Portfolio positioning using forward curves: from signals to strategy

The forward curve

The forward curve assists in hedging against the volatility of future pricing in the energy market. We take a look why it happens and why it’s important.

Why it matters for traders

Insight is valuable and knowing the future price of the energy market in comparison to the current pricing is crucial to determine whether prices will rise or fall over time and how to react

Market fundamentals

Portfolio positioning using curves involves exploiting where the market is in terms of low or high pricing. This focuses specifically when the market is in is in contango, or whether its in backawardation. Contago is when spot prices sit over future prices and so prices will be bought at a cheaper price in the future in the hope that they can be sold for profit in the future as the hope is the spot for that time period will increase in time. Backwardaton, however, is the opposite, in which spot prices sit much lower than future prices, causing market participants to buy up cheaper current prices.

Market behaviour can also be infliuenced by the sentiment of the market at that time. The forward curve itself is a consensus of what the future market rate will be and so portfolio managers use this consensus  information to work out if pricing is being under estimated or over estimated and then exploit the opportunities between those points.

Liquidity and positioning

It's important that conditions and positioning of liquidity at the time of trade is optimal, because this can dictate how likely is is that a hedge can be executed. The more liquidity there is in the market, the more capital there is to be able to hedge successfully. It acts as a shock absorber where there is a lot of volatility in the market that requires financial cushioning to trade.

Market behaviour

How the phenomenon appears in curves

The key ways that the phenomenon appears in curves is via contango or backwardation, which is also known as upward curving slope or downward curving slope. An upward curving slope indicates good market conditions with good supply, where’s a downward curving slope indicates supply issues or increased energy demand.

Typical patterns observed

There are a number of other different patterns we can identify in the forward curve that can be useful insight to traders:

Flattening curves: tightening policies or economic slowing can lead to flatter curves, which shows long-term rates are rising slower than short term rates.

Inverted curves: again, when long-term rates fail to perform against short term rates, this can be an indicator that a recession is on the horizon.

Humped curves: short and long-term rates fall short of medium term rates, which can indicate volatility or economic changes.

Trading implications

The trading implications of portfolio positioning suing forward curves depends entirely on positioning in the market. For example, when physical inventory is high, the backwardation environment can benefit from buying low and selling high at a later date. However, if the market flip-flops between contago and backwardation, this can often be due to supply shortages such as power outages, which are big drivers of volatility.

How traders act on signals

For traders to execute successful strategies when positioning portfolios using forward curves, traders must identify discrepancies in the prediction of price of energy and the actual price of energy.

Examples of strategies

Learning when to execute trades based on how the market is behaving and determining correct or incorrect predictions can lead to lucrative opportunities if done right.

Rolling strategies: when a future contract is coming to its end, we can do something called rolling the contract. This involves closing this near-to-end contract and replacing it with a newer contract. If the difference in the rice between these contract is positive, a profit can be made.

Arbitrage mispricing: forward prices are always a prediction, so when the spot market price at that time differs from the price that was predicted, arbitrage trading opportunities can be executed.

Volatility trading: looking out for signals that energy shortages ma occur, for example when backwardation is in play, can signal that high priced trades are on the horizon.

Risk considerations

While forward curves allow hedging against price volatility, risk should also be considered. If a price is locked in on the forward market at a lower price than the current spot market by a consumer, it might be thought a good deal had been reached. However, if prices actually drop in the future, perhaps thanks to overproduction of wind energy, the buyer will actually be paying more in the future than it is actually worth in the sport market at that time.

Mispricing can also be a wealth of opportunity for traders, but the unrealaibliltiy of usual models must be factored in, as the data used to inform these usual models is patchy compared to regular usages.

Rolling portfolios can result in a profit, but if the new contract replacing the near-ending futures contract actually ends up being more expensive,  this is a potential cost, therefore a risk to the buyer.