James Cordier

About the Author James Cordier

James Cordier is the author of McGraw-Hill's The Complete Guide to Option Selling, 1st, 2nd and 3rd Editions. He is also founder and president of OptionSellers.com, an investment firm specializing in writing options for high net-worth investors. James can be reached through his website at www.OptionSellers.com where a free guide to selling options is available to qualified investors.

Natural Gas Price Rally Makes Selling Call Options an Attractive and Fundamentally Sound Strategy

I’ve been asked if I favor the short side of markets – a perpetual bear regardless of price or momentum. The answer is absolutely not. In fact, I’m starting to turn bullish on a basket of commodities this summer (don’t miss our piece on the Cattle market in your July Option Seller Newsletter) However, the research you read here is mostly for public consumption. For that, we try to keep the focus on overpriced options. And more often than not, overpriced options tend to be (but not always) found on the call side.

If you happened to catch our interview with Mark Sebastion in last month’s newsletter, Mark pointed out that at any given time, 50% of options are overpriced, 30% are fairly priced and about 20% are underpriced.

Options tend to get overpriced when public interest and speculation enters a market in a big way. These can be especially ripe opportunities for option sellers when these speculators bid the price beyond levels that fundamentals support.

Which brings us to this month’s Natural Gas market.

Natural Gas: Folklore vs. Fact

It is a common myth among novice futures traders that you buy natural gas at the beginning of summer because increased demand for electricity from US air conditioning needs will spur demand for the natural gas that fuels many electricity generating plants. While this is a massive over generalization of price forecasting (as is most trading folklore), it is grounded in fact.

The US does get a bump in natural gas demand in the summer as electricity use does spike and demand for natural gas does increase. But it’s a mild increase and represents a mere blip in comparison to the winter seasonal in which demand surges for natural gas heating needs.

But it is not the size of the demand jump that really matters to price. What matters most to price is where supply is in relation to that demand. It’s in this equation that the novices most often get it all wrong.

Natural Gas Consumption

Despite common market “wisdom,” natural gas consumption in the summer is relatively light.

The Real Seasonals of Natural Gas

Common sense would seem to dictate that prices should rise as retail demand increases. But seasonal price forecasting is rarely so simple in commodities.

The fact is, seasonal price strength tends to occur in the Spring as distributors replenish inventories that have been depleted through the winter. This is high demand season on the wholesale level – from which commodities most often take their price cues.

By the time summer arrives in earnest, this accumulation phase is well underway. Prices will tend to begin falling as wholesale inventories start to build. Thus, in natural gas,prices will tend to peak when wholesale supplies are lowest (in late Spring) and bottom out when wholesale supplies reach a peak (in early Winter.)

This is why it is not uncommon to see natural gas price weakness begin to enter the market in June and price strength appear in December. The seasonal chart below illustrates this tendency clearly.

Natural Gas 15 yr Seasonal Chart

Natural Gas Prices tend to peak in late Spring and decline as inventories build into winter.

The Fundamentals of 2016 Natural Gas

June of 2016 finds the Natural Gas market firmly in the grip of a supply glut. The latest IEA inventory report shows current inventories at 2.972 trillion cubic feet (tcf). This is a record high for this time of year. The chart below illustrates 2016 inventories in comparison to historical highs and lows for different times of year. Note also the cyclical trends in supply discussed previously.

EIA Working Gas in Storage Current Yr vs. Historical Highs and Lows

2016 Natural Gas Supplies are at historic highs for this time of year.

Opportunity for Option Sellers

With supplies at historically high levels and a strong seasonal tendency for weaker prices during the summer months, natural gas have nonetheless spiked in the opposite direction in June. This could be the function of a late “last gasp” seasonal top. But it’s also likely due to speculators entering the market ahead of “air conditioning season.” 2016 has seen bouts of warm weather this Spring. And with temperatures predicted above normal for the remainder of June, buying into the air conditioning storyline gets easier for headline driven specs.

This week’s EIA storage report added an extra boost to speculative furor with a less than expected injections into storage. Injections were reported at 65 billion cubic feet (bcf). With expectations for a 79 bcf injection – the bulls took this as another sign that lower supplies and higher prices are ahead in the natural gas market.

But they are not looking at the bigger picture. Overall supplies are at record levels – 32.1% above the average for this time of year, seasonal tendencies overwhelmingly favor bears and the market appears to be perilously overbought.

Nonetheless, the latest spike upwards has brought a surge in both volatility and call option premiums. That makes selling call options an attractive and fundamentally sound strategy at present.



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