Natural Gas plan

The logic behind for this trade (or Lumber I'm currently in) is as follows:


'The price of Natural Gas (NG) will never go zero.'

In order to take advantage of this opportunity, I start buying it from certain price levels (depending on aggressiveness). The simplest way is to buy futures outright and cost-average as it moves down. This type of cost-averaging is different from 'scale-in' in day trading. Because you know it will eventually go up.

A smart or safer way to get involved with NG is to sell puts. Currently NG is traded at 8.2ish and 7 Oct Put goes around 0.150 (or $1500).

http://quotes.ino.com/chart/?s=NYMEX_ON.V08.7000P&v=d12&t=l


The 7 (if assigned) would be the first leg of NG as if you are long futures outright from 7. For futures, you have to wait until price comes down to 7 and buy it. For options, you do not have to. If you think you can bring enough premium, you can sell way before it gets to the 7.

So, say, you sold the 1 contract of Oct 7 put. Two cases can happen:

Case 1. NG did up/down moves but on the option exp day, it didn't close below 7. The option you sold expired worthless, meaning you get to keep the whole premium you wrote ($1500).

Case 2. NG's closed below 7 (say 6.8), meaning you'll get an assignment very next day. In other words, in your futures account, you'll see one NG long contract from 7 (7 put option is gone) as if your option is converted into futures contract. (Since you sold 1 option, you are assigned 1 futures.) Now that the current price of NG is 6.8, you'll also see you're -$2000.

Note that in either case, you get to keep the premium anyway, so your account's balance went +$1500 more than before you wrote (or sold) the option. This also means, instead of losing -$2000, you're only down -$500 (= -$2000+$1500). If you bought futures contract outright at 7, you're -$2000, but because of option's premium you're only -$500 at the end. This is exactly why you want to utilize options. The benefit of using options don't stop here. In the case 1, you got paid $1500 by trying to get in at 7 whereas if NG didn't come down to 7, you're sitting on your hands doing nothing.

Of course, there's a catch. What if while you're holding your put option, NG drops below 7 and quickly moved higher and keep rallying to 9? The max profit from selling 7 put option is $1500 whereas if you bought futures outright at 7, your profit is $20,000. The choice is entirely up to you. I like to play on a safe side and that why I like to sell options and keep the sure thing instead of being a hero.

There are a few choices you need to make. At what price are you going to start selling? How much options premium do you like to bring? At what level are you going to start cost-averaging? What's your exit level if assigned 1, 2, 3 etc? Are you okay with margin?

If you're aggressive you can start selling 7 or 7.5 option. But since I'm not, I'll try to sell 6.5 put with $2K premium. Note that 7 or 7.5 you can bring $3-4K premium. My cost average level would be every 1 basis point. I'll throw an order to sell 5.5 put for $2K ish if NG keeps dropping. 4.5 and 3.5 the same way. The realistic downside of NG is about 5, so I would likely get filled on 2-3 levels max. For two levels, I have to go thru 10K-ish and for three levels, the drawdown would be $30Kish.

On the upside, if I get assigned on 6.5, I'll sell 7 to 7.5 call option for $4-5K premium. If the call expires worthless, I'll roll over to the next month and sell another call for $4-5K premium with the distance being at least 0.5 to 1. If I get assigned on that call, it'll offset my long (from 6.5), so I'll be flat. If price is attractive enough, I'll sell another 6.5 put for $2K. I'll do this over and over again.

Last year, NG stays around this price for a long time, so it was very very profitable (not me, but the guy I learned the way how to trade this way. Let's say at least $50K). I'm looking for at least $20-30K with this opportunity. Why is this possible? That's because unlike Lumber, NG's contract is traded every month. Lumber contract is quarterly whereas NG is monthly.

What you need to implement this strategy is:

-Pit-traded futures account (so that you can write options)
-Enough account ($50K minimum)
-Patience to go through drawdowns