Executive summary

In this article, Rich Excell discusses weather forecasts, supply and demand dynamics, and the positive moves in the Natural Gas futures market. He then details the use of a broken wing butterfly spread to express a bullish position.

Earlier this summer in another Excell with Options article, I wrote that Natural Gas futures may be at an inflection point, with fundamental and technical catalysts emerging. Traders can create spreads to capitalize on directional moves with attractive reward-to-risk and leverage, but risk management is essential.

While it took a few more weeks than expected to breakout, Natural Gas futures prices have indeed moved off the low prices that plagued the late spring and early summer period. Can this price action continue?

Image 1: Relative performance of all CME futures products the past three months

In fact, over the past three months, the Natural Gas futures market has been on fire. Natural Gas futures have been the best performing futures product, doubling the gains of bitcoin and becoming one of the few markets to move positively in what has been a negative summer for most markets. On the one hand, traders may look at this price action and think to themselves that perhaps we have moved too far too fast. This mindset may point to a mean reversion type of idea. Other traders will note that futures had been down for such an extended period, and sharply from the previous year, that this move is only the beginning of what may transpire.

Image 2: One year chart of natural gas spot prices

The chart above comes courtesy of EIA and shows the extent of the negative price action over the course of the last two years. Having peaked at close to $10 / BTU in the summer of 2022 on the back of the massive shortage of global energy supplied, particularly in Europe, prices had fallen to $2 / BTU by the start of 2023 and stayed there for the first half of the year. From this vantage point, the move in spot to about $3 / BTU is a tiny fraction of what could happen going forward, not that the prices we saw in 2022 were anything close to what we normally might expect. However, even before the shortages in Europe, we saw natural gas spit in the $4 to $6 / BTU range, which does suggest there could be remaining upside.

Image 3: Baker Hughes rig count

According to data from S&P Global Commodity Insights, the average total supply of natural gas fell by 0.1% compared with the previous report week. We can see some aspect of this from the chart above. It shows that the rig count across the U.S. has been rolling over as the year has progressed (far right of chart) and the structural number of rigs is less than half of what we saw at the peaks of the fracking revolution in 2014-2015. Operators are showing much more discipline on this commodity cycle, not adding much incremental supply despite of the rapid move higher in price we saw in 2022. In fact, we can see that even though rigs were adding in 2022 from the depths of the Covid-19 low, this number was below the pre-Covid-19 numbers we saw. This has kept supply in check. The fall in prices this year came more from the mild temperatures we saw the previous winter, which meant demand was far below what the market was expecting. Will that happen again this year?

Image 4: Three-month weather forecast from NOAA

While not conclusive, forecasts from the NOAA for the next three months suggests temperatures are leaning toward being colder than normal. This pattern presents itself for the northern most portions of the U.S., with the southern portion of the country suggesting it is more of a 50-50 proposition. This is not strong enough information for a consensus position to be built, but a potential catalyst that we might see some downside surprises in shorter-term temperature outlooks heading into the Thanksgiving holidays. This gives traders a reason to look to the Natural Gas market either for hedging or for tactical directional ideas.

Image 5: Natural Gas futures term structure

This preference for potentially colder temperatures mixing with declining supply leading to higher futures may be creeping into the market. Putting aside the seasonal influence, I can see priced into the futures market, with higher prices in January and February versus April and May. I can see that the curve has shifted higher across the term structure. If I look at the shifts in the futures curve over the last one month, I see where futures were in September (green) versus where they are now (blue) and where they were one week ago (purple). Across the board, futures have been shifting higher with the bulk of the move in the front contracts. While I can see the current levels are still below where they were forecasted to be in July of this year (red), expectations are building.

Image 6: Seasonality chart for generic front-month Natural Gas futures price

Because of seasonality in the Natural Gas futures market, traders often anticipate this rising demand in the winter, which is why we can see bullish price action on average in September and October. With these two months combined they were the strongest period on average over the last 16 years. In fact, if we look at 30% moves over the last three months in Natural Gas futures, this year’s moves are even stronger than we have seen historically, which may give some pause that much of the move is priced in. Corroborating this may be that December is traditionally the worst month for futures prices, down almost 8% on average in the last 16 years. It is also possibly the start of a negative three-month stretch for the futures market, presenting a potential headwind to any rally that occurs toward the end of this year. Even as I was leaning toward a bullish mindset, this seasonality is enough to want me to consider expressing my view via long options ideas in case the move in the future begins to pullback and the strong pull from seasonality kicks in.

Image 7: Implied volatility term structure for natural gas

As I begin to think about expressing my trade with long options, I want to find the ideal part of the term structure to express it. I can see that the implied volatility term structure shape follows that of the futures curve, upward sloping through February, then falling precipitously into next Spring. I want to make sure I avoid the higher priced options of January and February, thinking instead that I want to look closer to the front part of the curve. In fact, the weekly options at the very front part of the curve start to look attractively priced for a short-term long volatility idea.

Image 8: Natural Gas CVOL and Skew history

I want to have a sense of where the current level of implied volatility is historically. For this I always look to the CME Group CVOL tool. This chart shows the futures price with a dashed line, the CVOL level in dark blue, and skew in purple. I see the very high levels for both CVOL and skew that existed in much of 2022. This year, ss futures fell, so did the level of CVOL and skew. Though even with the fall to $2 in futures, the skew never moved in favor of the puts. While the level of CVOL is elevated if I look on a prior six-month view, I can see that if we get moves back higher, there is still considerable potential for much higher volatility levels. However, I do appreciate that while I would like to be long volatility for this idea, I am buying options at implied volatility prices that are approaching the highs of this year. This gives me some pause and makes me want to defray the cost of my trade expression if I can do so without dramatically impacting the payout profile for my trade. I can also see that the purple skew line is at the highs of this year, telling me that the upside call options are one of the bigger drivers for the move higher in CVOL. While I want to put on a bullish trade, selling upside in some way may be the best choice to reduce costs.

Image 9: Matrix of implied volatility by strike across three weekly expirations

To determine which strikes might be the best places to place my long options view, and which strikes may be best to help reduce the cost of the structure, I look to the vol surface matrix in QuikStrike. Here I can quickly put in the expirations I am interested in, weekly options in this case, and compare not only the at-the-money options across the three expirations, but also the relative pricing of calls and puts within each expiration. I am drawn to the LN3X3 contract, not because it is the lowest implied volatility, but because it gives me more time to have my view play out. As I look at a 63 implied volatility, I want to reduce this cost. I look to the put side and see that implied volatility hangs in at similar levels, but when I go below 3.30 strikes, the implied volatility begins to drop off more quickly before recovering at the low premium puts. On the upside, I can see the very high premium relative to the at-the-money all call options have, with the higher I go the higher the implied volatility is. I look to find the best combination of a strike that is far enough out-of-the-money that I still will win if my bullish view plays out but has enough premium that it can serve to help reduce the cost of my structure.

Image 10: Broken wing butterfly for weekly LN3X3 using 3.30/3.45/4.00 strikes

The resulting idea I have come up with is a broken wing butterfly. While in a traditional butterfly the strikes are equidistant, in a broken wing butterfly, the strikes are not equidistant. This means the trade is not delta neutral, but instead has a directional lean to it. This fits my view of wanting to have a more bullish lean to my idea. If I look at the expected return chart at expiration, I can see that the current level is the maximum loss for the idea, with moves in either direction benefiting the PNL. However, the PNL benefits much more on a move to the upside. This sort of broken wing butterfly need not be, nor may not optimally be, a set-it-and-forget-it type of idea. Instead, it is one where more aggressive risk management using delta hedging may make sense. As weather forecasts begin to surface, and moves happen in the futures, a trader may be able to either add to the delta of the idea by buying futures with more confidence after the catalyst if still bullish. On the other hand, if the trader begins to see the view was not correct, the trader may need to sell deltas and change the overall payout of the idea into a more delta neutral, if not delta negative idea. As I suggested, there may well be more upside in the futures as the supply and demand picture looks positive to me over the next month or two. However, if this does not play out, negative seasonality may begin to grip the market and a trader may need to be nimble to change their focus. A long option idea with a positive delta lean is just the beginning position, with the expectation that risk management and trading decisions will be made as new information comes out.

Image 11: PNL simulation for the LN3X3 broken wing butterfly

As I am anticipating the need to use prudent risk management for this trade, I want to be able to anticipate where I can make or lose money before I start to do so. For this I can use the matrix in QuikStrike SpreadBuilder. In this matrix, I take my position and compare it to different moves of the futures and of volatility. As one might expect with a long delta position, as futures move higher, the position has positive PNL (green). As futures move lower, the position has negative PNL. The trade is initially long volatility. Thus, one might expect for moves higher in at-the-money volatility for the position to make money. It does so if the futures stay where they are or move higher. On any move lower in the futures, even if volatility moves higher, the trade will still lose money. This is because the 3.30 put option I sold in the strangle portion of the butterfly is much closer to at-the-money than the 4.00 call option. Also, even if implied volatility moves lower, if futures are moving higher, I will make money. Therefore, a move higher in implied volatility will not help me as much as I might want on the downside nor will a move lower in implied volatility hurt me on the move higher.  This tells me that from a risk management perspective, I need to be faster to execute any delta sales should my view be incorrect, and the negative seasonality begins. 

One always must have a view to make money, even if that view is on the speed of the move more than the direction of the move. When we use options, we can develop the payout profile that most closely fits our view, but also is supported by what the market is pricing in.

Good luck trading!

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