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How to Profit from UNG's Volatility


Share-issuance concerns need to be resolved.

When last we checked, the SEC was examining whether United States Natural Gas (UNG) could issue new shares to meet the demand for -- well, new shares.

So far, nothing. But the options still trade -- quite actively, in fact.

Steven (not Stephen) Sears takes a look in Barron's Striking Price.

"UNG's number of outstanding options contracts is nearing two million. Most of the trading involves buying options to profit from an increase in the underlying ETF's price, or to hedge ETF positions because of concerns UNG's growth may adversely influence performance, says Sveinn Palsson, a Credit Suisse derivatives strategist.

"Contributing to UNG's popularity, Palsson says, is that natural gas has 'thus far completely missed out on the rebound in other commodities.'

" 'More importantly, though,' he adds, 'as classic asset allocation -- diversification theory -- has come under pressure for its failure during the recent crisis, natural gas is showing low correlation to other assets.'

"Serendipitously, UNG's implied volatility is elevated, which lets 'buy-writers' pocket a hefty premium while positioning for an increase in natural-gas prices and hedging their portfolios.

"UNG's 3-month implied volatility recently traded at 22.4 points higher than one-month realized volatility. Translation: UNG options are pricing in a big move over the next 3 months even though UNG's float -- the number of outstanding shares -- is stuck.

"To monetize UNG's rich volatility, Palsson likes selling an October 15 call against UNG stock. This works for investors who own UNG, or who would like to buy UNG."

The 10-day HV has picked up a bit this week, but it looks more like a function of one strong day in the stock than anything else (UNG was up about 8% on Thursday).

But I like the idea. Generally when you see a volatility pop, it's way more pronounced in the front months; the back months lag considerably, and anticipate mean reversion. The term structure in UNG is remarkably flat, however. And pumped.

180-day duration options trade at almost an identical volatility to 30-day options. You see that when volatility looks normal. But that's not the case here.

Of course, UNG itself can't be normal until it resolves this share-issuance situation. Not to mention the root of the problem -- namely, the fund creators need to keep rolling out futures (well, swaps, but they ultimately translate to futures) -- and they've gotten so big that they size out the marketplace.
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No positions in stocks mentioned.
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