A Warning For Natural Gas Longs

On Friday, hedge fund manager and market technician Tim Knight warned that the United States Natural Gas ETF UNG might be headed for steep leg down. For any investors who are thinking of holding their noses and staying long natural gas, I thought I'd post a couple of quick ways to add downside protection to that ETF.

1) Hedging With Optimal Puts

3.6% cost. Uncapped upside.

These were the optimal puts*, as of Friday's close, to hedge 1000 shares of UNG against a greater-than-20% drop between now and April 18th.

As you can see at the bottom of the screen capture below, the cost of this protection, as a percentage of position value, was quite expensive at 3.55%.

2) Hedging With An Optimal Collar

No cost. 20% upside cap.

If you were willing to cap your potential upside at 20% between now and April 18th, this was the optimal collar** to hedge 1000 shares of UNG against a greater-than-20% drop over the same time frame.

As you can see at the bottom of the screen capture above, the net cost of this collar was zero.

Note that, to be conservative, Portfolio Armor calculated the cost of this hedge by using the bid price of the call leg and the ask price of the put leg. In practice, you can often sell calls for more (at some price between the bid and ask) and buy puts for less (again, at some price between the bid and ask), so, in actuality, an investor opening the optimal collar above may have actually gotten paid to hedge.

Possibly More Protection Than Promised

In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this post on hedging iPath S&P 500 Short Term VIX Futures ETN VXX.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.