Trading natural gas primarily involves buying and selling contracts based on its future price. This allows individuals and institutions to speculate on price movements or hedge against price volatility.
The most common method for trading natural gas on financial markets is through the use of futures contracts.
Understanding Natural Gas Futures Contracts
According to the reference provided, Natural gas futures are contracts in which two parties agree to exchange a certain amount of natural gas at a set price on a set date in the future.
Here's a breakdown of the key components:
- Contract: A legally binding agreement between a buyer and a seller.
- Underlying Asset: A specific quantity of natural gas (e.g., 10,000 million British thermal units - MMBtu - for a standard NYMEX contract).
- Set Price: The price agreed upon when the contract is initiated, known as the "futures price".
- Set Date: The future date on which the exchange or settlement is scheduled to occur, known as the "expiry date".
How Futures Trading Works
Traders buy or sell these contracts based on their outlook for natural gas prices.
- Buyers (Long Position): Believe the price of natural gas will rise by the expiry date. They agree to buy the commodity at the set futures price.
- Sellers (Short Position): Believe the price of natural gas will fall by the expiry date. They agree to sell the commodity at the set futures price.
The actual trading involves fluctuation in the contract's value before the expiry date. If the market price moves favorably to a trader's position, the contract's value increases, and they can sell it for a profit before expiry. Conversely, if the market moves against them, the contract's value decreases, potentially leading to a loss.
Settlement at Expiry
The reference states, "At the point of expiry, the trader would either receive the physical delivery of natural gas or settle their position in cash."
This highlights two main types of futures contracts:
- Physical Delivery: The seller is obligated to deliver the actual natural gas to a specified location (often a major hub like Henry Hub in Louisiana), and the buyer is obligated to take delivery and pay the set price. This is common for producers, consumers, and large trading firms.
- Cash Settlement: Most retail traders and many financial institutions trade cash-settled futures. Instead of exchanging the physical commodity, the contract is settled based on the difference between the set futures price and the prevailing market price at expiry. If the final market price is higher than the futures price for a buyer (long position), they receive a cash payment. If it's lower for a seller (short position), they receive a cash payment. If the market moves unfavorably, they owe money.
| Trading Action | Price Expectation | Outcome at Expiry (Cash Settlement) |
|---|---|---|
| Buy (Long) | Price Increase | If final price > set price, receive difference; If < set price, pay difference |
| Sell (Short) | Price Decrease | If final price < set price, receive difference; If > set price, pay difference |
Why Trade Natural Gas Futures?
- Speculation: Traders aim to profit from predicting price movements without needing to own or handle the physical commodity.
- Hedging: Producers can lock in future selling prices, and consumers (like utility companies) can lock in future buying prices to manage price risk.
- Leverage: Futures contracts allow traders to control a large amount of natural gas with a smaller amount of capital (margin), amplifying both potential profits and losses.
Besides futures, natural gas can also be traded via other financial instruments such as options, exchange-traded funds (ETFs) that track natural gas prices or futures, and over-the-counter (OTC) derivatives, but futures contracts are a fundamental mechanism for price discovery and trading.
