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Option trading in practice – Weeks 14 and 15

16 Aug 2018,

Dear Readers and Traders, in this article I want to summarize our gas trading activities, show you the changes in the portfolio as well as the conclusions we have made in our models regarding the temperature adjusted balance between supply and demand. Also, I would like to thank you for a number of very good suggestions, ideas and information that you have sent me. I made from them some important conclusions that I am going to describe at the end of today’s article.

 

 

Summary of the week

Since last week, natural gas has grown steadily, shifting our portfolio back to the negative numbers. Although gas prices reached its maximum since our strategy was launched, the portfolio is roughly 2% higher than was at its minimum.

Obr.1: Account Overview

Figure 1: Account Overview

 

Changes in the portfolio

Now the prices of the nearest futures contracts are around 2.95 USD / MBtu, which is a level where we no longer mind having larger part of our gas portfolio in short. For this reason, we will maintain our short position ETF: KOLD on a similar levels and we will roll the ETF: KODL  positions ideally in horizontal direction.

Last week we made several changes in the portfolio in respect to above mentioned. August options for BOIL with strikes 26 and 27 were rolled horizontally for one month later with a credit of USD 80, that is an average of about 20 cents per contract. August’s BOIL option could have been rolled for a month and strike later also credit-wise, so we did not hesitate to roll it up rather than roll it horizontally.

2 options for August on KOLD were closed with almost full 15 cent profit and we opened two new September options with a strike of 39 for one dollar each. We opened the new third option on KOLD with the August expiration and strike of 37 for 60 cents (if the gas goes up or stagnates, this option will make a full profit and will hedge other positions, if the gas will go down, the time premium will disintegrate and we will roll it for September). By the third one – at the money options on KOLD we compensate our short on UNG, where we now have an exposure of about $ 20,000.

We would also like to show how our total delta of the portfolio have changed since the last update. Now we have increased the short on gas to about 50% of our account, compared to just 7% three weeks ago. Much of this movement in our exposition has taken place due to the change in the delta of the options and it is consistent with our statement from the past: that we want to build more positions near 3USD / MBtu.

Obr.2: Souhrnná delta portfolia

Figure 2: Summary of the portfolio´s delta

 

 

Model of temperature-adjusted balance between supply and demand

Why do we still believe in a drop of the natural gas prices and why are we still willing to go short? We will try to provide a more detailed analysis in the following paragraphs.

If I would only show you the following graph of the development of natural gas reserves, it would be clear why the price of the last two weeks is rising. Stock growth almost stopped to grow and stocks reached 5-year low. In absolute terms, the situation does not look very positive for the short and is diametrically different from the situation two years ago, when the market was filled with natural gas and the gas drop to 2USD / MBtu was only a matter of time.

Obr.3: Vývoj zásob zemního plynu

Figure 3: Development of natural gas reserves

 

But if we want to compare apples with apples, we need to look deeper into the data. We are now analyzing the period from 1.5. to 4.8. in 2017 and 2018 (in 2017, shorting gas was a profitable strategy) to compare the fundamentals in both years.

Why in this period? This part of the year represents the so-called injection season, ie the season of the year, when stock inventory growth occurs, and the development of gas reserves is not affected by so-called heating degree days (HDD = heating days when gas is burned in heating plants, – part of the year where HDD is prevailing is called the withdrawal season. The Injection Season is simply a well-defined part of the year that can be compared year-on-year, and where demand-side factors are purely limited to cooling degrees days (CDD = i.e. factor measuring how warm it is and how much it needs to be air-conditioned).

 

In these 14 weeks, stocks grew by 238 Bcf more than last year (stocks are 1011 Bcf this year – 773 Bcf last year), despite the cumulative higher temperatures in the past 14 weeks (827 CDDs instead of 763 CDDs last year). This means that, despite the warmer weather, the stocks are being built faster. The reason why we are moving on the chart to an absolute 5-year minimum of stocks volume is not because of slow stock growth but because of hard winter with an extremely low stocks left.

Obr.4: Vývoj zásob zemního plynu

Figure 4: Development of natural gas reserves

 

Our thermally neutral estimate of year-on-year surplus of supply over demand is +2.43 BCf per day due to stock growth ((1011-773) / 14/7) and +0.65 Bcf daily due to higher temperatures, ie +3.08 Bcf daily.

How did we calculate 0.65 Bcf?

Looking at the year-on-year comparison of natural gas consumption in order to gain electricity (so-called Powerburn – during the summer season – this is an increase in consumption due to air conditioners), the chart below shows that blue points belonging to 2018 as well as orange points belonging to 2017 are showing a positive correlation between the number of cooling degrees days and the daily volume of Bcf of burned natural gas in gas power plants. One marginal CDD means this year’s daily gas consumption growth by about 0.1426 Bcf. We can deduct that if the last 14 weeks in the US were 64 CDD warmer (827 CDD in 2018 – 763 CDD in 2017), then one week was 4.57 CDD cooler. As a result, daily gas consumption was +0.65 Bcf / d (0.1426 * 4.57) higher due to higher temperature. Therefore, the thermally neutral year-on-year change in the balance between gas supply and demand must also be cleared, so we look at the overall year-on-year change of supply by +3.07 Bcf.

Interestingly, from the comparison of both regression equations (blue 2018 and orange 2017) in the chart below, we see an increase in gas consumption in gas power plants. We see an increase from 21.1 Bcf per day to 23.7 Bcf per day. This increase is a result of the closure of coal power plants and the opening of new gas power plants across the US. We will certainly meet in the upcoming years a similar rate of structural growth in demand. The other two sources of domestic gas demand in the US (industry and gas consumption in heating plants) did not show year-on-year structural growth. Structurally, only export is growing, but we will talk about it at other times.

 

Obr.5: Powerburn vs. CDD

Fig.5: Powerburn vs. CDD

 

Conclusions from your questions

I would like to thank you once again for the questions I am receiving from you. They gave me very good feedback and confirmed the weak points I felt when writing articles. From my side there are several conclusions:

– Today’s articles are not completely intended as an investment strategy for copying, it’s some kind of style that not everyone can and will do, but it can show things from inefficient ETFs, options, and working with fundaments. Writing is also quite time consuming for me, and I know it could be better.

– Your observations are leading me to do a complete structured publication (“cookbook”) and perhaps even – for better clarity – a video tutorial where I would discuss all the theoretical and practical things about gas fundamentals, inefficient ETFs and the use of options, so that a trader, even when he makes a mistake with the fundaments, has a greater chance of success than in a pure shorting of the underlying asset.

– For those who would like to trade, I am thinking about creating a weekly report, where there would be current fundamentals, let’s say one to three educational model portfolios with a possible trade set-up and planning for possible trajectories in the sense of when the price is on X, then I do Y, and on the contrary, if it drops to Z, I take a profit and I’m waiting. Since everyone has different account sizes and different levels of trading aggressivity, I will have to think about how to design the educational model portfolios.

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