition to selling calls I would prefer to use some technical analysis to further help our timing of when to sell our options.

Let’s look at a current chart of UNG:

Structuring the Trade

We could just enter into this investment by simultaneously buying UNG and selling an OTM call against it. However, I am less convinced of the recovery at this point so the lower we keep our risk the better.

Ultimately let's assume I want to put on a 2,000 share position but I will start by putting on a half position of 1,000 shares. At the same time I will sell 10 contracts of OTM calls and 10 contracts of OTM puts.

Let’s look at the front month options:

Assume we do the following:
Buy 1,000 Shares UNG @ 10.32
Sell 10 Jan 11 Calls @ .14
Sell 10 Jan 10 Puts @ .21

By selling the puts we can either automatically leg ourselves into the trade and lower our cost basis or simply collect the premium if they expire worthless.
Remember we must always consider risk FIRST even if we are investing. You should still have a point where you plan to exit regardless of time frame. With this in mind I would put a hard stop loss at 9.48. Even if we are investing we must keep a positive expectancy and it wouldn’t make a lot of sense to hold through a large draw down if we may never fully recover it.

If we are put the stock immediately we will have a cost basis of $9.98. Putting our stop loss at $9.48 we are essentially risking 1,000 to hopefully make at least 8,000(ideally more). This is a 1:8 risk to reward which is good however you look at it. If for some reason we don’t get put the stock immediately we can add our remaining 1,000 shares after it gets over resistance at $11 and raise our stop loss accordingly.

Now we can use support and resistance levels as guidelines for selling our covered calls.

Depending on where the stock is sitting we can sell the correct OTM call with it. Here is where an individual has to decide how active they want to be. You can use calls and puts to help you take profits and get back in by simply selling options on only half your position at a time or you can just keep rolling the front month OTM contract each month. The support and resistance levels I drew in are rough guidelines as there are obviously intermediate levels. Everyone will have to use their own discretion as to where they think the most valid levels are.

Personally, I would rather use some strategic selling to help achieve even better returns but in the long run the difference may be negligible. In the event your entire stock gets called away from you then you can simply just wait to buy it back on a dip or sell some puts to get paid to wait and help lower your cost basis.

Hopefully that helps illustrate a good investment opportunity with an option overlay strategy that will help reduce risk and increase returns. So even if natural gas doesn’t shoot higher here, we don’t mind waiting since we can just sell some options on top of our shares to generate income.

Disclosures: None