DGAZ Price Simulated Back To 2007 Using UNG Prices

Natural gas is one of the most fascinating commodities. It isn’t just the price that’s volatile. Natural gas itself is unstable, dangerous, difficult to transport, and expensive to store. Natural gas is uncorrelated to almost everything else, and also exhibits seasonal tendencies. If this sounds like the land of opportunity for a trader, you’re right. It’s also the siren’s call to the rocks for the unwary. ANG correlationss one famous example, in 2006 Brian Hunter misjudged the market, losing over $6 billion on a calendar spread gone sour and collapsed his firm, Amaranth Advisors. Their assets were taken over mostly by Citadel and J.P. Morgan. The timing of Amaranth’s losses precedes the creation of the UNG ETN by about 6 months. To what extent they are related events, we can’t say. In any case, here are charts of the natural gas futures price, and UNG since its inception:

Natural Gas price 20070418 to 20150425

UNG

UNG is the big daddy of natural gas ETN’s. UNG began trading on April 18, 2007. Over that time, a lot has happened with the price of natural gas, both up and down, but the first thing most people notice with UNG is that it has spent most of it’s life grinding lower. The short explanation is the contract rolling cost, known as contango. The contango in this case happens when selling out a long position in this month’s futures contract before delivery doesn’t leave you with enough money to buy next month’s contract, so you wind up with fewer of next month’s contracts. One of the big factors causing contango is that carrying a long position in futures is effectively paying “the market” to store your commodity for you, and as we already explained above, natural gas is costly to store and transport.

 A popular carry trade is shorting natural gas and collecting the “roll yield.” A paper short position in natural gas futures is a synthetic version of the gas producer who stores the commodity (in the ground or in tanks) until delivery when the contract expires, and gets paid a storage premium for that time. This might sound simple, but the gas producer doesn’t know if the price will go up more than the storage premium, and the further out they try to get paid for, the more opportunity they could have forgone, since their price is locked in when they sold the futures contract.

If shorting natural gas is your thing, then VelocityShares has introduced a product for you. On February 8, 2012, DGAZ debuted. This product attempts to replicate a triple leveraged short position in natural gas. As we’ll show, they do a decent job at this goal. The following chart shows DGAZ since its inception:

DGAZ_04-24-2015

But how can you know what the ride might be like in this vehicle, since it is so new? Shorting natural gas looked very profitable when we looked at UNG, and if DGAZ does what they claim (it basically does), then what gives? We used Portfolio Workstation and a few other algorithms to answer this question by using UNG’s prices to create a hypothetical simulation of how DGAZ might have traded if it had instead debuted in 2007 alongside UNG. Without further ado, here is the picture:

 DGAZ-sim_from_UNG-20070418_to_20150424

In order to double-check our work, and also double-check how closely DGAZ tracked the movements of UNG, we created a ratio chart, with our DGAZ price simulation based on UNG in the numerator, and the real DGAZ in the denominator as a benchmark. Here is that ratio chart:

DGAZ sim to yahoo ratio

This ratio chart shows a fluctuation around the 1:1 ratio, with the implied DGAZ price (numerator) differing from the actual (denominator) by up to 12%. These differences could indicate temporary arbitrage opportunities. We note that it could differ by more than 12% in the future. The big ratio spike up and down in January and February of 2014 marked a major turning point in natural gas. We’ll be watching for this to mark price inflection points in the future.

As an interesting note, on the date of inception for the real DGAZ, February 8, 2012, the simulated DGAZ open price matches the real open price exactly at $51.70. This is purely coincidence because if we had performed this study on a different date, we would have had to use slightly different numbers for the transaction cost estimate and the nav adjustment algorithm. This phenomena also appears in the ratio chart, it starts and ends at exactly 1, even though we only targeted for it to end at exactly 1.

If you are interested in purchasing the simulated DGAZ daily ohlc data for informational and testing purposes, look for it on our Purchase page.

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