2009-10-16: Reducing risk - TradingAdvisor's Hedge Strategy
The goal of a hedger is to guarantee an approximate future price in order to reduce or eliminate risk of exposure to interim price fluctuations. The success of a hedger is based upon how accurately he estimates the futures price at which to lock in a sale or a purchase.
A dynamic hedge strategy may be a profitable tool to handle fluctuating energy prices. TradingAdvisor's hedge strategy consists of multi - period momentum indicators for hedge entry and a set of standard deviation calculations for hedge reduction/exit.

TradingAdvisor’s hedge strategy tells you when to take action, but as important it also tells you when NOT to. TradingAdvisor’s hedge strategy consists of two components. Firstly, the strategy tells you when there is a significant market turn, and when the market comes down it is relevant to sell your production.

Secondly, this mechanism tells you when to have open positions. An illustration of this can be avoiding selling a production hedge in an uptrend. This shows that there is great benefit from avoiding selling prematurely when prices still are rising. The value of your production will experience a considerable increase.

Importantly, it is relevant to know when to open up the hedge again if the market comes up a bit before the prevailing short trend continues, thus initiating new short hedge signals.
TradingAdvisor’s dynamic hedge strategy sees this crucial element contributing to improved performance for your hedge strategy.

This logic is analogue for an industrial / consumer hedge.
The entry method uses the Rate of Change indicator which calculates and plots the net change expressed as a ratio, between a bar’s closing price and the price the number of bars ago specified in the length. Measuring current prices versus earlier prices sheds light on the pace of a trend and possible trend reversals.
While several time spans for oscillators are suggested by different analysts, it should be understood that there is no one span that applies perfectly to all market conditions. It is always possible to find a length that works for a precise period in time or in specific market modes. However, this success would reflect a specific situation that occurred in the past and would be of doubtful practicality for predicting the future. On the other hand, it is not possible to find a time span that is satisfactory in all markets at all time.

Analysis should not be limited to oscillators based on one time span but should include other periods in order to obtain a more complete picture of what is happening. There will always be several market cycles or trends in the market at the same time and the odds that the price is about to reverse its trend increases significantly if three different time spans are simultaneously giving strong signals that a reversal in the momentum trend is imminent. The multi-period oscillator method is an entry method and should be applied together with an hedge reduction/hedge exit method in order to complete TradingAdvisor's dynamically hedge strategy.

The exit method is based on adaptive standard deviations stop and is a measure of the market risk imposed on a position. Risk is directly proportional to volatility. The amount the price can change in a given interval is the amount the price can go against the trade during that interval. If a market trend is thought of as a straight line then around this serially dependent, smooth behaviour is "noise" or random stochastic behaviour. The strategy accommodate for this market behaviour by placing stops far enough away from the trend to accommodate noise. The magnitude of the noise means that the position should not be exited on a minor move away from the trend. The standard deviations exit method measures how much noise is normal and place stops on the outer fringes of this normal behaviour.

These stops are displayed as three dots for each bar in addition to a yellow "warning line". The first, second and third dots reflects one, two and three standard deviation moves against the trend. When in a hedge position under normal circumstances the stop level three, displayed as red dots on the chart, is recommended. Otherwise, during high volatile periods or in profit-taking mode level one, displayed as green dots, can be used. Also a scale-out strategy can be used for a more dynamic hedge strategy.
When scaling out of a hedge the entry method described above can be used for re - scaling in the hedge. When prices moves against the original hedge position the fast oscillator tends to turn, from a negative to a positive value for a short position and from a positive to a negative value for a long position. After scaling out when the fast Rate of Change oscillator turns back and get into gear with the intermediate- and long term Rate of Change oscillators, it is time to scale in the hedge again.

The power business is a high volatile business, where demand and supply fluctuate. Additionally, water supplies rise and fall throughout the years and seasons, causing an unstable production capacity. This gives a business that is exposed to a high risk level, a setting where unpredictability calls for instruments to handle risk.

Global uncertainties, political gamesmanship, aggressive speculators and a changing regulatory climate have made energy prices even more unstable. Increasingly, energy companies find they must hedge their risks more and more. Risk management process reduces financial exposure associated with price volatility by substituting a transaction made now for one that would have been made at a later date. Control over price changes is managed by using these financial instruments.