Buying Natural Gas Put Options to Profit from a Fall in Natural Gas Prices

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Contents

Buying Natural Gas Put Options to Profit from a Fall in Natural Gas Prices

If you are bearish on natural gas, you can profit from a fall in natural gas price by buying (going long) natural gas put options.

Example: Long Natural Gas Put Option

You observed that the near-month NYMEX Natural Gas futures contract is trading at the price of USD 5.5150 per mmbtu. A NYMEX Natural Gas put option with the same expiration month and a nearby strike price of USD 5.5000 is being priced at USD 0.3700/mmbtu. Since each underlying NYMEX Natural Gas futures contract represents 10,000 mmBtus of natural gas, the premium you need to pay to own the put option is USD 3,700.

Assuming that by option expiration day, the price of the underlying natural gas futures has fallen by 15% and is now trading at USD 4.6880 per mmbtu. At this price, your put option is now in the money.

Gain from Put Option Exercise

By exercising your put option now, you get to assume a short position in the underlying natural gas futures at the strike price of USD 5.5000. In other words, it also means that you get to sell 10,000 mmbtus of natural gas at USD 5.5000/mmbtu on delivery day.

To take profit, you enter an offsetting long futures position in one contract of the underlying natural gas futures at the market price of USD 4.6878 per mmbtu, resulting in a gain of USD 0.8120/mmbtu. Since each NYMEX Natural Gas put option covers 10,000 mmBtus of natural gas, gain from the long put position is USD 8,120. Deducting the initial premium of USD 3,700 you paid to purchase the put option, your net profit from the long put strategy will come to USD 4,420.

Long Natural Gas Put Option Strategy
Gain from Option Exercise = (Option Strike Price – Market Price of Underlying Futures) x Contract Size
= (USD 5.5000/mmbtu – USD 4.6880/mmbtu) x 10000 mmbtu
= USD 8,120
Investment = Initial Premium Paid
= USD 3,700
Net Profit = Gain from Option Exercise – Investment
= USD 8,120 – USD 3,700
= USD 4,420
Return on Investment = 119%

Sell-to-Close Put Option

In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the natural gas option sale will be equal to it’s intrinsic value.

Learn More About Natural Gas Futures & Options Trading

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

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Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Natural Gas Call Options to Profit from a Rise in Natural Gas Prices

If you are bullish on natural gas, you can profit from a rise in natural gas price by buying (going long) natural gas call options.

Example: Long Natural Gas Call Option

You observed that the near-month NYMEX Natural Gas futures contract is trading at the price of USD 5.5150 per mmbtu. A NYMEX Natural Gas call option with the same expiration month and a nearby strike price of USD 5.5000 is being priced at USD 0.3700/mmbtu. Since each underlying NYMEX Natural Gas futures contract represents 10000 mmBtus of natural gas, the premium you need to pay to own the call option is USD 3,700.

Assuming that by option expiration day, the price of the underlying natural gas futures has risen by 15% and is now trading at USD 6.3420 per mmbtu. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying natural gas futures at the strike price of USD 5.5000. This means that you get to buy the underlying natural gas at only USD 5.5000/mmbtu on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying natural gas futures at the market price of USD 6.3423 per mmbtu, resulting in a gain of USD 0.8420/mmbtu. Since each NYMEX Natural Gas call option covers 10000 mmBtus of natural gas, gain from the long call position is USD 8,420. Deducting the initial premium of USD 3,700 you paid to buy the call option, your net profit from the long call strategy will come to USD 4,720.

Long Natural Gas Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 6.3420/mmbtu – USD 5.5000/mmbtu) x 10000 mmbtu
= USD 8,420
Investment = Initial Premium Paid
= USD 3,700
Net Profit = Gain from Option Exercise – Investment
= USD 8,420 – USD 3,700
= USD 4,720
Return on Investment = 128%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the natural gas option sale will be equal to it’s intrinsic value.

Learn More About Natural Gas Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Trading Natural Gas Options

Options allow traders to leverage their bets on the underlying assets represented by the option. These handy financial instruments can be used to trade stocks, bonds, currencies, and even futuresand commodities. In this article, we will focus on the basics of trading natural gas options.

Overview

Unlike options to sell or purchase stocks, where the option can be executed in exchange for the underlying asset directly, natural gas options are exercised into futures contracts that represent natural gas contracted for delivery. This is not something a trader should lose sleep over, as a futures contract is as much of a security as a stock certificate.

In practice, natural gas options operate like every other type of option, with a call representing a long position and a put representing a short position. While a trader can go full bull or bear by buying one or the other, it is more common to use strike prices to create a spread over which the combined options can yield a decent return with controlled risks. Of course, once you start combining calls and puts in a range of strike prices and factoring in the time limits, you can end up with complex strategies that sound like failed 80s hair metal bands, such as the “iron condor.”

Influences on Natural Gas Prices

All directional bets like bear spreads and bull spreads, and even neutral strategies like the butterfly spread, require a trader to have an idea about which way natural gas prices are going, based on available data. For options on US natural gas, the US Energy Information Administration (EIA), is the place to get all the information on supply levels, production, and variation from historical norms. The EIA also tracks imports and exports of gas. While the International Energy Agency is a source for tracking production changes abroad.

It is not all about supply and production, however, as weather can be a wildcard that throws off forward-looking projections. For example, hot summers can drive up natural gas prices as more energy is consumed to power air conditioning. The price of oil also has an impact, as the equipment can be shared and the same companies may be exploring and producing both oil and gas. For instance, the shared technological advance through hydraulic fracturing has increased the production of both oil and gas in the US, driving down the price of natural gas during times when it would have traditionally risen.

The Bottom Line

Natural gas options and the strategies used to trade them are the same as for any other option. The difference, and the main challenge for traders, is that the factors that influence natural gas prices are those of a commodity rather than a stock. There are no quarterly earnings numbers to cause volatility at set intervals, nor a single CEO hiring or firing that will show up on the price chart. Trading natural gas options requires getting familiar with the EIA reports, liquefied natural gas (LNG) export numbers and so on. Once you have the data, there are multiple strategies that can be used to profit from the expected directional change or price volatility/stability.

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