2009-11-19: Identifying trends -TradingAdvisor's Hedge Strategy
Nordic power trends evolve from different factors. When studying trends, hydrology still comes out as a determinant factor in influencing Nordic power prices, but recent years have given new strong variables contributing to price formation; such as oil, dollar, emissions, coal and gas. The complexity of the energy market has grown, lately also greatly influenced by finance and world politics. Increased volatility makes trading and hedging a hazardous game for many a player, but we see that trends do still develop in this complex market. The need for objective rules for when to buy and sell is evident.

In this article we study a selection of trends in the Nordic energy market and see how TradingAdvisor’s Hedge strategy maps the larger trends for the nearest forward NordPool contract through years of great price fluctuations. We find that the Hedge strategy functions well as a tool for determining intermediate to long term trends. The conclusion is that this tool helps the hedger and trader to take position on the right side of the trend and avoid immature exits when the trend unfolds. In future articles we will study the effect of combining this tool with more tuned short term trading strategies, thus increasing profits further. The Nordic energy market is volatile, but trends do still occur.

At the end of 2002 the price curve for the Nordic market wanders far above any historical figures. An energy market is lifted to new all times high in a couple of days in early December, making space for an formidable upside - and downside. A market in panic is difficult to handle, and history shows that a technical strategy may be a profitable aid to handle a nervous market. During an intense autumn and winter the hedge strategy collects more than 40 euro. The strategy identifies an uptrend evolving in August. It takes a long position and collects about 10 euro before exiting during a correction in October. The strategy re-enters the market as the prevailing trend continues and captures a profit of more than 30 euro. This extreme movement enhances 2002 performance.

At the end of 2004 a mild and rainy autumn and winter gives a considerable downtrend continuing into 2005. Substantial water supplies put a down pressure on prices, and we see the power market fall about 19 euro from end of August until mid January 2005. The hedge strategy takes position shortly after the top of the falling trend and rides the trend down, gaining approx 13 euro.

The year of 2006 gives room for the big movements - extreme rises and bloodletting corrections. After trading in a range the second part of 2005, we see an increase of power prices from January 2006. After an upward movement of more than 20 euro, a correction wipes out most of the gains during a few days in late April and early May. The hedge strategy takes a position in February, and exits as the market trades below the second standard deviation at the end of March, securing profits before the wipeout. The market starts strengthening again and during the dry summer in 2006 the power prices rise to new highs, a strengthening of more than 40 euro. The strategy takes advantage of these movements and secure profits of about 25 euro in bullish, but volatile times. The strategy identifies the major trends, but more important it exits securing profits before the market turnarounds wipe out entire profits.

So, 2006 is a good year for identifying long trends, but how is this working for the short side of the strategy? After the peak of the long trend a whipsaw movement is seen initiating a shift in market mode. A bearish scenario develops in September and gives an opportunity for the short side of the hedge strategy to take position. The short position is being held, and the strategy rides the trend as it unfolds throughout the year and into summer of 2007, making substantial profits of more than 40 euro.

The end of 2007 and the start of 2008 is a wet period and the Nordic energy prices meet a 5 month downward move of nearly 30 euro. Many expect a further market fall; however the market starts to climb in April gaining more than 20 euro during summer. The hedge strategy collects profits from the short trend ending in April 2008, and then leaves the arena to the long side of the strategy. The market we see this summer resembles that of 2006. Strong rises in relatively short timeframes are interrupted by a major decline wiping out most of the upward move, wasting the gains for many a player. The strategy takes a position as the market rises and exits before all the profits vanish. This bloodletting introduces a new upward move before a heavy downtrend develops. In 2006 the downtrend lasts for about 8 months. The down trend in 2008 starts in September and falls more than 40 euro until the market flats out in March 2009. The hedge strategy takes a short position in October 2008 and follows the market down before it exits with profit.

This year the rising prices of oil, coal and gas make a huge impact on Nordic energy prices. In spite of full water reservoirs the Nordic prices rise. However, after the rise in the first half of 2008, the down trend eventually occurs and results in a long bearish trend giving great opportunities for profits. The challenge is to know when to enter and exit a market that shows increased complexity with different variables pushing and pulling prices in opposite directions.

When examining the length of holding positions we note a difference between the long and the short side that is worth mentioning. The average time in winning trades is 42 days for the long side of the strategy and 94 days for the short side of the strategy. This reflects how the strategy identifies the heavy downtrends we see in the power market. The last years have been volatile in the Nordic power market, but have also produced enduring down trends.
We find that the hedge strategy is a solid tool for identifying market trends. Being a rough tool using standard deviation instead of stop orders in the exit logic, this is a precisely tuned instrument for determining intermediate and long term movements. History shows that this strategy secures the players the advantage of taking positions on the right side of the prevailing trend. The exit logic prevents players sitting too long on losing positions hence preventing a total wipeout of profits and enables the player to stay in the game to trade.