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Steps for Energy Trading and Risk Management

December 29, 2020 by Daniels Trading| Tips & Strategies

In the capital markets, the term “risk” means different things to different people. At the exchange level, risk is a function of systemic liquidity. For institutional investors, it’s a degree of market exposure. For retail traders, risk is the amount of money in harm’s way at any given time. However, no matter your role in the marketplace, one thing is certain: You must actively manage risk.

For instructive purposes, there may be no better place to examine the concept of risk than in the energy markets. Read on to learn more about energy trading and risk management at the exchange, institutional, and retail levels.

Promoting Market Liquidity

As the world’s largest derivatives marketplace, the Chicago Mercantile Exchange (CME) facilitates billions of dollars worth of transactions each business day. One of the CME’s most popular sectors is energy futures and options. Accordingly, West Texas Intermediate Crude Oil (CL), Henry Hub Natural Gas (NG), RBOB Gasoline (RB), and NY Harbor Heating Oil (HO) are the leading energy contracts.

Learn how our powerful software can empower your trades.

At this point, you may be wondering how an exchange is exposed to risk. After all, they are simply matching buyers to sellers without taking a bullish or bearish position in the markets. Where’s the harm in that?

For derivatives exchanges, counterparty risk and liquidity freezes are two primary areas of concern. The exchange’s core business is to clear, settle, and guarantee all transactions conducted via its facilities. In the event that involved parties default on their obligations, the exchange is responsible for ensuring that markets remain liquid and trade continues uninterrupted. Thus, energy trading and risk management are taken very seriously at exchanges such as the CME.

On a daily basis, the CME takes several steps to guard against catastrophe. First, the CME closely monitors members for signs of financial and operational distress. Second, market participants are required to post performance bonds (margins) to show that they are able to meet their financial obligations. During periods of heightened volatility, the CME is likely to raise margin requirements to guarantee that markets stay as orderly and efficient as possible.

Diversification

If you’ve ever consulted a financial advisor or invested in a 401(k), then you are familiar with the concept of portfolio diversification. Essentially, diversification is the act of spreading investments across a variety of assets to minimize risk. A traditional example of a personal diversification strategy is the 60-40 rule, which dedicates 60 percent of the portfolio to stocks and 40 percent to bonds.

The concept of diversification is applied a bit differently in regards to institutional energy trading and risk management. To fine-tune risk exposure, producers, hedge funds, and banks use energy derivatives in countless ways. For example, a hedge fund may buy energy commodities to hedge against forthcoming USD inflation. Conversely, oil or natural gas drillers may sell energy products with respect to seasonality as a way of managing downside pricing risk.

Aligning Risk to Reward

For the retail trader, clearing transactions or sophisticated diversification strategies are of little concern. The task at hand is straightforward: Make money consistently and for as long as possible. To be successful, retail traders must align risk and reward properly on a routine basis.

If you’re an active retail trader in the energy markets, then volatility is no stranger. Sudden swings in pricing occur frequently in WTI crude oil, Henry Hub natural gas, and RBOB gasoline. To weather the turbulence, a trader must view energy trading and risk management as inseparable. Fortunately, there are a few ways that retail traders can preserve capital while pursuing profits in the live market:

  • Use stop loss orders
  • Apply leverage conservatively
  • Execute trades with positive risk-to-reward ratios

All retail traders share one goal: to make money. And the best way to do so is to cut losses quickly and let profits run. By using modest leverage, positive risk-to-reward ratios, and stop losses, retail traders can maximize their longevity in the marketplace.

Want to Learn More About Energy Trading and Risk Management?

Perhaps the best way to learn the ins and outs of energy trading and risk management is by engaging the live market. A great way to trade the CL, NG, RB, and HO contracts risk-free is with a complimentary trial of dt Pro. Sign up for your 14-day demo account today!

Demo DT Pro Today

Filed Under: Tips & Strategies

About Daniels Trading

Daniels Trading is division of StoneX Financial Inc. located in the heart of Chicago’s financial district. Established by renowned commodity trader Andy Daniels in 1995, Daniels Trading was built on a culture of trust committed to a mission of Independence, Objectivity and Reliability.

Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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