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This Income Trade Could Earn 39%

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The past five years have been a tumultuous period for U.S. natural gas prices . The widespread use of hydraulic fracturing (aka fracking) to release gas from shale formations revolutionized the industry, dramatically increasing production.

As a result of this massive new supply, natural gas prices spiraled lower, briefly dropping below $2 per Mcf (thousand cubic feet) in April 2012. Since that time, spot prices have moved steadily higher as demand has slowly picked up to the point where the supply/demand imbalance is being resolved.

We saw a big spike in price this winter, as harsh weather led to a sharp increase in demand. Prices then settled into a stable pattern near $4.50 per Mcf, which is a higher level than we have seen in the past few years. Companies engaged in natural gas production now have the benefit of selling at higher prices, resulting in wider profit margins.

Shares of Ultra Petroleum (NYSE: UPL ) look particularly interesting at this juncture, as the company is making some significant investments that will benefit from higher gas prices.

In 2012 and 2013, Ultra Petroleum responded to falling natural gas prices by cutting spending on its drilling programs. The company reduced its spending by 44% in 2012, followed by a 54% cut in 2013. This left it spending just $385 million on production projects, compared with $1.5 billion two years earlier.

The cut in spending was a wise move at the time because it allowed the company to conserve cash during a period when it was difficult to sell natural gas at an attractive profit. But in today's market, with natural gas prices well above $4 per Mcf, the economics have changed.

For the first time in two years, Ultra Petroleum is boosting spending, with plans to plow $560 million into drilling new wells. The company plans to increase its activity at the Jonah and Pinedale fields in Wyoming and the Uinta Basin in Utah, properties that have a history of attractive returns on investment.

I expect higher natural gas prices and increased spending to help drive UPL higher. And we now have an opportunity to set up an attractive income trade on the stock by selling puts.

Our trade for today is to sell the UPL July 28 puts using a $1.15 limit order to ensure you get a fair price.

By selling these puts, we are accepting an obligation to buy 100 shares of UPL per contract at the $28 strike price. As of this writing, UPL is trading just below this level. While the strike price is above the current market price, the trade is attractive for two key reasons.

First, I expect UPL to move higher between now and July expiration. If this occurs, the $1.15 per share ($115 per contract) in option premium is ours to keep free and clear.

Second, we are receiving an attractive price for the put option contracts. So if we were assigned shares, our net cost (including the premium we receive from selling the puts) would be $26.85 per share, which is below the current market price.

To cover this potential obligation, we will want to set aside $2,685 per contract. If UPL rises above $28 as expected, the contracts will expire worthless on July 18, and the $115 in income represents a 4.3% return over the $2,685 in capital allocated for the trade. Since we will be earning this in just 40 days, our per-year rate of return works out to be 39%.

Of course, if UPL remains below $28, we will be required to purchase the stock at a net cost of $26.85. But given the bullish dynamics for natural gas and the ramp up in spending by UPL, this looks like a very attractive investment.

If we do wind up purchasing shares, we can sell a covered call to generate more income from the trade and partially hedge the risk of owning the stock.

This article was originally published at ProfitableTrading.com:

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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