UNG Short Butterfly

UNG is the ETF that tracks Natural Gas prices. The trade that I am about to illustrate below has more to do with options volatilities and less to do with the actual price action. Thus, I am not including some of the technical analysis I did before entering the trade.

Price Action Analysis
I think the following few lines illustrate most of the major points that are important regarding the price action. Firstly, in the past month we have seen a sharp price reversal followed by a couple weeks of consolidation. I believe the consolidation should end soon seeing as how Winter is around the corner. Natural Gas demand generally increases in the Winter months - that would explain the sharp increase in price in the previous month.

A short lesson in volatilities
I am including this section to explain the meanings of all the different volatilities:

Implied Volatility(IV): An option price can be calculated using a model like the Black-Scholes or the Binomial Model. The implied volatility can be calculated using any of these models and reflects the markets conviction about how much the underlying security will move.

Historical Volatility(HV): The annualized standard deviation of the price in a given period (I have used the 30-day and the 90-day HV).

Historical Implied Volatility: Basically the IV of options traded in the past. Good to compare what the IV of an underlying has been in the past. The difference between HV and the historical IV is that the HV is the actual volatility recorded while the Historical IV is what people in the past thought the volatility would be.

What does this mean in tangible terms? The higher the IV, the higher the option's price. So, if the historical IV is higher than the current IV, it means the options are selling for cheaper today than they have in the past.

Implied Volatility vs Historical Volatility
As I mentioned, the trade below has more to do with my convictions about the option implied volatility than with the actual price action. If you look at the Avg Imp Volatility (IV) chart (which is the average of all implied volatilities for the front month options traded for UNG, weighted by relevance of the option), you will notice that it has plummeted within the last month. In contrast, 30 day Historical Volatility (HV), the annualized standard deviation, has risen and the decline in the 90-day HV has been a lot slower than the Avg Imp Volatility.

The above divergence in HV and IV is what prompted further investigation. I looked at the IV for the option trading in April expiring in July 09, the IV for the option trading in July, expiring Oct 09, and the IV for the option trading in August and expiring in Nov 09. The average IV for these options was 68-70%. Compare that to the IV for the options I traded ( 45%, 46%, and 53%). Clearly, the IV are much lower right now than historically they have been.

Trade Hypothesis
As I mentioned, basically this means that the 3-month out option is trading for much cheaper today than it has in the past. This I found to be weird seeing as how the price has been consolidating and should rise more in the winter.

Thus, I think the option price, in conjunction with the IV, should rise in the coming months. So, using the most basic conventional wisdom, buy low sell high, I entered into the following trade.

The Trade


You can see the actual trade on the chart above (under "Positions and Simulated Trades"). The risk profile shows what happens if the IV stays the same. As I mentioned I expect it to rise so the chart above is the worst case scenario.

My max loss is close to $350 (on 12/11 - I will not be holding this to expiry). I am expecting a max profit of around $500. A realistic profit would be around $300. If UNG breaks above $17 and stays there until Jan, I will make $975.

If the IV stays the same, I have a 47% chance of profit by 12/11. I think a more realistic chance of profit is 60% based on my hypothesis (As a side note, I really need to make a model that lets me calculate probabilities on expected IV).

- Wown
StockJockz.blogspot.com