2008-08-11: Trading a portfolio - reducing risk increasing profits
’Don’t put all of your eggs in one basket’, is a frequently given advice. This proverb describes the risk of investing exclusively in one kind of financial product.

The benefits of diversifications are well known. Risks are limited when you place your bets over a number of financial products or different markets. If a specific market performs worse than it has in the past, the overall result will not be disastrous.

A demand for information of several markets and products in the energy compound seems to be rising. More and more players enter new markets, to trade and to monitor market information. The energy complex may be seen as an organic whole, however there are huge differences in the different markets that constitute the energy business. There are periods of high correlation, but there are also times when markets seem to leap in different directions, causing low or even negative correlation. The degree of market noise may also vary between the different product categories.

In probability theory and statistics, correlation indicates the strength and direction of a linear relationship between two random variables. The correlation coefficient is used to determine the relationship between two data series. It returns a value from -1 to 1, which is a measure of the influence that the independent data series has over the dependent data series. The closer the value is to 1, the stronger the correlation, the closer to -1 the stronger the inverse correlation. If the value is near to zero the correlation is non-existent.

When comparing the German and Nordic markets, through the contracts Cal 09 Base to Nordic Year 09, one finds variation in the strength of correlation. In the time period January 1 2008 YTD the correlation varied between 0.80 to – 0.27.

When studying the relationship between the Emissions market and Nordic energy prices, visualized through the EUA contract Dec 08 and Nordic Year 09, correlation was found fluctuating between 0.60 and – 0.36 from 1 January to this year date.

Several authors have offered guidelines for the interpretation of a correlation coefficient. However, all such criteria are in some ways arbitrary and should not be observed too strictly. This is because the interpretation of a correlation coefficient depends on the context and purposes. A correlation of 0.9 may be regarded as high in social sciences and low in other aspects. The contribution of complicating factors may differ tremendously. It is important to know that correlation often implies some causal relationship. What correlation does not do is prove causation. The important issue will be how a mix of markets will enhance the performance of your trading!

Whether these findings are considered good or bad, are a subjective issue. The focal point is to find a suitable level of risk management, appropriate tools and analyses combined with a mix of markets one feel confident trading.

When combining assets that tend to have low correlation with each other, a reduction of volatility in returns is achieved. Even minimally diversified portfolios can greatly reduce the likelihood of a large loss. Portfolios with high levels of diversification can enhance the possibility of loss protection as well as overall performance.

Prices in wholesale power markets are determined by supply and demand functions and are influenced by various factors such as fuel prices, temperature, precipitations, wind speed, Co2 and economic growth. Although market design is similar among countries, various price series have specific and unique characteristics, such as seasonality and highly volatile wholesale prices. Wholesale prices are lower in the Nordic countries as the large proportion of energy is generated in hydro plants. The degree of volatility does also differ among the various products.

In periods correlation may be high, but now and then various markets/products seem to detach themselves from each other causing a wider difference in prices, resulting in lower correlation. The fact is that energy markets are experiencing constant change and this will also be in future years. The markets change and price volatility is part of the game. However, it is volatility and prices that traders trade. Energy market projections are subject to much uncertainty. Many of the events that shape energy markets are random and cannot be anticipated, severe weather, political disruptions, strikes and technology. Additionally, future developments in technologies, demographics and resources cannot be foreseen with certainty.
Causing unforeseen leaps in market prices, the various markets may be hard to explain.

The benefits of diversification are indisputable. A balanced portfolio is an advantage in today’s volatile energy market. The markets may be seen as a whole and a larger perspective is by many considered a necessity. But, nevertheless, the markets seem to move in opposite directions from time to time. As one market experiences huge price fluctuations, another market is trending. The answer to this may be complex, both products being parts of a whole, but correlation seems to be low from time to time.

Trading a mix of markets can reduce risk from general problems arising from an ever-changing energy complex. The convergence of energy and carbon trading, offers new opportunities for risk management. The complex is poised for many more years of robust growth as the markets further globalize. It is a great time to be in the energy business. The downside is that risks are more invasive. Risk and reward are a double-edged sword which means more winners and losers in this highly risky business called energy trading.

A diverse portfolio may help you to balance the overall risk and volatility. This may stabilize investment returns and help you reach your investment objectives over time.