New Position Initiated - UNG April $6.00 Calls at $0.60, November 08th, 2010

Hello and welcome back to CRI's OnlyDoubles New Trades blog.

New trade for November 08th, 2010.

CRI's recently released TTA - First Two Weeks of Q4,'10 Report suggested that technology & commodities ought to do well for the quarter. With the recent run-up in certain commodities, value is getting hard to find. Not only have prices of base metals hit upside objectives, one might argue there is an asset bubble forming. I don't see this changing until the US Fed stops pumping money into the system but maybe we ought to be considering other commodities that don't have such dramatic downside risk.

That brings us to CRI's latest acquisition: UNG April '11, $6.00 Call Options. While most would consider natural gas a very risky asset, CRI might take the opposite opinion. Aside from the seasonally bullish backdrop and an expected unusually cold winter, one might consider natural gas 'cheap' too.

 

So aside from wanting to be long natural gas vs. oil itself, are there any other compeling reasons for us to want to buy natural gas?

Lets take a look at the UNG chart and see what it might be telling us...

 

This is a very interesting chart indeed. As one can clearly see, prices have fallen quite dramatically over the past year or two. But there a few little things that suggest that maybe the market has been a little too bearish on natural gas prices.

Some of these things include:

1. The current 1 year 50% level is more than $2 higher than current prices (that's more than 30%).

2. Momentum has actually been building not falling even though price is going down. This is known as a divergence and while it in itself isn't enough to buy, it suggests that the market is a lot stronger than what price is leading us to believe.

3. There is a double bottom in price that has broken the most recent four month downtrend line.

So as a technician, there is enough technically bullish criteria for me to seriously consider a trade. The question now is how to go about it. One could just go and buy the UNG (at the breakout near $5.85) and risk down to the recent lows ($5.20). There is a potential to make $2.22 on the trade (or about 38%) but there may be a way to do a little better. For this we turn to the options market.

Whenever I consider an options trade I always ask one simple question: Will the intrinsic value of the option (that being the market price minus the strike price) at our target be twice what the current premium is for a six month position. If the answer to this question is yes, then I can seriously consider the trade. For example, UNG's target is the 50% level ($8.075). Currently the six month (April, 2011) $6.00 Call option is currently trading at $0.60. If UNG goes to $8.00 some time over the next six months, this call option will have an intrinsic value of $2.00 (or more than twice what it is currently trading at).

So, for this trade, lets take that original risk money (5.85-5.20 = $.65) and lets go buy some call options with that. We will risk the whole $.65 and hold the options until expiry. At the same time, we will work an open order to sell half at $1.30 (double our purchase price)....Should we get near expiry and the sell order has not been filled we can either roll the position out to a late month or abandon the trade.... 

Remember, make sure the system you are using is at least 66% accurate and for heavens' sake, don't put more than 5% of your risk capital into any one play.

That's all for this post,
Brian Beamish FCSI
The Canadian Rational Investor
the_rational_investor@yahoo.com
the-rational-investor.com