Business News/ Markets / Stock Markets/ This seasonal trade could work wonders. All it needs is an X factor. Do you have it?
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As a professional trader, I seek to achieve three objectives from my trading activity:
As a professional trader, I seek to achieve three objectives from my trading activity:
1. Highest trading profits from my trades,
1. Highest trading profits from my trades,
2. Achieved in the shortest possible timeframe,
3. With controlled risk to my trading capital.
Anything that helps me achieve these objectives is always welcome. Over the years I have realised having the seasons on my side is a big advantage. When my trade is aligned with a seasonal pattern, my profits tend to be higher.
Like buying gold a few weeks before the big fat Indian wedding season in May every year. Or buying shares of cotton garment manufacturers ahead of the summer. Seasoned investors buy stocks of alcohol companies around September. A spate of celebrations follows until February of the following year, which leads to higher alcohol consumption and rising stock prices of companies in that sector.
The best seasonal “fruit"
In this article, I share a high probability seasonal trade in natural gas markets. Being a trader who uses a 360° worldview style of analysis, I will share my logic too.
Natural gas is used as a fossil fuel, just like crude oil. But it has many advantages over crude oil. Gas burns more efficiently and is therefore a cleaner fuel. It is also more abundant and therefore cheaper. That makes it a fuel of choice for indoor heating purposes in the winter. Gas traders know this routine and plan their trading blueprint accordingly every year.
Winter officially begins in October every year after the autumnal equinox. It ends after the vernal equinox (beginning of spring) in the following year, typically in March. Summer peaks by the summer solstice, which comes in June.
A gas traders playbook
Every trader is like a cricket batsman. A batsman knows he cannot score a boundary on every ball. He focuses on taking a single or a double as often as possible, and waits for an opportunity to score a perfect boundary. Similarly, gas traders are treading water (trading for small profits) in other parts of the year. Winter is the season for catching profitable whales (equivalent to scoring a boundary in cricket).
No gas trader worth his salt will take time off during this time of the year. This is his time to earn his bread, butter, jam and chocolates!
The nuts and bolts
Seasoned traders know markets discount events in advance. They make their moves before such events to stay in step with the markets. So they start trading November gas futures in September itself. The reason is that the derivatives (futures and options) markets offer at least three monthly contracts, if not more, to trade simultaneously. Which means the November series gets active in September itself. Since winter has not yet set in, the price remains sluggish. As we near the end of September, you will notice the magic of seasonal trading begin in earnest.
The price of gas starts to rise. But that is not all. Cost of carry (financing cost or interest charges payable by bulls) rises sharply. So September futures could trade at ₹180, October at ₹210 and November at ₹255. These are actual prices as on Friday, 30 August 2024.
What we have noted is that bulls are paying about 20% financing charges per month to carry over their long positions. This is based on hope that winter will witness a huge rise in demand from the indoor heating industry. This is more or less correct. But the interest cost is not justified by any parameter.
For more such in-depth analyses, read Profit Pulse
The faster they rise…
Where an average retail trader will assume that seasonal demand provides a buying opportunity, a veteran will have other thoughts. He knows that 100-200% annualised financing costs are a death trap.
He also knows bulls (buyers) have to pay financing charges and bears (short sellers) receive financing charges. A savvy trader starts short selling the far month futures (the third and last in the series of contracts available for trade). This is because the third month futures quote at the highest price. This goes well with the saying ‘buy low and sell high’. So in September, he will sell November futures.
The trader will keep carrying forward this short sell trade every month by rolling over (closing the short sale in the expiring month and initiating it in the next month). Financing costs are 10-20% per month at this time of year, so he will receive this outsized interest till the vernal equinox (March) series. Give or take a couple of weeks, depending on the severity of the winter.
In most years the trader is highly profitable by the vernal equinox in March. In some years big gains come by the summer solstice in June. The trader keeps collecting the steep finance costs as interest income.
Once the snow melts, so does the price of natural gas. There is no more demand from the indoor heating industry. The old saying ‘the faster they rise, the harder they fall’ fits like a glove. It is routine to see natural gas prices fall with lower circuit limits. (Circuit limits kick in when a traded instrument rises or falls by a maximum predetermined magnitude and is stopped for further trading.)
The secret sauce
Gas prices rise spectacularly when it snows in western countries and plunge when it gets sunny again. How does a trader make money? More importantly, if this is a known fact, why doesn’t everyone do it?
The trick to this blueprint is truck loads of capital. Of the financial and psychological variety. After 38 years of trading in the financial markets I am certain that traders make money with their minds. We traders are ‘brain warriors’. Given a challenging situation in a trade, it is invariably the mind that gives up first, the bankroll runs out later.
No one knows just how high gas prices will go in the winter. The peak is usually around New Year. When you start short selling in September (placing trades in the November series), you have no clue till what level you will be short selling. Admittedly, the 10-20% cost-of-carry (interest charges) that you receive as a short seller helps a lot. But you are taking on a variable that you have zero control over—the weather.
The colder it gets, the higher gas prices rise. Then there is the risk of any surprise geopolitical event. In February of 2022 Russia invaded Ukraine. Putin used natural gas as a bargaining chip against the western powers. He threatened to cut off sales of gas. Prices zoomed geometrically. Any such geopolitical event can trigger a strong rally. These are risks that only deep-pocketed, mentally tenacious traders can handle.
Natural gas—affectionately nicknamed “natty" by global oil and gas traders—is also called a “widow maker" in winter, and now you know why!
This is the reason why not every trader prefers natural gas. It is a highly demanding, strenuous commodity to trade in the winter season. From both the financial and emotional perspective. How many traders can sit calmly in front of a terminal screen and short sell natty only to see it close circuit up at night? In this article I am familiarising my readers so the element of shock is removed for a newbie trader. As Warren Buffett says, risk is not in doing something but in not knowing what you are doing.
The sum and substance of the tale is, natty trading is a high-stakes game where you bet big to win big. Yes, there are losses too sometimes. But the weight of evidence is tilted in favour of taking this trade rather than skipping it. Let your own risk appetite decide whether you are up to it.
A word of advice: there are two ways to make ₹ 10,000 from a trade. You either buy 10,000 shares of a company and sell it if the price rises by ₹1, or you buy 1,000 shares and sell when the price rises by ₹10. Though the end result appears to be the same, the risk involved is substantially higher in the 10,000 shares trade.
Remember my three criteria listed above—earn the maximum possible profits in the shortest possible time and at the lowest possible risk. Here, less is more.
When trading natty in the winter, less is indeed more. Remember price moves in multiples of circuit limits. Cost of carry per month is 10-20%. You cannot bet the farm on such volatile trades!
Proof of the pudding
Any discerning investor-trader will want to know how this strategy has performed over the years. Here is a tabulated presentation of the return on investment (RoI). Do note the following:
- The returns presented are without the cost of carry (interest income earned up to 10-20% per month in winter months). Since this is a variable figure, it will change year to year.
- Natural gas is a leveraged trade. You pay a small deposit (span margin) to trade an entire lot of gas. So your profits (and losses) are far bigger. The leverage is up to 8 times in summer and 3-4 times in winter. So your profits are 3-4 times larger.
In the table below, we see the price fell (resulting in profits for a short seller) in 9 years out of 14 by the vernal equinox in March of the following year.If you factor in the cost of carry earned, all years were profitable.
The price fell in 8 years out of 10 by the summer solstice in June next year. Remember, the longer you hold a short trade, the more interest income you garner. So I would ideally prefer the June summer solstice trade over the March vernal equinox trade.
Barring 2020, when covid lockdowns saw an unnatural price rise in the financial markets, the summer solstice trade offers the benefit of hindsight of 14 years for a trader.
I saw a Hollywood blockbuster movie calledThe A-Team a few years ago. Liam Neeson’s dialogue—Give me a minute, I’m good. Give me an hour, I’m great. Give me six months and I’m unbeatable!—is profound wisdom for natty traders in the winter.
He who waits wins. Just take care of position sizing (less is more, so avoid large trades) and you should be doing great.
November futures of natty are showing signs of coming to life on my trading terminal. Time to get to work.
Have a profitable day!
Note: The purpose of this article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your investment advisor. Derivatives trading is extremely risky. Substantial loss of capital may occur. This article is strictly for educative purposes only.
Vijay L. Bhambwaniis the author of the first official commodities trading guide in India. He designs statistical and behavioural trading models for his family owned prop trading outfit. He stays at South Mumbai and trades markets since 1986. He tweets at @vijaybhambwani and has a video blog at www.youtube.com/vijaybhambwani
Disclosure: The writer, his dependents and his prop trading organisation have exposure to natural gas derivatives contracts discussed here.
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