I have seen all types of supposed strategies developed. Whether published in a book or evolved on a trading floor, most are just a list of one trading instrument after another, defining the instrument and claiming that is a strategy.
Trading instruments using financial or physical, swaps to options, is not a strategy. It is just an instrument, or a means, or the tactics to executing your trading strategy to get to your objectives. Your objective being a big fat bonus. Most books on the market, especially in energy, are written in a textbook manner and are obviously written by people who have not internalized what trading is about.
Trading Strategy Definitions
I want to further ensure we are clear on what is a trading strategy.
Speculative
First, the term “speculation” is widely used without clarity. Generally, when the term does arise, it is in a negative connotation. Since we have already defined our free-market capitalist society as risk-based, speculation is what we all do, to an extent.
Speculation, to me, is betting markets directionally, or with trading spreads/margins where you have no local knowledge or asset positions to leverage. To ensure clarity of what I am moving you toward is to build a real trading business. So, we will not use the term speculation.
Proprietary
Another term that is politically correct, and yet still has its own connotation is “proprietary trading.” It has connotations from speculation to the real trading strategies I am introducing. We will not be using this term either in defining a tried and true trading strategy. I will use it in direct discussions, but not in this book to keep the ideas clean, bifurcated.
Economic
This is the one and only trading strategy type I will ever discuss, going further. For clarity’s sake, what does “economic” mean? There are fundamental, underlying economic reasons that drive these trading strategies. I am not going off into an economics class discussion.
As a trader, though, a few basic economic and accounting concepts are key. I will use these terms interchangeably, in combination throughout to move you to think in these terms to leverage local and tacit knowledge into long-term repeatable trading plays.
Marginal Cost
Marginal Revenue
Gross Margins
Mean Reversion
Supply
Demand
Switching Costs
Fixed Costs
Variable Costs
Did you notice I have already used these terms in the hedging section as well?
Connecting-the-dots from hedging to trading strategies is why I chose to put hedging first so that one can get a feel for what discipline looks like. These basic terms make up most of what you need to understand in your market to discern the drivers for internalizing markets.
The secret is to discern these in the specific market you are trading, and how it is changing over, or will be changing over time. Change is constant. And, it cycles back as I have articulated in several examples.
Therefore, history is great, it does repeat itself but momentum of where we are going is more important than where we have been, in many cases.
Therefore, if you are trading from some basic price history analysis, or even margin analysis, what does it tell you?
I don’t think it tells the complete story. A story worth betting your or someone else’s dollars on?
Someone told me years after I was trading that natural gas couldn’t fall below $6.50/MMBTU because that was Chesapeake Energy’s marginal cost. I didn’t know if it was or not. What I did know is that if it was, and even if it was for the entire natural gas market, it didn’t matter.
I didn’t stop to explain to him how I had bought the frac margin of Ethane vs. NG for the fixed cost, which was below the total cost. He wasn’t going to hear one thing I said, which was fine as he needed to learn it for himself. It is why he doesn’t work in energy trading, but in some bankruptcy area now.
At that time about 10 years ago, the demand destruction for gasoline was at about a 2% decline, which was basically unheard of in our economy. Gasoline consumption shows growth even in recessions, if you look at the data.
For natural gas, at that time the demand destruction was 7% – wow.
If you ever see the 99th percentile, and beyond into unchartered economics, which if you have been in trading long enough, you have seen untold times in every energy market, throw out the math, throw out the economics and bring in the human nature!
The pendulum is going to swing beyond any rational, normal pattern when human nature, including Mother Nature, joins the trading business.
The pendulum, the lag of supply/demand always gets out of balance in every market, yes, including tulips, as I have shared.
Though these work themselves out in the long term, i.e. via mean reversion, in the short term, human nature drives markets to extremes.
In short periods of time, volatility equates to big losses and big gains. That is why you never lay all your cards on the table, and why you never hedge or trade to the extent your policies allow for – i.e. do not hedge or trade to 100% of your authority. When you get to 75%, and have proven your ability to make money, ask for a trading limit increase, don’t test the boundaries to see who is looking. Someone may be, they may not be, but if you get there and something out of your control occurs, guess who is going out first?
More and More about Less and Less
If it is not intuitive at this point. More and more about less and less is why no economic or mathematical tool will ever give you the complete picture of what you need when it comes to developing and executing hedging or trading strategies. I like having PhDs around to give me input, not mechanical trading arms to execute from.
Everyone believes they have an edge, regardless the trader, market analysts, or mathematician to magician that they must try, to execute, and those just half-baked, just out of the oven analysis are fine for very small trading experiments. Therefore, all models are wrong, some are useful.
Better yet, as you bring more and more models, I will know less and less about what are the real drivers of making money. Change is quick, and those economic factors I have put forth are, and will continue to be very important to line up.
Simply as human nature and the pendulum swings, economics win, in the long run.
Experimenting
The first strategy you ever employ, regardless of how great you have been, is to start small. Do small experiments to validate your thinking, and that of other’s. When you wear a risk, it will fine-tune your ability to think even more than before. That thinking, and the results of early experiments, not $3 million dollar losses in 10 minutes, is going to be the key to success.
Trading Strategies vs. Hedging Programs
As we move deeper into trading strategies, some will not know the difference between hedging and trading strategies, or find more clarity in reading trading strategies while they develop hedging strategies.
The simple view is that both are managing to a target. A target or risk/reward.
The difference is simply that trading strategies are trying to grow profits. Hedging strategies generally are trying to narrow outcomes into a defined playing field, today and into the future – maximizing the set of cards, and playing by the rules in your arena are what hedging is about.
Trading is playing a little outside of you comfort zone.
Trading Strategies Less Risky Than Hedging Programs?
What do you think? Is your trading strategy less risky than running a hedging program?
This is a valid question for many. Go back to contracting or even asset planning models, and you will see there is great variability in those plans, and once decisions are made to enter, exit, buy, or build an asset, things change.
The time lag, the feedback timing, is much greater than unwinding most trading strategies, and if not done properly, especially with change today increasing at an increasing rate, that asset play meant to diversify, or hedge your feedstock, may create more risk than it maximizes.
Said another way, marginal costs, for example, can change between planning and plant commissioning. Therefore, this thought may create an ah-ha moment to contemplate in relation to hedging, creating synthetic assets, or trading for profit.
Successful Trading Strategies have these 3 Things!
- Fundamental Economic Analysis
- Continuous upward results, year after year
- Incentive compensation systems that reward for properly.