Options allow traders to leverage their bets on the underlying assets represented by the option. These handy financial instruments can be used to trade stocks, bonds, currencies, and even futures and commodities. In this article, we will focus on the basics of trading natural gas options.

Overview

Unlike options to sell or purchase stocks, where the option can be executed in exchange for the underlying asset directly, natural gas options are exercised into futures contracts that represent natural gas contracted for delivery. This is not something a trader should lose sleep over, as a futures contract is as much of a security as a stock certificate.

In practice, natural gas options operate like every other type of option, with a call representing a long position and a put representing a short position. While a trader can go full bull or bear by buying one or the other, it is more common to use strike prices to create a spread over which the combined options can yield a decent return with controlled risks. Of course, once you start combining calls and puts in a range of strike prices and factoring in the time limits, you can end up with complex strategies that sound like failed 80s hair metal bands, such as the "iron condor."

Influences on Natural Gas Prices

All directional bets like bear spreads and bull spreads, and even neutral strategies like the butterfly spread, require a trader to have an idea about which way natural gas prices are going, based on available data. For options on US natural gas, the US Energy Information Administration (EIA), is the place to get all the information on supply levels, production, and variation from historical norms. The EIA also tracks imports and exports of gas. While the International Energy Agency is a source for tracking production changes abroad.

It is not all about supply and production, however, as weather can be a wildcard that throws off forward-looking projections. For example, hot summers can drive up natural gas prices as more energy is consumed to power air conditioning. The price of oil also has an impact, as the equipment can be shared and the same companies may be exploring and producing both oil and gas. For instance, the shared technological advance through hydraulic fracturing has increased the production of both oil and gas in the US, driving down the price of natural gas during times when it would have traditionally risen.

The Bottom Line

Natural gas options and the strategies used to trade them are the same as for any other option. The difference, and the main challenge for traders, is that the factors that influence natural gas prices are those of a commodity rather than a stock. There are no quarterly earnings numbers to cause volatility at set intervals, nor a single CEO hiring or firing that will show up on the price chart. Trading natural gas options requires getting familiar with the EIA reports, liquefied natural gas (LNG) export numbers and so on. Once you have the data, there are multiple strategies that can be used to profit from the expected directional change or price volatility/stability.

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