Monday, September 21, 2015

UNG Analysis: Trading low volatility

Update 12/6/2016: After I entered my diagonal spread, a covered call equivalent, on UNG in September 2015, it continued a relentless recline into March of the next year, moving in tandem with the global fall in crude oil. From there it partially recovered, but never enough to return to profitability.

I sold the long leg of the diagonal today for a loss, both on the long options themselves and on the position as a whole.

Shares declined by 23.7% over 441 days, or a -20% annual rate. The options position over the lifetime of the diagonal produced a -16.6% loss on debit for a -14% annual rate.

What could I have done better? The strike on the long leg was $12. I sold my last short leg in late January, when the stock was trading at about $8. It declined down to about $6, then rose into July, reaching $8. It moved sideways from thereon until October, when it gained more volatility with a sharp decline.

Lesson #1 is that I didn't really have a good exit rule. The nature of covered calls and diagonals, like all net long strategies that I've encountered, is that hope springs eternal. There's no clear point where I can say, "It's over", and thrown in my hand.

Lesson #2 is that I failed to take advantage of the rise from January. It would have given me some trading opportunities, even though the premium would have been quite low, given the price decline. Alternatively, I could have rolled forward the long call, taking a big loss but giving myself more premium from selling the short leg. That's 20-20 hindsight, of course. Who knew what UNG would do from January onward? Not I.

Lesson #3 is that I should have exited the zombie long leg sooner. I kept hoping for a continued rise, which never came, and the position reached a point where time decay, the evil master of all long options positions, began eating away at the value significantly.

The good thing about failed trades is tht they given an opportunity to learn. This has been a valuable set of lessons.

United States Natural Gas Fund (UNGs) is a commodity pool based on natural gas futures. UNG broke below its 20-day price channel on Sept. 18 but was rejected for further consideration because of low implied volatility relative to its one-year range.

I'm reconsidering UNG as a candidate for a covered call using the LEAPS variant, which replaces the shares of the long leg of a covered call with LEAP, defined as options that have a year or more before expiration.

[Natural gas prices in Wikipedia]

Volatility and Strategy

My most used strategy relies on  high implied volatility for success. There is, however, a whole universe of low volatility creatures creeping through the underbrush of the market ecosystem.

My daily analysis that identifies potential trades based on their price channel breakouts, reported daily in my "Prospects" posts, screens for the historical odds of a channel breakout -- a trading signal -- producing a profit.

I consider high-odds breakouts as candidates for directional positions, such as a short vertical spread,  and low-odds breakouts for non-directional positions, such as short iron condors. I also look at where implied volatility stands relative to the high and low of the last year, expressed as a percentile of the range.

In my work so far I've rejected trades on stocks having low implied volatility. My goal with this analysis is to add the low volatility stocks to my universe of potential trades, rather than rejecting them out of hand.

One of the most reliable strategies around is the covered call, in which the trader sells calls and holds shares as insurance against the call being exercised. A call options is a contract to buy stock at a stated price. If I sell a call, I'm promising to sell the buyer the shares at the price on the contract. With a covered, my ownership of those shares enables me to know in advance what it will cost me to meet that contract.

Shares, of course, are very very expensive. To sell a covered call on the S&P 500 exchange-traded fund SPY, for example, I would have to buy 100 shares for $19,682, and then sell a SPY calls for $362 each month for the income. That's a lot of money to put into one position, money that could be used profitably in other ways.

My insurance, however, doesn't have to be shares of SPY. It can be a call option contract where someone promises to sell me the shares at a given price. If my short call is exercised, then I turn around and exercise my long call, providing me with the shares to meet my obligation.

Options lose value with time. The shorter their remaining lifespan, the quicker the time decay. It is in my interest, in choosing an option for the long leg, to select one with much time until expiration.

LEAPS are options that are a year or more away from expiration.

But what am I looking for in the underlying stock?

Covered calls, whether using shares or LEAPS for the long leg, make money if the price stays pretty much the same. A strong rise causes the short leg to lose value, and a strong fall causes the long leg to lose value.

So I'm looking for symbols that have a tendency to not follow through on their trading signals. That points toward UNG, which has had only one profitable bear signal in the past year, out of seven attempts.

I'm also looking for low volatility, which tends to occur with stocks with fairly stable prices.

With the LEAPS variant, as with any covered call, the goal is to hold the long leg over time, allowing numerous opportunities to sell short-term calls against it.

That's the goal. Now let's see out it works out in practice.


I shall use the OCT5 series of options, which trades for the last time 39 days hence, on Oct 30, for the short leg and the JAN 2017 series, which completes trading 487 days from now, on Jan. 20, 2017.


UNG has completed seven bear signals in the past year. Only one was profitable, and six lost money. The successful signal yielded 18.5% over 44 days. The unsucessful signals on average lost 4.6% each over 19 days. The success rate is 14.3%.


Click on chart to enlarge.
UNG 1 year daily bars

On the chart above, the break below the price channel is circled in yellow.

Implied volatility stands at 37.8%, which is 1.8 times the VIX, a measure of volatility of the S&P 500 index. UNG’s volatility stands in the 12th percentile of its annual range.

The Trade

For the long leg, I shall buy the $12 calls, expiring in Jan. 20, 2017. The premium cost is $2.50. For the short leg,

Short the $12.50 calls
sold for a credit and expiring Oct. 30.
Probability of expiring out-of-the-money


The premium is $0.36. The stock at the time of purchase was priced at $12.13.

Decision for My Account

I've opened a LEAPS-based covered call on UNG as described above.

Note: After opening the position, it struck me that this strategy will work best on bullish breakouts, not bearish, since a bearish breakout with low historical odds of success will tend to reverse to the upside, moving the short call into unprofitable territory. Oh, well. I shall manage the position aggressively as I see how it works out. Basically, its a race between a whipsaw and time decay.

-- Tim Bovee, Portland, Oregon, Sept. 21, 2015


My volatility trading rules can be read here.


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Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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