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A Trade Idea Based Solely On Risk/Reward

As some may be aware, I spent nearly twenty years making a living in a dealing room. Contrary to what many believe, those who are paid to trade are, in my experience, not necessarily smarter or better educated than those who pay for the privilege. They have better, faster access to information for sure, and they also have the focus that comes from concentrating on one market all day every day, but it is possible for anybody trading at home to get the same info and to specialize. There is, however, one major thing that sets floor traders apart.

Their role as market makers means that they often end up with positions that they didn’t intend to take and that leads to a completely different focus when observing markets. Rather than look first at the entry point for a trade, most professional traders concentrate more on exit points. Rather than ask themselves “where should I buy this” they ask themselves “if I buy this here, where will I sell it?” That view sometimes reveals a short term opportunity that is too good to miss.

Sometimes that even means taking a position that you are not entirely convinced about from a fundamental perspective, just because the proximity to a logical stop loss level means that with even a moderate price target the risk/reward ratio is strongly in your favor. I would argue that that is the case right now with Natural Gas, or more accurately with the U.S. Natural Gas ETF UNG.

UNGChart

UNG hit a low last week of $14.09 and, following a rapid bounce off of that level has returned to the mid 14s at the time of writing. The reasons for UNG trading down here are pretty obvious. First and foremost, like oil, there has been a huge increase in supply as shale deposits have been recovered in the U.S. There is also the fact that this winter has been, so far at least, relatively warm and demand has been anything but robust.

I understand all of that and from a fundamental perspective would be wary of bottom fishing the commodity via futures or any other means. That doesn’t mean, though, that I would pass up a trade with a great risk/reward ratio just because it involved going long Natural Gas, and buying UNG at these levels sets up as exactly that.

At some point the fall in price will lead to some planned supply increases being delayed. That may not be in the next few weeks, but the realization that it is coming could easily lead to a snap back in the price in the short term. Similarly, the ECB’s decision to fully embrace QE has no direct immediate effect on U.S. natural gas, but if it quells fears of a global slowdown and lends support to oil it could spark a rally. If that is even a remote possibility, buying UNG at around $14.50 with a stop loss at around $13.50 and a target of a return to around $20 is an attractive trade.

When you approach UNG as I was taught to, considering exit points above all else, then the 1:5 risk reward ratio is what appeals. Whether or not you believe a recovery in natural gas prices is imminent is not the point. Just the chance that it could come makes the trade worth the relatively small risk.




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