Option Selling - Part 4 - Futures Options vs. Equity Options

Here's an article by the book authors that summarizes the advantages of selling options in the futures markets versus the equities market:

http://www.traderslog.com/optionscomparison.htm

It really boils down to the 1st reason listed: margin requirements are way less in the futures markets, meaning your ROI is much higher.

I can typically sell a far out-of-the-money futures option with 3 months to expiry and receive a $500 premium, while only requiring about $1500 or less to be set aside (the margin). That's a 30% return in 3 months. A similar type of trade in the equities market supposedly might get you a $300 premium and require $3000 in margin -- only a 10% return.

It's really the difference between whether you want to make $50,000 over 10 years or make $500,000 over 10 years.

Margin requirements can be even further reduced in the futures market due to the SPAN margin system, which takes into account your whole portfolio when determining your overall risk exposure. My favorite trade type that takes advantage of this is a short option strangle, which allows you to significantly increase your return on investment. I'll talk about SPAN margin and Strangles in my next post.

As for the authors' 3rd reason for why to trade futures options, that being that the futures options markets are more liquid, I don't think the statement has much weight. I haven't done any equities option selling, but I can't imagine it being less liquid than what I see in the futures options markets. Some commodities hardly have any options traded in a day. Yes, I'm looking at you, Cocoa -- not a single trade of the May options at any strike price over 2 days. And the bid/ask spreads, if there actually are any bids or asks, are simply insane. So the futures options markets are anything but easy to trade in.

Option Selling - Part 3 - The Book and The Strategy

After researching books on option selling, I ended up buying the book "The Complete Guide to Option Selling (2nd edition)" by James Cordier & Michael Gross.

This is the book to buy if you're interested in option selling in the futures market. Actually, I think it is the only book out there devoted to the topic, but thankfully it is a great book written by experts who explain things very clearly, and whose views I could fully agree with every step of the way. However, do NOT buy this book to learn about the futures market or options trading, as it does assume you have some knowledge in these areas. I skimmed some good introductory books in Chapters/Indigo a long time ago, but I don't remember their titles.

In the book, they present a fairly specific approach to selling options, and they sold me (no pun intended) on their techniques, even completely changing my mind on a few key strategies (longer-term vs. shorter term options and naked selling vs. spreads).

James Cordier's company is Liberty Trading group, and their website is here: http://www.libertytradinggroup.com/

Oh, and I should've posted this perfect introduction to option selling from their site for my "Why Sell Options" post: http://www.libertytradinggroup.com/benefits.html

But the point of this post is to point out the core strategy that I'm following, which is explained here: http://www.libertytradinggroup.com/strategy.html

Since the above links explain the concepts so well, there's nothing really for me to add here. If you're too lazy to read the links, the core concepts are:

1) Knowing your fundamentals

2) Selling with 3-5 months to expiry

3) Selling deep out-of-the-money options (as in 50 - 100% out-of-the-money).

4) Proper risk management.

The only thing I've noticed in my trading adventures so far is that it's really hard to find an option that's 50 - 100% out-of-the-money with any decent premium. Although, I guess I've been looking closer to the 3-month expiry dates than the 5 month ones. I need to learn to not be so scared to go out longer term. However, I still think those percentages don't make sense in some commodities. For example, with gold, knowing the fundamentals (concept #1), you know trying to sell gold puts at $550 (50% of price) is ridiculous -- everyone else knows this too, which is why you can't get a gold put at that strike price for even $20. So I think there's some leeway in those percentages. But the key is to go farther out of the money than you think (I'm already close to getting burnt by not following this advice in one of my trades).

Option Selling - Part 2 - Why Sell Options?

So what are the main reasons for selling options?

1. Odds are on your side

Studies have shown that about 80% of options expire worthless. This holds true in bull and bear markets, for both put and call options. The large majority of those who buy and hold options will lose 100% of the premium they paid for it. For a detailed article on these stats, see this article: http://www.tribecacapital.com/pages/sellers_vs_buyers.pdf.

As the article mentions, more than 80% of the buyers are actually losing money, because even if an option expires in-the-money, the buyer had to pay a premium for the option, and so the option would have to expire a certain percentage higher than the strike price for them to break-even. There's certainly a large number of options that expire in the money but where the buyer still comes out at a net loss. The only unfortunate thing about the study is that there is no information on the percentage of people who still make a profit on options that end up expiring worthless by selling the option before expiration - e.g. selling during a temporary price spike.

I'm surprised at the 80% number, but I guess it just shows how the option contracts that are out there are not evenly distributed around the asset price. For 80% of the options to be expiring worthless, most people must be "gambling" on out-of-the-money strike prices that are rarely ever going to be reached.

If we only look at options that are far out-of-the-money, the odds of them expiring worthless are obviously higher. You're looking at maybe a 95% chance of keeping the buyer's premium if you sell these options. Of course, the farther out of the money you go, the lower the premium you'll receive, so there's a balance to find.

By being a seller of options, you already start with the odds on your side before you even make a trade.

2. No need to predict where the market will go

Let's say gold is at $1000 and you think it will go down. You could sell a gold futures contract. However, if you guess the direction of the gold price incorrectly, of course you will lose money as gold rises. But even worse is that when you're right about the longer-term direction, you can still lose money from short-term moves. For example, gold might spike to $1050 and you might be forced to exit your trade at a loss as part of your risk management (as you're already at a $5000 loss now). But gold could then reverse and drop to $950, meaning you were right about the direction in the end, but you still lost money on the trade due to the volatility.

Now let's say you instead had decided to sell a gold call option at a strike price of $1300, which expires in 3 months, and you get $500 for this sale. Gold can stay the same, drop, or even go up, and as long as it is under $1300 at expiry you keep the $500 premium from the buyer. Even if you were completely wrong and gold skyrocketed a whopping $250 to $1250 at expiry, you'd still keep the $500 premium. (And even if gold were to skyrocket to $1250 before expiry, you'd likely be able to get out at less than the $5000 loss you would have taken with the futures contract itself when its price reached a mere $1050. Note: this addresses point #5 later on.)

This is one of the best things about selling options. You can be completely wrong about the direction of the market (as we traders often are) and still make consistent profits, as long as you are selling far enough out of the money and not overpositioning yourself (i.e. being greedy).

3. Time is on your side.

For an option buyer, every day that goes by, the option loses some of the "time value" that makes up the premium of the option. If the underlying security doesn't move, time will gradually erode the value of the option. Option buyers know how depressing it is watching your option gradually lose its value while you wait for a move in the underlying asset.

As an option seller, time is always working for you. When selling far out-of-the-money options, ALL of the value of the option is time value and this time value can drop quite quickly. For most options you sell, you will be able to buy the option back a month before expiry to close out the trade early for almost nothing. This allows you to capture most of the potential profit early and get into some other trade, instead of waiting another month to just collect a measly extra $50 or so.

4. It's easy.

Do you stress out about timing your trade entries, figuring out when to exit when the trade goes against you, find it hard to monitor the markets daily - or hourly? With selling options, you simply enter your trade and wait. You don't have to time things perfectly (you might not collect as big of premium if your timing is off, but even movements against your position will likely not affect you if you are far enough out of the money). It's easy to take profits... because you don't have to! You just sit and wait and let the option expire worthless -- no action required on your part. It's much less stressful too, as even a move against your trade is of no concern unless it's a significant move.

5. Lower risk than owning the underlying asset (in my opinion)

I may try to provide a realistic example of this some other time, but knowing me, I won't get around to it. The gold example in point #2 above pretty much illustrates the point.

And those are the key benefits to selling options.

Option Selling - Part 1 - Introduction

I mentioned a while back that I've discovered my trading destiny and would post about it. Well here it is...

The investment approach I am going to be following in my futures trading account from this point forward is Option Selling, also known as Option Writing. More specifically, I will be selling far out-of-the-money naked options on futures with 2-4 months until expiry. I believe this is the ultimate strategy for making consistent small profitable trades that will result in an average portfolio return of about 50% per year.

What is Option Selling?

Most investors have heard about options. If not, there are many places you can read about options trading, such as here: http://www.investopedia.com/university/options/option.asp.

Usually only the buying of call or put options is discussed. But think about it -- when you buy an option, you are buying from someone who is selling, or writing, that option contract. The buyer pays the seller a premium for the contract, and the seller keeps this full premium as long as the underlying instrument does not reach the strike price.

As an option seller, you are no longer predicting or betting on where the price will go; you are picking a price level (usually an extreme one) and betting that the price will not go there. You can be completely wrong about the direction that the price ends up moving and still make money, as long as it doesn't reach your extreme price level.

A Comparison:

Selling options is often compared to selling insurance. Say I own a car insurance company. I might sell a 1-year contract to 1000 drivers at an average of $1000 per contract for a total of $1 million. i.e. the buyers each pay me a $1000 premium to protect them if they get in an accident. I know that 90% of these drivers will not end up using their insurance for the year. The other 10% (100) of those drivers that get into accidents and choose to use their insurance will cost me an average of about $4000 per accident. That's $400,000 I have to pay out. $1 million in premiums - $400,000 in payouts = a profit of $600,000. Not bad.

I ensure that the 10% figure will stay that low buy only selling insurance to low-risk drivers. If I were to sell to high-risk drivers, I might charge a $2500 premium.

Insurance companies are just playing the odds, and making sure those odds are always in their favour. And that is why insurance companies are always profitable.

Now this example isn't perfect, because in the options world we don't have to sit by and watch while "accidents" happen. In the car insurance world, you can't control the fact that there might be a $1 million claim that comes up. But imagine for a moment if I could monitor all the cars in real-time, and when I see an accident about to happen, I could slow down time itself to bullet-time. So I see Joe starting to slide on some ice and headed for another vehicle. There's a chance his car might get totaled, which would cost me, say, $20,000. So I phone Joe up while he's sliding and say, "hey, I'll make you an offer: I'll give you your $1000 back PLUS an extra $3000 to cancel our contract right now". Joe thinks he can avoid the vehicle, and if not, it will just be a fender-bender, and so he says "Deal. Sweet!" And we're both happy.

In the options world we can manage our risk during the lifetime of the trade like in the above example. When selling far out-of-the-money options, we always have plenty of time to get out at a reasonable loss even if there is a severe move in the market.

A quick note on risk:

Usually any mention of selling options is relegated to a paragraph on how it is extremely risky (unlimited risk!), extremely complicated, requires huge amounts of capital, and is a technique only employed by full-time professional traders, and everyone should stay away from it!

The truth is that selling an option -- even naked selling -- is no more risky than buying/selling the underlying stock/futures contract itself, and usually much less risky when done properly. One quick example is described here: http://daytrading.about.com/od/options/qt/ShortOptionsRisk.htm.

Option selling is not understood by even most professionals, and the exaggerations of risk and misinformation around selling options are just perpetuated by such professionals. This myth of incredible risk is so pervasive that is hard to convince people otherwise, and it means that most people stay far away from selling options.

Selling options on futures is more risky than selling equity options, but only because of the leverage that exists in the futures market, not anything to do with option selling itself. In other words, selling a futures option is typically no more risky than buying/selling a futures contract itself, and when done properly, is way less risky. I will try to talk more about risk some other time.

Summary

I should have just linked to this article, because it covers everything I've said and much more, and is way clearer than what I've written.

Next Steps:

Here are the topics I hope to cover over my next set of posts:

- Why Sell Options?

- The Strategy

- Futures Options vs. Equity Options

- 50% return? Yeah right.

- Risk: Naked Selling versus Spreads

- Risk: Selling Options is less risky than owning the underlying asset?

- My trades so far and potential trades - Sugar, Gold, Orange Juice

- Strangles

Sprott And Gold Update

Everyone knows from practically my first post that Eric Sprott is my idol, and I haven't mentioned Sprott in a while, so it's probably a good time to do that.

For anyone who thinks that the worst is over and everything is hunky-dory, please read the latest (October, 2009) "Markets at a Glance" article by Eric Sprott here: http://www.sprott.com/main3.aspx?id=54.

If that article isn't enough to scare you, I don't know what is. And remember, Eric Sprott is alway right :)

Who knows how this state of affairs will eventually affect the markets, but it seems that one thing is fairly certain: the U.S. dollar is toast. Other countries have begun to recognize this. As mentioned in the article, countries have historically supported their own currencies by stockpiling about 63% of their foreign currency holdings in US dollars on average, and this number is now down to 37%.

Furthermore, today the IMF sold 200 tonnes -- or $ 6.7 BILLION worth -- of gold bullion to India. Details and commentary are here:

http://www.businessday.co.za/articles/Content.aspx?id=85875

This was about half of a previously-planned sale by the IMF, but no one expected one big transaction like this. People are speculating China may buy the other half. This is further evidence that countries are trying to get away from the U.S. dollar. This news caused gold to shoot up from $1060 to $1085 today, even while the U.S. dollar was up.

This is great for my Sprott mutual funds holdings, which as you know are heavy in precious metals and energy. (Yes, most of my investments are still in Sprott funds, even though I've been focusing on my trials in short-term trading this last year or so). I just checked the Year-to-date numbers for the funds I'm in:

Sprott Fund YTD returns:

• Sprott Gold & Precious Metals Fund: +90%
• Sprott Energy Fund: +52%
• Sprott Canadian Equity Fund: +26%

Not bad, however they still haven't made back the brutal losses from last year. Remember, you need a 100% gain to recover from a 50% loss.

While gold could pull-back short term, I'm still a big believer in holding gold for the long term. I agree with the guys at Sprott that gold is gradually on its way to $2000 over the next few years. Everyone laughed at them at all their previous gold price predictions, but they all came true.

Natural Gas - Final Trade Update

I am now out of Natural Gas, and I actually ended up making a small profit in the end.

I closed out my December contract at $4.84 today (which I had went short on at $5.00) for a $400 gain. Combining that with my November contract that I lost $150 on, my final outcome of my natural gas trades was a very small profit of about +$220 after commissions.

The warmer weather and maxed out natural gas reserves has caused natural gas to finally come down as expected. That cold snap in October combined with other factors that caused the price to rise sure had me scared for a while -- as I mentioned, I was down almost $4000 at one point. But the fundamentals prevailed in the end.

There is still weakness in natural gas for the short-term, but it is too risky to bet on this now with winter approaching. And besides, I am moving on to bigger and better things...

NG trade

Natural gas continued its climb the first couple of days last week, with November futures reaching over 5.30 and the December futures reaching over 6.00. At those prices my contracts were down $1400 and $2500 respectfully. Finally prices began descending Wed, Thurs, and Fri.

On Friday, my November contract almost touched my break-even price of 4.75. With only Monday and Tuesday left before expiry, I decided to sell at the end of Friday at 4.81, for a small loss of $150. I didn't want to risk holding over the weekend, just in case prices went up. (Remember, even a 0.20 rise would be a $500 loss).

Today (Monday), prices continued their decline with quite a large drop. November closed down 27 cents at around 4.50, with 1 trading day left. So if I had held on just one more day, I could've turned a $500+ profit. Oh well, things could have gone much worse, so I'm happy getting out when I did, considering where things were at just a week ago.

The drop was nice because now my December contract is down to 5.20. I had planned on taking a large loss on it, but who knows, it might actually go under $5.

Anyway, after this trade, I think I'm done with trading pure futures. Too risky and too stressful. I know, I know, I only made 1 trade. And I'm glad it didn't go exactly as planned, or else I may have fooled myself into thinking it was easy money. But all is not for naught! The setting up of my OptionsXpress account was all part of a larger plan to eventually reach my trading destiny, which I am now ready for... and I'll leave that for my next post.

NG Update

It was a bit of a scary week with all the cold weather. Natural gas spot price kept going up, reaching 4.25, but the November futures kept bouncing off 5.10 or so. Luckily, last Thursday's Storage Report showed a larger-than-expected 69 bcf net increase in stocks, reaching a total of 3658 bcf for Oct.2, which I think helped keep the ceiling on the futures price, as I had hoped it would do.

I've been watching the weather forecast all week, here: http://www.weather.gov/forecasts/graphical/sectors/conus.php?element=T

(Turn off "Table Mouseover Effect", click +12 hrs if necessary to show "High" Temperatures", click the word "High", then use the "Next Image" buttons at the bottom to view each day's forecast up to a week ahead).

A week ago you could see that the cold weather would end around today (Wednesday), which turned out to be correct, and now for the next week it looks like it will be much warmer.

Natural gas prices have dropped quite a bit the last two days. Spot price is now at 3.80 and November price is 4.44. People think the drop was primarily related to news that UNG will begin to move its investments out of futures to other instruments due to anticipated regulatory restrictions and position limits on futures trading. See this article for more details:

http://online.wsj.com/article/SB125544223957682433.html

The weekly storage report gets released tomorrow (data is for the week up to Oct.9), and it should show the total stocks are above 3700 bcf, which I think will scare people.

Looking at the detailed historical data provided by the EIA, storage usually tops out between Oct.25 and Nov.16, most often right around Nov.7. I'm predicting that this year's storage will probably top out around 3900 bcf, based on historical patterns and extrapolating for this year. If this happens, certain regions will likely reach their maximum capacity and not be able to take any more natural gas.

So the fundamentals look perfect for a further drop in natural gas prices over the next couple of weeks... at least to me. However, all the trading reports I have access to on OptionsXpress keep saying everything looks bullish, there is strong support, prices are set to rise, etc.

Weather

November natural gas has still been hovering around $5 (good thing I didn't sell more at 4.70!). Spot price is now up to $3.20.

What worries me is a cold weather front that will be moving through the northern states over the next week or two. Temperatures are expected to be much colder than average. This could really push prices up a lot.

Hopefully the natural gas storage report released on Thursday will help keep the spot price from shooting up too much. Also, next week UNG supposedly has to start rolling their November contracts into the December ones, and the shorts are hoping that this will force the November contract price down.

Natural Gas - no new trade

After some research, I've decided it's not worth the risk to enter into any new NG position.

The commenter on my last post prompted me to look into the price action history for the last 2 big spread spikes seen in the graph. These details can be found in the historic weekly EIA updates (see here: http://tonto.eia.doe.gov/oog/info/ngw/historical/ngwu_2006_07.html).

Well, it turns out that right after the $1.50-$2 spread back at the end of September 2006 occurred, the spot price rallied $3 over the next month! Spot went from an average of about $4 to over $7, while the Nov Future went from about $5.60 to over $7 as well (actually expiring below the spot price). There was no major reason stated for the increase other than cold weather.

For the 2nd largest spike, in Nov 2007, this time the spot price didn't really move at all, and the futures contract did come down over $1 to close the spread.

I've been reading a bunch of message boards and it's amazing how split the view is on what the November futures are going to do. A lot of people actually think it will go up and close in the $5 to $6 range. And of course a lot of people, like me, think the price will have to drop. Another big topic is UNG, which controls a large percentage of natural gas futures, and there seems to be a lot of confusion on how they are affecting the market. I think there is a lot of manipulation going on.

I've decided not to sell another contract because:

a) The market knows best - Nov must be $4.70 for a reason. In 2006 the market was right.

b) There is a lot of uncertainty in what the price will do; there are a lot of people on both sides of the fence.

c) Colder weather is expected next week.

d) I calculated that I could only handle about a $1 increase in the futures prices if I sold another contract. No trade is worth the risk of getting wiped out over such a small move. Currently I can weather a $2 increase in futures price (which would probably require a $3-4 increase in spot price - in 24 days).

I still think Nov will easily drop below $4. Even with colder weather, the latest economic news shows the demand isn't there, and storage is at record highs, so I can't see a repeat of 2006 happening. But whatever, I'm just going to play it safe and be happy with the small gains I'll make if I'm right. And if I'm wrong, at least I shouldn't lose my shirt.

Natural Gas Insanity

Yesterday (Friday), the natural gas spot price dropped a whopping 60 cents from 2.92 to 2.32, a 20% drop. And what did the November futures contract do? It went up 25 cents! All futures months went up. This is insanity.

Over the last week the spot price has dropped over a dollar, while the November futures contract hasn't moved. With the Nov contract closing at about 4.72, this has resulted in a $2.40 spread between the spot price and near-month futures contract, which by the way has only 25 days left until expiry.

Here's a graph I found showing that this is the largest spread in over 3 years (and I bet even longer) - check out our spike on the right:

Image source: http://graphics.thomsonreuters.com/109/US_GASSPREAD1009.gif

Link is from this article: http://www1.hymarkets.com/html/news/2009/10/2/1254509240nN02332141.html

I've been scouring the latest news stories & blogs, and no one is offering any real explanations. They're all basically saying, "wow, there's a crazy spread" and that's it.

This premium cannot last another week, so it seems like an opportunity of a lifetime to make money. When the markets open Sunday evening, I'm going to try to sell another Nov e-mini contract -- or two -- at anything I can get above 4.50. I doubt it will fill because the price will likely open lower than that.

Birthday trade

Today I sold 1 e-mini November natural gas contract (QGX9) at 4.75.

It was up 23 cents from yesterday's close. I really can't see this rally having much more steam. I've read that the rise is due to a combination of short sellers getting out and people being more optimistic about the economy (an improving economy will boost demand in NG). That's all fine and dandy, but the reality is:

- Natural gas inventories are going to reach record highs - they'll increase until mid-October.

- Weather/Temperature has been very favorable.

- There have been no hurricanes.

- There has been no sign of increase in demand yet.

So yes, sure, NG demand will pickup at some point, but for the next month there is no justification for the spot price to keep going up. I'm still reading analysts predictions of NG falling below $3 in October, mainly citing the inventory levels and favorable weather (meaning no big increase in demand).

Current spot price is either 3.44 or 3.59. The site that shows 3.44 showed yesterday's close at 3.37. That would mean it only increased 7 cents today, while the futures all increased about 25 cents, which seems strange, so I'm wondering if the 3.59 number is more accurate. I don't know what its previous day's number was though. I still have to find a site with spot prices I can trust. Either way, I have anywhere from a $1.16 to $1.31 buffer, with 34 days left till expiry. I feel very safe in this trade. In 4 trading days the Nov contract will become the near-month contract, as the Oct one expires on Sep.28th. It will be interesting to see the behaviour of the Nov contract when that happens.

The weekly inventory numbers will be released tomorrow morning. As long as the inventory increase isn't way lower than expected, I think NG will drop quite a bit in the coming days. But who knows, because right now the rally is against me.

NG trade

I entered my first futures trade today! I sold 1 e-mini December futures contract at $5. That contract is QGZ9 if you're curious (QG = natural gas e-mini, Z = december, 9 = 2009). Current spot price was around $3, Oct contract (which expires in about 9 days) was 3.20, Nov was 4.35. The Dec. contract ended up at 5.07 the last I checked.

This trade requires about $1300 margin, and for every $1 move in the contract price, I lose/gain $2500. With futures, you need to be aware that the required margin value doesn't change over time, but your Futures Buying Power does, and this is what determines whether you get a margin call (i.e. are forced to liquidate or add more money into your account).

Futures Buying Power = (Total account value (cash and futures positions) - sum of margin requirements for your open trades). So say you start with $10,000. Your account value and futures buying power are both $10,000. If you buy/sell 1 e-mini NG contract, your account value is still $10,000, but your Futures Buying Power is now reduced to $8700 ($10,000 - $1300 margin requirement). If the trade moves against you by $1, that's a $2500 move, so that means your total account value will be $7500 and your futures buying power will be $6200 ($7500 account value - $1300 margin). This trade would have to move about $3.50 against you for you to get a margin call -- i.e. the point when your account value drops to $1300 and your futures buying power is $0.

Here are some things I learned:

• I was wrong about futures trading 24/7. They usually stop trading at 5:15pm on Friday and resume at 6:00pm on Sunday. They trade from 6:00pm to 5:15 every weekday. However, hardly anyone seems to trade in the evenings, or even that much in the afternoon. So basically it ends up being not much different than stock-trading hours.
• The e-mini contracts have waaay lower volume than their corresponding regular contracts, and the spreads are horrible. E.g. when a regular NG contract is at $5.00, the corresponding e-mini contract might have a bid of $4.95 and an ask of $5.05, and a single trade won't happen for 10 minutes.
• Because of the bad spread, when an e-mini trade does occur, the trade price is usually 2-3 cents lower than what the latest trade of the regular contract was at. E.g. When my order at $5.00 went through, I could've gotten a normal-sized contract at $5.03 at that moment.

It might have been better to buy the Nov contract, since it will drop more within the next month than a later contract, assuming spot price stays the same or goes lower, but I thought I'd give myself a little more time in case their is a temporary spike here. I'm tempted to sell another contract, for a total of 2, but I should probably play it safe on my first trade.

I am hoping for NG to drop in the coming weeks (obviously) and to sell my contract at $4 for a $2500 gain.

Here's another interesting article:
http://www.zerohedge.com/article/why-has-natural-gas-spiked-60-labor-day

Natural Gas Links

I found some great links that provide pretty much all the up-to-date information one needs to understand what's currently going on in the natural gas world:

Weekly Natural gas update (updated every Thursday evening):

http://tonto.eia.doe.gov/oog/info/ngw/ngupdate.asp

Weekly storage report (updated every Thursday morning):

http://www.eia.doe.gov/oil_gas/natural_gas/ngs/ngs.html

EIA Short-term Energy Outlook (updated monthly):

http://www.eia.doe.gov/emeu/steo/pub/contents.html

Natural gas continued it's mini-rally today. Dec contract jumped about 35 cents to 4.95. I can't check the markets until the afternoon tomorrow, but I may enter a short position then unless the rally appears to still be just as strong.

Some choice quotes from the most recent articles above:

"EIA expects that the Henry Hub price of natural gas will average $2.25 per MMBtu in October 2009, which is the lowest monthly average spot price since September 2001. Prices are projected to bottom out in October, and then rise through February 2010, averaging $4.59 per MMBtu in February, and fall from March through August 2010."

"Despite a 20-percent drop in prices and a 45-percent drop in working natural gas drilling rigs since the start of the year, total natural gas production increased slightly from January to June 2009. This current production trend reflects significant improvements in horizontal drilling technology and robust productivity from shale gas discoveries in Louisiana, Oklahoma, Arkansas, and Pennsylvania."

"As electric power demand for air conditioning wanes, a continuation of recent natural gas supply trends could cause spot natural gas prices to fall below current projections before cooler temperatures induce higher demand for space heating. In the projections, prices rise modestly in 2010, reflecting increased economic activity and lower production levels as a result of the current drilling pullback. However, it will take some time to work off current inventory levels and enhanced production capabilities should limit significant increases in prices throughout the forecast period. On an annual basis, the projected Henry Hub spot price averages $3.65 Mcf in 2009 and $4.78 Mcf in 2010."

Trade Update: DXO

I mentioned that I sold most of my DXO a couple of weeks ago. I was planning to hold onto the remaining amount (about 20%) for a while, but lo and behold, Deutsche Bank decided to shut down DXO due to concerns over new regulatory restrictions imposed on the futures exchange. There is some info about this here:

-http://www.dailymarkets.com/stocks/2009/09/09/why-did-the-double-leveraged-oil-etn-dxo-close/

-http://247wallst.com/2009/09/01/the-death-of-an-energy-etf-dxo/

They are supposedly redeeming the notes at today's closing value, but just to be safe, I sold yesterday at 4.37, since there was nice spike in the price anyway. That was about my break-even price.

I'm just glad this happened now after I was able to sell at a profit, and not when I was temporarily down 50%!

On another note, my futures trading account with OptionsXpress.ca is finally all setup! Too bad I didn't set this up sooner -- I'm up $5000 in my virtual trading (I was able to sell Dec Natural Gas at 5.09, and it's now at about 4.60). I'm going to wait to see what happens tomorrow because as I feared, NG dropped pretty far before my account got setup, and now a rebound has finally begun. The spot price was down as low as 1.83 and just jumped up to around 2.45 in 2 days. The Dec contract got down to 4.30 and rebounded to 4.70.

I don't want to sell into a rally, so I'm going to wait until there is a down day. BTW, there are a whole bunch of comments on my last post that talk about the risk involved here.

Natural Gas Futures

The NYMEX natural gas September contract (expires at the end of August) is around $2.80 right now. This is the lowest price in a long time.

There is a huge oversupply of natural gas right now. Almost every article I read talks about how the near future for natural gas prices looks grim, and no-one expects it to go over $4 anytime soon unless there is a major hurricane (hurricane season is just starting) or a really cold winter.

Here are some recent articles to read:

http://seekingalpha.com/article/156703-natural-gas-grim-outlook-through-late-2010

http://www.cattlenetwork.com/Natural-Gas-Outlook--Spot---Futures-Decline--Storage-Continues-To-Increase/2009-08-13/Article.aspx?oid=826606

It's all over the news in Alberta too. The alberta natural gas price has been forecast to even fall under $1 in the coming weeks:

http://www.calgaryherald.com/business/Natural+prices+could+fall+below+report+warns/1928706/story.html

(Note: prices in Canada are quoted in different units, but the conversion factor is close to 1.1, I believe).

So why I'm I interested in this? Well, the NYMEX December contract (expiring end of November) is currently trading above $5 right now. Every 1 dollar move in natural gas is a $10,000 change in value for a single contract (which requires about $10,000$5000 margin).

Now it seems to me that the December contract is very optimistically priced. If the Natural Gas spot price were to remain at its current price for the next month, the December contract would likely drop to around $4.20, judging by November's current price. This would be an $8000 gain / 80%160% gain in one month if you had sold the December contract (like shorting a stock).

It seems like easy money, however:

- the price is so low, it could easily rebound a bit. A $1 move up means a $10,000 loss. Natural Gas has many times historically moved $2 or more within a single month.

- the market is usually smarter than you. If it's so obvious that prices are going to stay low, then why is the December price currently still over $5? There must be something the big players know that I don't.

I'll have to play it careful. For one, I wouldn't actually buy the regular contract - it's too big and I could lose all my money. There is a mini natural gas contract that is 1/4 the size ($2500 for a $1 move). I'd only sell a couple of those. Secondly, I'll probably hedge my trade by buying a nearer term contract, in case prices do go up. I'll have to figure out mathematically what makes the most sense.

I worry that I won't get my account setup soon enough though, and by then prices will have dropped further, making it too risky to sell natural gas at such low prices. I wanted to get in at the beginning of August, when I first started reading up on all this dire news on natural gas. At that time, the December contract was above 5.50. Already I'd be up about $5000 on 1 normal-sized contract.

Oh well, if natural gas doesn't work out, I'll probably buy into gold on dips and sell on short rises. A $10 move in gold is a $1000 gain on one contract (about $5000 margin). I feel way more familiar with gold anyway.

Futures/Commodities Trading

For a long time I've been interested in commodity/futures trading. It's this bizarre world: trading contracts dealing with wheat, sugar, orange juice, oil, gold, frozen pork bellies.... And everything is crazy leveraged: You can control some amount of a commodity with just 1/20th of its value. E.g. You can put down a $5000 deposit (the margin) to buy 1 contract of gold, which is 100 ounces, which is worth around $94,000 at today's prices. You can make or lose thousands of dollars per day.

It used to be only the uber-rich would play in commodities, other than farmers who would buy futures to actually hedge against changes in the markets that would affect their income negatively. But in more recent history, new "mini" contracts have sprouted up that are 1/2 to 1/10 the size of the regular contracts, allowing smaller players to get into the market. It is also easier to setup futures trading accounts nowadays. However, I've never run across anyone talking about trading futures, other than one older family friend years ago. You just don't hear Joe in the office talking about his soybean contracts doing well.

The commodity markets are hard to learn about and understand. There is not much good information out there and I think it takes a lot of experience to really get a feel for things. Even though there are trillions of dollars traded in futures each year, there aren't many little guys participating. It is risky. I remember reading stats on how most amateur futures traders end of losing most of their money, mainly due to not understanding and managing the risk involved.

Anyway, it is really interesting stuff and I'm going to try to get my feet wet. I was surprised that there aren't more online brokerages that offer futures trading accounts. In fact, I couldn't find one true Canadian one that looked trustworthy and mature. After much research, I finally settled on OptionsXpress.ca. They're still an American company which happens to have a small Canadian arm to allow us Canadians to get involved.

OptionsXpress really impressed me. They have an amazing website with tons of information on it. It makes you feel very welcome and comfortable. All of their information is easy to follow and understand, and they are completely open about everything. You really seem to know a lot about them after reading through the site (compared to some sites that don't have much info and thus seem more shady). They seem trustworthy, their trading platform seems solid and easy to use, they have tons of help and examples for every type of trading action available, all sorts of common questions are answered in their FAQs, and they have a Live Help feature -- it all really gives you peace of mind. I actually used their "Live Help" feature and chatted online with a person, who was very helpful and answered all my questions. I've started the process of setting up an account, and everything has been so smooth so far. They give you FedEx shipping labels for free overnight shipping of your application, and you get automated emails for each stage in the process (e.g. "We just received your application and are now processing it). I'm looking forward to using them. However, who knows, I may not even get approved -- it's a two step process: first creating a regular equity/options account, and then applying for futures trading.

It seems the most popular online broker is interactivebrokers.ca/.com. They have crazy low fees and apparently have the most powerful trading platform, but I've heard it's very complex to use because of this. They seem geared more towards experts than to first time traders, so I didn't feel comfortable going with them. All the other brokers I looked into just didn't seem as organized, informative, and trustworthy as OptionsXpress.

The first thing I want to trade, if I can get an account setup soon, is probably the most volatile commodity out there: Natural Gas. More in my next post...

Trade Update - DXO, DIG, FAZ

It's been a long time since I've updated this blog, but I actually haven't done any trades until recently anyway.

Yesterday I sold most of my DXO at $4.85 and the rest of my DIG at at $30.24.

Oil is up to $74 and I decided to get out. I made about 15% on the DXO trade - not very much, but I had a LOT of money in that trade.

I'm a little disappointed. I said that holding DXO would be an easy 100% gain, and it should've been (DXO went below $2 a couple of times and is now about $4.85). I bought too much too early on the way down and had no more money left to buy when it was really low. Even with not timing it well, I still actually made about 30%, if we're just talking in US dollars. What really hurt me was the change in exchange rate. Most of my DXO was bought when the Canadian Dollar was at a low $0.78 to the US dollar, and now it's at $0.93. So I "lost" over 10% in gains due to the Canadian dollar skyrocketing. Due to "the constant leverage trap" with leveraged ETFs/ETNs, DXO did not perform as well as it could have if it didn't drop so low at the beginning. It also switched over to using the July 2010 futures contract as its basis, which has way more premium built in to it, meaning it wouldn't perform as well as near-term contracts assuming oil only moves up slowly.

So why'd I get out? Oil recovered nicely to $75 as expected, but I don't see reason for it to go much higher right now. The economy still sucks and the markets are irrationally optimistic -- the markets have been in a huge extended rally, so I thought I would get out while things are good before the next "storm" hits. I'm not saying oil won't keep going up. I just don't want to bet on it doing so. I think Oil will do really well long-term, but short-term, I'm too scared and so I'm taking my profits. I would consider re-entering if oil drops to $60.

FAZ - let's not even mention that. Worst trade ever. I'm still holding some of it which is pretty much worthless right now. Again, FAZ/FAS are only for day traders. They both lose money over the long term and are too volatile for non-day-traders to be playing. Luckily I didn't put much money into that, so my gains on DXO still far exceeded those loses.

On DIG, I believe I made just a couple of percent on the last 1/3 of my position that I sold. So I've averaged about a 25% gain on my full DIG position.

What's next? I'll save that for my next post.

Argggggh...

Well FAZ dropped 41% in one day! That's probably one of the biggest one-day moves ever of one of these leveraged ETFS. And I didn't sell - stupid me. Here's what went down.:

I bought FAZ perfect timing, and the markets gradually dropped the next 3 days. I was up about 15% on Wednesday and thought about selling, but decided to wait one more day. And then out of nowhere -- Wells Fargo sends out a pre-release announcement about their expected earnings. Maybe I'm just not paying attention, but I didn't know this was going to happen. Their earnings statement date isn't until April 22nd, one of the later ones in fact, and here they go letting their numbers out before any of the other banks. And of course the news was really good. Here's the deal: Wells Fargo was always one of the healthiest banks out there. They didn't get involved in any subprime loaning, they didn't need any bailout money (but got some like all banks), and so of course they're doing well! I'm no conspiracy theorist, but this was obviously all planned out to downplay the bad news of bad banks. I bet some serious institutional money was thrown into the markets timed with the release to help spur this rally. Seriously, everyone is over-reacting to the news, but I guess everyone wants a rally.

If I knew there was any news coming out, I would've gotten out. That was my plan as you could see from my last post. But I also said I would only hold 2 - 3 days, and I didn't get out when I should have. I should have at least set a stop at my break-even point, and even with the huge gap down, I would have only lost about 15%. I even still had time to sell Thursday morning, and I actually considered switching to FAS to try to recover my losses (which would have worked becase FAZ was down 20% at the beginning of the day, and ended down 41%, and so I would've made about 20% on FAS just in the last half of the day).

I should've sold no matter what, because I'll never break even. Huge drops like this are horrible to recover from in leveraged ETFs which have to match the *daily* performance of an index. Here's an example to show why:

Say some index is at 100 and it's inverse 3x ETF (e.g. FAZ) is at $100. Say the index goes up 14% in one day, meaning the 3x ETF drops 3*14 = 42% (like FAZ did). The index would now be at 114 and FAZ would be at $58. Now say the index returns to it's previous level the next day. This would require only about a 12% drop (114 * (1 - 0.12) = ~100). That means FAZ would increase 12*3 = 36%. FAZ would end up at $58 * 1.36 = ~$79. So while the market has returned to where it originally was, the holder of the 3x ETF is down 21%.

Let me re-iterate this: Even if the markets return to their previous level the very next day, the holder of the 3x ETF is down 21% !!! This is why huge movements in ETFs are so detrimental, and also why you do not want to own them long-term. This is known as the "Constant Leverage Trap". You can read more about this here.

Bah. Luckily I didn't put too much money into this, but I did put in more than I should've for such a risky play. I really need to start learning from these mistakes. I even said last time that FAS/FAZ were too crazy and you have to be a day trader to use them... and then I jumped back in anyway and got burnt again. Sigh....

FAZ

I bought some FAZ (3x inverse financials) near the end of Friday at 15.93. The market kept rising in the last 10 minutes and FAZ closed at 15.60.

It's of course a risky trade, being a 3x leveraged fund, and I'm buying in the midst of a rally. In one month, the Dow has gone from 6600 up to 8000, and FAZ has dropped from over $100 to it's current value of around $16. The trade is a gamble, but I'm betting that after a month of large gains, the markets will pullback here, especially since the Dow has now reached the key resistance level of 8000. It could fly through it -- anything's possible -- but I think it's much more likely to get stuck around the 8000 range or bounce off it. It's been a pretty large rally and the economic news is still pretty dismal. Earnings season is now here (roughly from Tuesday to 6 weeks later), and the news should be bad.

Take a look at the chart below to see the Dow 8000 and 9000 resistance/support levels:



I think one of the riskier things about this trade is that I'm buying pretty early, without any confirmation of a change in direction of the markets. I probably should have waited to see if the DOW blows through 8000 or starts to drop. Instead, I'm trying to time the top perfectly, which usually doesn't work out too well :)

I don't want to set a stop on this trade, because the 3x ETFs are so volatile it would probably get hit and I would lose money now matter which way the trade eventually goes. I'm pretty confident DOW won't go above 8400 right now. I'm planning to sell in 2-3 days.

Trade Update - Citi

Markets were up again today, but Citi did not outperform the rest of the market like I had hoped. I would've done much better if I had just held onto UYG. As I mentioned, I don't want to be holding Citi long (too risky, even if it could easily go over $2), so I just sold it off near the close today for about a 15% gain.

Trades:
Sold Citigroup at 1.63 (bought at 1.42) for a 15% gain in 3 days.

Citigroup

Citigroup was up 15% in the morning, but closed up only 6% at 1.54. I actually decided last minute I'd get out at the close, but my order was too late and didn't get filled. So we'll have to see what tomorrow holds.

On an unrelated note, DXO has been dropping. Last time it was at 1.80 I knew I should be buying, and it went on to reach 2.60 or so. Oil is dropping again (down to $42) and DXO is down to 2.22. I'm hoping it drops down to the 1.80's again, and if so, I think I will find some money to buy a whole bunch more to lower my average. Oil seems to have found its support in the $40's and any dip into the 30's is a great buying opportunity. And of course we'll be laughing once it returns to the 60's or 70's at the end of the year... that's the plan anyway :)

Trade Update - C

I bought some Citigroup near the close at 1.42. I know, I know... I tell everyone I'd never buy any banks, and then I go and buy Citi on a day that it's already skyrocketed up 35% :-)

I'm betting on another +30% day for it tomorrow, however unlikely that might be. The reason it's up is because of news from their CEO that they were actually profitable for the 1st two months of 2009. Because the stock price has been completely trashed up until now, and now there's finally a bit of good news, I'm expecting more people to jump on board tomorrow. Even if it pulls back tomorrow, I think I'll hold on for a couple of days before selling. We may be in a short-term market rally here, and I think Citi will recover to the $2 range. I'm not holding for more than a few days though.

Trade Update - UYG

Huge market rally today, led by the financials, averaging up 8% as of now (mid-day). Citigroup up 36%, Bank of America up 28%. UYG up 21% so far, so I exited my position, even though I think the rally may continue tomorrow.

Trades:
Sold UYG at 1.85 (bought at 1.53 on Thursday), for a 21% gain in 5 days.

Update

I forgot to mention last post, I bought a little bit of UYG at 1.53 on Thursday. With the markets dropping so far, so fast, I'm just looking for a short-term bounce again.

What's up

Sorry, it's been over a month since my last update. I've just been busy at work, and haven't been doing any trading really. So what's up? well not much... mostly everything is down.

Can you believe this: The Dow Jones and S&P500 are down 24% Year-To-Date already. Yep, even after the huge drop at the end of 2008, if you jumped back in the markets on Jan.1, 2009, you'd be down about 25% now just over 3 months later. So much for the advice you've been hearing people give about buying when things are "cheap" and holding for the long-term, since stocks always go up in the long-term :) Try telling that to Japan, where over the last 20-years (which is quite long-term), the stock market has dropped 80%.

What's in the news today... In the U.S., 11% of mortgages are delinquent (behind in payment by 1 or more months) or in foreclosure. Unemployment is already over 8%, and will hit double digits soon. GM is going under. et-cetera.

So if everything is going to the crapper, what do you invest in? Here are some ideas, mostly from the pages of Sprott of course:

1. Gold. Not mining companies, but gold bullion. You can hold this through an ETF like GLD or ETNs like DGL (or DGP, it's double-leveraged counterpart), or you can buy gold coins, and it looks like Sprott is coming out with a gold bullion fund soon. While gold could skyrocket in the coming years, don't use it to try to make a lot of money; Use gold to preserve your wealth in these troubled times.

2. Oil. Not oil companies, but oil itself. This is a more long-term idea that I've talked about before. Oil cannot go to zero. We are running out of oil. Right now, demand for oil is low, and yes the price of oil could go lower (and I've lost money on paper because of this), but the demand for oil is not going to go away anytime soon, and the price will go higher -- much higher. So if you can handle potential short-term losses for long-term gains, now's the time to get into oil. You can participate in oil through OLO (or double-leveraged with DXO), or the canadian ETF HOU, or even USO.

3. "Recession-proof" stocks. I really like Jean-Francois Tardiff at Sprott. He manages a couple of the Hedge funds there. On BNN recently, he picked 3 "recession proof" stocks, all of them income trusts, as good investments for 2009:

1) SIF.UN Energy Savings Income Fund - sells natural gas in 5-year fixed price contracts to residential homes. No matter the price of natural gas, they will always make a profit since they fix their margin (e.g. buy 5-year gas contracts at price X and charge the customer price X + 20%). Number of customers is growing strongly. The yield of this income trust is currently around 12%.

2) FMD.UN Future Med Healthcare - distributor of hundreds of healthcare products mostly in Ontario. They just bought a company in Quebec. Expect revenue growth because of the acquisition. Yield is currently around 12% and likely to be increased.

3. LIQ.UN Liquor store Income Fund - the whole idea that in bad times we drink :) This company just acquired a competitor, which was much more aggressive in pricing. With that competition gone, their profit margin should grow. Price has dropped a lot, so yield is now around 15%.

Assuming no changes in distributions, if these income funds' stock prices were to remain flat through 2009, you'd still make over 12% from the distributions alone. Just remember that these distributions count as income (not dividends or capital gains), so you would be taxed on the full amount, so you'd probably want to hold them in an RRSP or TFSA.

Trade Update - FAS

Sorry, I'm behind on blogging... So as you know I bought a puny amount of FAS at $12.55. It's probably a good thing my mistake happened, since FAS has since plummeted.

When I realized my mistake, I removed my stop, because I didn't want to pay commissions on such a small trade... I didn't really care what happened with it.

Then yesterday with the markets way down in the morning, I bought a proper amount of FAS at $10.01. I set a stop at $8.50 (for a max 15% loss). I thought this was a steal of a deal and was expecting a rally since it was Obama's inaugaration day. But FAS easily hit my stop and plummeted to $7.60, and incredible 40% drop from the previous day's close! It's still hard to believe these 3x ETFs... 40% in one day -- amazing.

Anyway, so I'm feeling pretty crappy about that trade, but still felt there's got to be a rebound here with such large drops. So today, with the markets up, I waited for the first sign of a rally in the afternoon, and I bought in again, getting in around $8.50 -- basically where I previously exited. It was a pretty bad price since it was much lower earlier in the day. But the rally was strong to the close, and FAS finished at 9.90.

It's nice it finished so strong, so that now I can put a stop just above my entry point and not lose any more.

Man, I think it's a little too stressful to trade FAS/FAZ -- you practically need to be a day trader.

Trade Update - FAS

Okay, I'm stupid...

I planned to buy FAS (3x bull financials) to catch a short rebound, since the markets have been mostly down the last 5 days in a row including being down sharply (3%) this morning.

I bought almost perfectly at the bottom at 12.55 before lunch and it immediately shot up to $15.00 before I realized my mistake: I was in such a hurry, I entered 1/10th the number of shares I meant to (because I was used to buying SKF which is in the $100's, not the $10's), so I ended up hardly owning anything. I can't make enough on this to even cover the commissions now, so I'm not sure what to do. I'll probably just wait till tomorrow to see. I think it's too risky to buy right now. If the markets drop again, I'll try to get into it again in the $12 range, this time with a proper number of shares, but I'm probably too late. Bah - so much for my perfect trade.

Lesson: Always review the trade confirmation page to make sure the total order amount makes sense before you click OK.

Trade Update - SKF

I stuck with the plan and sold my SKF today at 138.10 (bought at 106), for a nice 30% gain in about 5 weeks.

Oil up

Oil closed up at $46 today, probably mainly due to the conflict in the Gaza strip. More details here.

In the last 5 days DXO has gone from $2.20 to $3.13 -- up over 50%! It just goes to show how much money could be made or lost with this ETN depending on your timing.

It looks like the Palestinian conflict could get worse, meaning oil could climb more. If oil gets above $55, I may sell off half of my DXO. Why? Well, while I still believe oil will go much higher long-term, I had obviously underestimated how much the economic downturn would affect it in the shorter term and how low it could go. If the current price is just being propped up by the recent conflict, it may be prudent to sell off some while it's high in order to be able to buy back in at a lower price. Also, I've got too much of my portfolio weighted in it right now since I kept averaging down as it dropped lower.