BY BEACON ENERGY'S STEPHEN KESSLER
- The futures have been meandering aimlessly, though we seem to end up back in the $3.00 area after a day or two. Today’s market feel was different, it looked like it was much more of a market entering an orderly rally rather than one that will just collapse back to $3.00 quickly.
- We are still moving enough to survive owning Q gamma (.06-.065 break-evens), but that requires diligent, disciplined gamma hedging with minimal returns. It is likely a statement about the fact Q vol is fairly priced more than one about an immense opportunity. I would still own a small piece with the hope we catch one .15 move before expiration and in the interim it has been reasonably easy to capture .06-.07 most days allowing you to hold it.
- Overall we started this week with a Monday morning vol slaughter in 2017 on virtually no volume. Premiums just melted on quotes as the market rallied modestly. I am not sure FH can hold its hefty vol premium if the entire strip of months preceding is having a vol collapse.
- The past few months have also involved extensive discussions about the pricing of near term fences. Steady put selling has left that side of the skew soft for months and I have been one of the fans of owning the 15-20 delta puts at such depressed skew. They have underperformed on most drops in vol terms, but the gamma has paid enough to ride them out. The fences have done very well on rallies as calls and call skew both have gotten hit each time we climb above $3.00 so anytime we have been down at $2.90 or below it has been a good opportunity to put them on. Calls in 2017 have gone offered on virtually every bounce/rally.
- FH vols have also remained strong, as we near the end of summer that may well continue but it is worth looking at the fact that FH is carrying .08-.09 break-evens, essentially .02 higher than VZ. Those futures spreads have had movement and even if winter ends up cold there is some question in my mind if the $3.00-$3.50 strikes are going to outperform since they would quickly become puts on a rally. It is easier for me to see skew steepen while at the money vols may prove initially sticky into futures strength since it is more likely the explosive options would be the $4, $5 and $6 calls on any threat of bitter cold weather. That is one of the reasons I have questioned the skew/value in the .25 wide put spreads in Q1 - I am not convinced there is an extreme difference between $3.25 and $3.00 in those months - even $3.50 does not feel like a scary price for the underlying during the winter. It would make more sense to me if the first band of skews were flatter then accelerated as we got to smaller delta options.
- Another FH observation I have is related to F alone. There is still some question for me if it is a “true” winter month. Certainly the cash market in F can be extraordinarily volatile, but the options expire the day after Christmas - basically before any real cold has come. It can rally more on expectations of weather than real weather so I question its 3.5-4 vol premium to Z - a full penny higher in gamma break-evens Even if the fall starts out mildly, G and H still have time to catch real cold weather as the calendar turns to 2018, but by that point F is gone so it needs an aggressive fall weather pattern. Even that may prove to be only so bullish. 15 degrees below normal in November is not as impactful as 15 degrees below normal in January or February. If the fall starts out looking cold I really think the funds are more likely to reach for G and H - options that have the most explosive potential in an unusually cold winter.
- The shape of the call skews in FH is also worth looking at. There is substantial (justifiable) skew between the $4 and $5 calls. As you look at the differential in the $5 vs. $6 and even $6 vs $7 this begins to flatten quickly. I would argue it should almost be the opposite. If $5 comes into play in the winter I believe the $6, $7, $8 and even $9 calls have the potential to explode in G and certainly H. Pricing in somewhat of an orderly vol spread between wing calls in the winter feels counterintuitive to the argument (made by many) that a truly cold winter could bring unprecedented prices. At the very least it will bring significant uncertainty - likely a vol explosion at some point into a rally. Right now $3.25 and $4.25 feel far apart in the winter - if we went to $5 I think $7 would feel close because the market suddenly stops moving tick by tick in a grind. Regardless I think those upside calls in G and H are worth looking at as a relative value play versus the meatier skewed calls. In this environment of apathy, it can be the one that goes against the crowd that gets rewarded. Some of the pricing of FH options may provide that kind of opportunity while the fronts are languishing.
Natural Gas Broker, Beacon Energy Group
Kessler has been brokering at Beacon Energy Group since 2010, putting out commentary on natural gas market movements as well as his own trade insights. Kessler has more than 25 years’ experience within the derivatives markets, and prior to his role at Beacon, he was trading natural gas and soft commodity options both independently as a market maker and with a hedge fund.
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