What's the difference between hedging and trading?

Do you know the difference between hedging and trading? ?Do you know what a stop loss is?

As a trader I was once told something by a wiser head than mine that has always stuck with me – ‘the market can remain irrational longer than you can remain solvent’.?A simple but humbling view of the importance of knowing what you’re doing, why you’re doing it and being willing to admit when you’re wrong.

Across the energy sector at the moment there are many individuals and companies that confuse the basic concepts of hedging and trading with potentially dire consequences – and some of the media talking heads (and industry spokespeople) appear none the wiser either.

Trading sounds sexier, and nobody wants to join a business to become a 'hedger' they want to be a 'trader' with all the images that creates. Having done both, hedging is equally as complex and rewarding to do well, but comes with the advantage of avoiding sleepless nights worrying about an open position (most of the time). Both are critical, and a clear distinction between them is also vital for long term business success.

So what do the terms mean?

Hedging is about removing risk, not picking the best price.

In electricity commodity hedges ultimately have to be placed at a half hourly level – creating huge complexity to achieve the 100% hedge that is talked about by some.?Hedging also involves understanding the exposure between what you buy and what you sell (as an energy of any other business).

If you are running a fertiliser factory (for example) using a day ahead price may not be appropriate to ensure your operation is competitive if your output is not priced on the same basis, so you could choose to take a longer-term price fix to manage your exposure.

Trading is about maximising value based on clear entry and exit points.

Nobody wants to overpay, but seeking a profit from a price movement is complex and there are many factors that drive price. Increasingly energy prices are linked globally, and are subject to increasing volatility (the speed of price change) as the generation mix is more volatile than it used to be.

If you’re not tracking Far-Eastern LNG demand, Russian gas production, or wind forecasts, with a clear view on when to take a position and when to close it – maybe trading isn’t the best idea.

Stop losses are about admitting that sometimes you’re wrong on a trading decision

Taking the loss and moving on to fight another day rather than risking more than you can afford.?No matter what your view the market, sometimes everybody is wrong in either absolute or timing terms.

Nobody is always right, so taking a loss isn't a failure; it just separates risk management from roulette.

No matter what your exposure to energy, a clearly articulated approach to risk management is critical.?If you need help, or even a confidential discussion to chat through your position get in touch.