Options - A plan for all seasons

It's interesting to note that despite all the "market-moving" news events of this year - hurricanes, fear of inadequate supply builds for winter, terrorist threats, shipping delays and refinery shutdowns - energy markets have almost uncannily continued to follow their normal seasonal tendencies.

Perhaps this is because although these news stories and macro-economic factors are important, they primarily deal with supply issues. The other side of the equation is demand. The ebb and flow of demand cycles in the northern hemisphere has a massive impact on price direction, regardless of the absolute dollar value at any given time.

Understanding fundamentals

Therefore, understanding the seasonal fundamentals driving natural gas prices in the US - the world's largest consumer - is important. Fortunately, it's also relatively simple. Demand is highest in the northern US states during winter when natural gas is used primarily as a heating fuel, and in the southern states in the summer when it is used as a fuel to produce electricity to meet cooling needs.

It should be noted though, that price tends to rally in anticipation of consumption and not necessarily once the excess usage has begun. This is because distributors wanting to meet higher demand must begin buying aggressively in advance of the actual retail demand season. On the flip side, once this inventory accumulation phase begins to ebb as supply stockpiles are built, prices often begin to decline as supply concerns ease and traders liquidate long positions. Ironically, this often happens just as the retail demand season is getting under way. This is why it is not uncommon for natural gas to post seasonal lows right in the middle of winter and unleaded gasoline to post its lows right in the middle of the travel-heavy summer, at least on the wholesale level.

Energy, particularly natural gas, is following seasonal averages almost to the tick this year. But it should be noted that seasonal tendencies are illustrations of averages and that means that if a move occurs as indicated in the seasonal charts, they can often come weeks earlier or weeks later than the averages reflect. This can make trading them using futures very tricky. But for an option seller, seasonals can be boons.

For a writer of far out-of-the-money puts or calls, being a few weeks early or late is less of a concern. As long as the market stays above (selling puts) or below (selling calls) the strike price, the seller of the options profits. Therefore, an interim move against the seller's position is not necessarily a reason to exit. When selling options, an investor does not have to determine where prices are necessarily going to go. He only has to select a price level where he feels the market will not go.

Sticking to seasonality

Selling options on a market that is adhering closely to a seasonal tendency can be a powerful strategy for an option seller.

This year, natural gas experienced a substantial rally that peaked in late October as Hurricane Katrina (and to a lesser extent, Hurricane Rita) slammed into key natural gas production areas near the Gulf Coast of the US, causing widespread supply disruptions. Ironically, this happened right at the time of year when gas prices tend to exhibit seasonal strength anyway as distributors were busy accumulating inventory for the winter season. Obviously, the hurricanes did not disrupt the normal seasonal tendency, but rather exaggerated it. The fact that injection season coincides with hurricane season is a coincidence that will most likely comfirm, if not intensify, seasonal price tendencies for natural gas, as many weather forecasters believe the US is headed into a cyclical 'active' period for Atlantic hurricanes over the next 20 years.

Nonetheless, the seasonal tendency is for natural gas to begin a steep decline in early to mid-October as injection season draws to a close. And despite the media continuing to beat the bull drums, natural gas prices on the New York Mercantile Exchange (Nymex) topped out on October 5. This was followed by a precipitous decline in prices as concern over supply abated and speculators liquidated positions. Notice that the news stories around natural gas focused on daily stock builds, drawdowns and continued supply shut-ins in the Gulf of Mexico. Yet the normal supply/demand cycles are what ultimately steered prices. This is big-picture trading.

Trading sideways

While there is no guarantee that the market will continue to follow historical tendencies, if it does continue to do so this year, we would expect prices to trade sideways to lower through December. In late December to early January, however, prices have been known to establish seasonal lows and begin trekking higher again. This often begins in the form of a speculator-led buying rally in response to the retail heating season beginning in earnest. The first blast of real winter weather is often a catalyst. However, it is distributor accumulation beginning again in preparation for summer cooling season that has ultimately been responsible for supporting most longer-term price trends into the Spring.

Trading strategies

Traders looking to take advantage of seasonal tendencies in natural gas can consider selling put options below the market in the period where natural gas has traditionally established a seasonal low. A seller of puts sells the option and collects a premium. As long as the price of the natural gas futures contract is anywhere above your strike price at the time of expiration, the option expires worthless and you keep all premiums collected as profits. It may not carry the thrill of fast-track futures trading but from a pure return perspective, it beats trying to predict the market's daily whims.

Selling strategy

Specifically then, for Nymex natural gas futures contracts, a put-selling strategy appears to be a high-percentage means of capitalising on a bullish trend redeveloping in early 2006. The bonus, of course, is that even if the market does not embark on a bullish trend and trades sideways to even moderately lower, a seller of puts can still take a full profit at expiration. He/she doesn't have to be 100% right in the market. He/she only has to avoid being 100% wrong.

And there is an extra bonus this year: at the time of writing, gas storage levels in the US are still 119 bcf below last year. In addition, about 45% of offshore Gulf of Mexico production is still shut in. The US gets about 20%-25% of its total natural gas production from the Gulf of Mexico.

Because the market is heading into winter with questionable supply, we believe it is possible that natural gas prices could eclipse the October highs sometime in the first quarter of 2006, especially if a particularly cold winter takes place in the northern hemisphere.

Fortunately, a writer of a put does not require this to happen to profit from natural gas prices this winter - he/she only needs natural gas prices not to collapse. Given current circumstances, a price collapse seems highly unlikely.

We see natural-gas trading at a high of near $15 per thousand British thermal units (Btu) and a low of $9 per thousand btu through the first quarter. Although this is a wide range, with attractive premiums available at strikes far below - and even far above - these levels, there are opportunities to sell premiums on either side of the market. These should be extremely high probability trades, not only because of the factors above, but because of the level that volatility has reached this year, allowing the sale of far distant strike prices.

So, with present seasonal factors being somewhat bullish for natural gas, we favour the put side. Put options can be sold at strike prices far beneath the 2005 lows for natural gas, which means that as long as natural gas prices stay above their yearly low prices (approximately $6 per Btu back in April), the puts will expire worthless, providing a profit to the put seller holding them at expiration.

James Cordier is head trader and president and Michael Gross is director of research at Liberty Trading Group, a Florida-based futures brokerage specialising in option writing on commodities.

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Web: www.libertytradinggroup.com.