Battle Scars As A Call Option — The UNG Experience

An earlier post had 2 parts:

1. A hands-on walkthru of spotting a hidden option in an ETFThe walkthru builds intuition socratically and since it’s already in question-and-answer form you can use it with minimal modification to scaffold an interview question.Again, that link: Financial Hacking: ETF vs Negative Oil Futures
2. A bit more advanced was the description of how I actually traded it in real life. A fellow professional option trader endorsed the approach and I’m not above shilling that:

I’m flattered to be given credit for explaining something so anyone can understand it. But recognizing why the pricing was the way it was, is not an act of “galaxy brain” genius. It was experience.

This is worth an explanation with a generous helping of personal color.

Back in 2009, I was trading as an independent (I had a backer deal where I put cash up in escrow that represented the most I could possibly lose and in exchange for that and some economy of scale stuff, the backer got 30% of my profits). I had left SIG a year earlier but because of my non-compete couldn’t trade oil-related derivatives.

I could trade natural gas options though. My backer, despite bankrolling about 100 traders, some of them with large businesses employing as many as 20 people, never had anyone trade natty options for them. My pitch emphasized a “steady hands” approach. As a dyed-in-the-wool market maker, I had little use for opinions or fundamental research. I had an arbitrage mindset — I would focus on my advantages of being a grinder. I stood in the pit, trading order flow that came to the floor, I had a partner who handled all the voice brokers upstairs and we had an assistant who made markets on the screens. The 3 sources of info would allow us to stitch a master vol surface or “sheet” that we would push out to all 3 spokes in an ongoing conversation that provided feedback as to when we should update fair values.

[Multiple times per day…”raise summer small calls 2 clicks, multiple brokers bidding and lower Jan meaty puts a point — I’m seeing consumer flow buying calls on winter fence strips, they haven’t printed yet”. The PitBulls experience rhymes with this. See Mock Trading]

Our backer was focused on futures and futures options but I had spent most of my first 6 years as a trader in ETFs — so I convinced them to let me build out the infra to price and trade options on UNG as a 4th spoke to find relative value trades against our core options book.

I was long UNG options vs a short in NG futures options because UNG vol traded at a discount.

Bad timing.

In the summer of 2009, in the wake of what Goldman deemed the “commodity super cycle” while pushing commodities as an asset class, commodity ETFs were under scrutiny for allowing financial speculators to more easily drive up the price of energy, food, and materials. Natural gas prices were in the crosshairs — the UNG fund announced it would cap the number of shares it would issue.

With a shortage of shares, UNG surged to a large premium over NAV (I don’t remember exactly what it was but something like 20% is lodged in my head). A large player had done their homework placing a smart 9-figure bet — they “created” all the remaining shares betting this would happen. I won’t speculate who that was in print but my hunch is not unironic.

I was in a bad spot.

Every time gas futures sold off, UNG basically stayed unchanged — the premium to NAV would just expand. When NG rallied, UNG still barely moved — the premium simply narrowed. Every day I was forced to pay theta on my UNG options while getting chopped to pieces on my short NG options. Meanwhile, the vol discount widened from about 1 point (the threshold where the arb became interesting) to about 20 points! Without a proper “creation” function, UNG was no longer hinged to NG futures.

I lost about $250k of my own money in under 2 weeks…a multiple standard dev p/l event for that time frame (I realize this is a quaint sum in a world where that’s the cost of a kitchen with red-knobbed ranges but even back then I’m like buy me a drink before you do me so dirty).

[My backers, to their credit, were understanding. They never flinched and allowed us to continue trading and building. We expanded into trading options on SLV, BAL, JO and SGG as our footprint in futures options grew.]

At the risk of overgeneralizing, a few things stand out:

1. Market risks (ie prices moving up and down) are the most trivial. It’s the ever-present possibility of rule changes (and the politics that can drive them) that remind you that the last line of defense in risk management are constraints to gross exposures not just nets. The UNG trade is also reminiscent of that trope about how a casino’s risk manager is more likely to lose sleep over an Ocean’s Eleven heist scenario than a string of bad luck at the tables.
2. Battle scars are great teachers. When USO traded at a premium as CL futures went negative, my reflex was not “that’s stupid” but “there’s more to this”. Even though UNG and USO went premium for different reasons I wouldn’t have figured out the gameplan as fast as I needed if I didn’t have that prior weird (and painful) pattern to match to. This is also an argument for having a team of trusted people to bounce ideas off. You don’t have to touch every stove yourself.

With this fuller context, you can re-visit the “galaxy brain” approach to trading USO options during that Covid dislocation:

🔗Options on USO when oil went negative