Signal Du Jour - Short Vol in UNG

How to deal with the strong risk perception in the asset?

With just a few days left until the end of the quarter, yesterday already had an Easter vibe. The market opened lower due to geopolitical tensions over the weekend, but within an hour of trading, all those losses were wiped out, and the equity market ended up flat on one of the lowest volumes of the year.

When things get tense with Russia, certain asset classes usually react more strongly than others, and commodities often fall into that category. Yet, natural gas and oil closed yesterday's day in relatively good order. That said, options traders were probably spooked by the events of the last 72 hours, so it's worth looking at volatility to see any potential opportunities.

Today, we'll focus on UNG, the ETF that provides exposure to natural gas through its positions in the futures market.

Let's go.

The context

Natural gas has had a slippery winter. Despite tensions with Russia and alerts in December about a potentially frigid winter in Europe, prices gradually declined from November to early February, leaving observers scratching their heads for answers.

UNG, which tracks natural gas prices through its positions in the futures complex, saw its (adjusted) price get cut in half throughout the period.

Short UNG over the winter was definitely a great trade, contrary to popular belief.

On the volatility front, though, things were far from quiet. The December price peak, which immediately sold off over the first few weeks of January, sent realized volatility through the roof. While things have calmed down since the beginning of March, volatility still sits at 50, 25% higher than the lows seen in 2023.

These kinds of moves likely rattled investors, and options prices must have stayed elevated the whole time. You'd expect sellers to demand a higher premium to take on the risk of providing protection to either the downside or the upside.

The VIX index has been on the rise over the past few weeks.

In fact, a reconstruction of the VIX for UNG over the first quarter of 2024 shows that the index not only overstates realized volatility but has been gradually increasing over the last few weeks.

This divergence between realized and implied volatility opens up opportunities on the short side of volatility.

Let's dig into the data.

The data and the trade methodology

Given that the VIX has been rising over the past few weeks, we'll start by examining the shape of the volatility term structure to understand the market's risk perception around the assets.