Hedging and History

We often will use technical analysis in our discussions with clients to help them make decisions on both short-window hedging and long-term hedging as they look toward the next heating season, writes Richard Larkin, founder of Hedge Solutions. Then he asks, What is technical analysis, exactly? And he explains:

In short, it is a discipline that traders employ to help them identify profit opportunities in both commodities and equities. The basic theory behind technical analysis is that, simply put, history repeats itself. Traders believe that by studying, analyzing, and quantifying certain statistics, one can determine repeatable patterns and thereby trade on those patterns profitably. Many in the trading community prefer this method over fundamental analysis. Why? For one, fundamental analysis can be much more time consuming and also require expensive means for collecting “fundamental” data that the trader does not have. Alternatively, technical analysis can be quickly applied across all commodities and equities. Some would argue that these methodologies can be applied to virtually anything.

There is an abundance of these systems for analyzing historical market data. The list is considerable and the consistency of the levels for success are as volatile as the market. The more traditional tools are Fibonacci, Elliot Wave, Stochastics, Moving Averages, Bollinger bands, etc. There are endless books and articles on how best to use these techniques and rarely do traders employ just one or even a few all at once. Most will use a number of combinations in their “system.”  Still others will use a combination of both technical analysis and fundamental analysis.

To be sure, the more historical data you have on any one product the higher your chances of success. Think of it in simple logic. If over the course of 40 years you are able to identify a pattern in pricing that repeats itself over and over again, then the likelihood is that it will happen again. And by the way, 40 years is considered to be a rather young commodity in our world. Agricultural products, like corn, have been trading on a futures exchange since the late 1800s. The heating oil contract, by comparison, was first introduced in 1978 on what was then called the New York Mercantile Exchange.

Let’s look at the logic and/or argument for using this technique in our business. I recently sent an email to my clients that examined the price action of the ULSD contract that we all know drives the heating oil prices. I was getting a lot of calls in mid-February due to the relentless upward trend in the price since the election in November. Out of 85 trading days (as of this writing), just 26 days had closed lower than the previous trading day. That means the market had gone higher almost 70% of the time. In an attempt to wrap my head around all this bullishness I reviewed a common technical indicator called RSI, or Relative Strength Index. Basically, the RSI measures the price momentum of the underlying futures contract. It is one of many indicators in my own little toolbox. So, when I looked back at RSI over the roughly 40-year life span of the ULSD (formerly heating oil) contract, the data was telling me that prices frequently sold off anytime the RSI was above 80. It was usually a significant move lower. Statistically it sold off a whopping 75% of the time shortly after exceeding an RSI of 80 (see chart).

It was clear to me that, unless you have a compelling reason to hedge (e.g., selling to your customers in the very near term) jumping in here was not a good bet.

What you do with this information depends a lot on your goals, and most importantly, the reasons you are trading the contract in the first place. My clients, and of course the industry in general, use the futures market as a hedge. They’re offering their customers the value of price certainty by going out and capping or fixing the price of their oil for the heating season. Typically, our clients will put the following season’s offer out sometime between April and July, and their customer is likely on a monthly budget program. We deploy a proprietary buying program that has them scaling in at various levels over roughly an 8–12-week period. Because we’ve broken down their total volume to a weekly decision to buy a certain amount of the total volume, it allows us to use technical analysis to give us a sense of the best time to buy over certain periods of time. Technical analysis gives us confidence in making those decisions. Do we place all of the emphasis on one indicator? No. Much goes into the hedging of their forward sales programs. The target margin is a primary consideration. The timing of the offer also plays a large part in the buying and hedging decisions. But it is certainly better than just sticking a finger in the wind and relying on random luck. 

These techniques are also very helpful during the heating season. We spend a lot of time monitoring rack to retail margins and looking for opportunities to lock in a margin for a period of time whenever those margins are well above their target for the season. Dips in prices present great opportunities to do this. Technical analysis, again, is a reliable tool that helps us advise clients on timing. To be sure, however, the main driver in that decision matrix is the margin itself. As an example, if a client’s target margin is X and a sudden dip in prices is raising that margin by 20%, why not lock that ideal condition in for several days or weeks and avoiding the risk of a sudden reversal in prices snatching it away? An option strategy allows them to do this without risk. Technical analysis just increases the odds that they are executing the buy at the right time.

Learn more about these tools at: www.hedgesolutions.com

Disclaimer: Hedge Solutions is a registered Commodity Trading Advisor and is a member in good standing with the National Futures Association. The information provided in this market update is general market commentary provided solely for educational and informational purposes. The information was obtained from sources believed to be reliable, but we do not guarantee its accuracy.  No statement within the update should be construed as a recommendation, solicitation or offer to buy or sell any futures or options on futures or to otherwise provide investment advice.  Any use of the information provided in this update is at your own risk.

A version of this article appears in the March/April 2021 issue of Fuel Oil News.

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