Detailed Glossary


A Detailed Glossary of Energy Trading terms for registered users



Risk

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nick

Index

by Nick Henfrey - Thursday, 26 March 2015, 7:24 AM
 

An Index is a set of prices that are published for a commodity or product, usually derived from trading data, using an open and independent method

Detail

An index consists of a set of time periods, with an associated price (or set of prices) for a particular commodity or product for each of the time periods:

The time periods are sometimes called grid points (or gridpoints)

A typical index has daily granularity forward from the date it is published for a number of days, then monthly for some months, then quarterly, seasonal and annual

For each time period there may be a bid price, an offer price, and an average (mean) price

Indexes are usually published at the end of each trading day, and represent some sort of average of the prices that Forward and Futures contracts actually traded at on that day (or for a pre-defined period of the day)

Various organizations publish indexes for different commodities and products:

Exchanges publish indexes for the various products they offer

Independent analysts publish indexes for commodities in markets they specialize

Trading organizations use indexes to:

Derive forward (valuation) curves

Fix in floating prices of floating price trades

Agree forward valuation of trade portfolios with counterparties for netting agreements

There is some similarity between indexes and curves since they are both sets of time-series data. The main differences are:

Indexes are published by independent organizations, and are available to any organization that wishes to subscribe to them

Indexes only relate to prices of commodities and products

Curves are usually created by, and proprietary to, the trading organizations that create them

Curves consist of any time-series data, including valuation, volatility, interest rates etc.

 

 

nick

Linear trade

by Nick Henfrey - Thursday, 4 September 2014, 4:42 PM
 

A trade with no optionality

Detail

Why?

The linearity refers to the delta - that is the variation of the value of the trade with the main underlier

Trades with no optionality have a value that is directly proportional to the value of the underlier - if we plot the value against the value of the underlier it will be a straight line - hence linear trade

Trades with optionality do not have a linear relationship between value and underlier. As the value of the underlier becomes less and less favourable the value of the trade becomes nearer and nearer to zero

Unsurprisingly these trades are known as non-linear

nick

Mark to Market

by Nick Henfrey - Thursday, 30 October 2014, 7:39 AM
 

A way of valuing the unrealized P&L of a simple linear Forward, Futures contract or Swap

Detail

Most businesses that own assets or hold inventory routinely value those assets and inventory, the change in value between two points in time is the profit or loss

Some assets, like computers, simply depreciate, and a simple depreciation percentage is used each year

Other assets, like buildings, vary in value with the market conditions, and are generally valued using a mark to market principle (that is we simply look and see what the building is worth at the end of the accounting period)

It's important to realize that each trade is an asset (or a liability) - it's a firm contract and must be valued like any other asset

The current value of a single trade is the difference between the price paid, and the value of the delivered commodity when it is delivered (which may be a cargo, a day of gas delivery, or a half hour of power delivery)

We can find the value of the commodity once it has delivered by looking up the spot trading price on the day of delivery

But to value the deal before delivery we must mark the value of the delivered commodity to the market; that is we set the value of the commodity to the price that is currently being paid for the delivery period

For example:

We have bought 10,000 therms of gas for delivery in March next year at 25p per therm

Each day we can look at the average traded price for that month, and mark the value of the 10,000 therms to that price

After two days we note that March is trading at 27p a therm, so we mark the physical value to the market price of 27p, and subtract the price we will pay, 25p. The unrealized P&L is therefore £200 ((27p - 25p) * 10,000). Each day we will need to repeat this calculation until the delivery is complete

nick

P&L

by Nick Henfrey - Monday, 13 April 2015, 5:46 PM
 

Profit and Loss (P&L) is a finance and risk reporting term to describe the profitability of an individual trade, a book, a desk, or a company. Whilst the P&L of a company includes all activity, and costs (offices, staff etc.) the trading P&L is a measure of the profitability of a single, or a set of, trade(s)

Detail

P&L is a change in the value of something, or a set of things between two points in time

You will often hear people refer to the P&L of the trade in terms of its value - the value at any point in time is effectively the difference between the value at that point in time, and the value before the trade was executed. We usually refer to this as the Lifetime to Date P&L or LTD P&L

Often we are interested in the change in value, the P&L, from the start of the year, from the start of the month, or from the last valuation. These are respectively known as:

  • Year to Date P&L (YtD)
  • Month to Date P&L (MtD)
  • Change on day P&L (CoD or DtD) 

As an example, let's say we bought some shares in a company for £60, and a year later we sold them for £100, then it seems obvious that we made £40 profit, assuming there were no cost of buying the shares, or selling them, nor indeed any other costs directly associated with the buying or selling

 
From the trading point of view we have executed two deals, or trades. Let's now think a bit more about these two trades, and ask some further questions:
 
We know the P&L after both trades have been executed (£40) but:
 
  • What was the P&L after the first trade?
  • What was the P&L of each individual trade?
Before continuing we will align our example with a more normal energy trading example.
 
In general traders don't buy a commodity, and then sell it later because of the difficulty and cost of storing energy commodities - see Storage
 
In general traders enter into a Forward contract, that is to buy the shares at  fixed time in the future, at a fixed price
 
The other advantage of Forward contracts is that the trader can enter a Forward contract to sell, as well as buy, at some time in the future. This is known as taking a short - i.e. negative - position
 
In the first trade:
 
We enter into a Forward contract to buy an amount of shares for £60 in March 2018
 
In March 2018 we will give £60 to the seller of the shares. This is called the financial side or leg of the trade. It has a known cash value: £60
 
The seller will give us (he will deliver) the shares. We don't know what they will be worth then, but we can look up the current expected market value of the shares in March 2018, and see what they're worth - see MtM for the details. We call this marking to market, or MtM. Let's say we go online and the market value is £58, then at that time the P&L of the trade is minus £2, we have made a loss. Each day a new price is published we should revalue our trade, and this should continue until the shares are delivered. We have a long position in this share until we sell it. We say the trade has an unrealized P&L of minus £2. We say it is unrealized, because we still have the contract to buy the shares and their value (to us) will continue to vary until we receive them
 
We call this the physical side or leg (it's physical because it's not cash, even though the share certificates are electronic, we still call this physical)
 
After ten months we note that the market price has risen to £110, the trade has a P&L of £50, the current physical side value of £110 less the cash or financial side of £60. We say the trade has an unrealized P&L of £50
 
In March 2018, our seller delivers the trades, and we give the seller £60. We note that the market price has dropped to £100, the trade has a P&L of £40, the current physical side value of £100 less the cash or financial side of £60. We say the trade has an unrealized P&L of £40
 
We decide to immediately execute the second trade and sell the shares for £100, by then the spot price, and execute a sell transaction
 
Between the two trades we can say that the P&L is £40 and that it is now realized. We can say the P&L is realized based on three criteria:
In general, with derivatives, these criteria are usually not met simultaneously, and realization may be defined according to one or more of these criteria, and may be dependent on other criteria as well
 
We have said the P&L of the two trades is £40, but what is the P&L of each individual trade? There are two general ways to define this:
 
  1. Ignore the physical side of each trade, so the first trade has a P&L of minus £60, the second trade has a p&l of £100, between them the P&L is £40. We can use this method when we are sure that the position of both trades has been closed out (which is another way of saying that the two trades' net position is zero). This method is sometimes called realized cash flow because it only considers the value of the cash elements of the trades
  2. Retain the physical side of each trade, and continue to mark it to market for each trade. By this method the realized P&L on the day the second trade was executed was £40, and the P&L of the second trade is zero. If we use this method the P&L of each individual trade will continue to fluctuate for as long as we use it. This method is sometimes called Realized MtM
In general the first method is preferred because it is simpler, we may have to use the second method when we are not sure the position is entirely closed out, or we know some is, and some isn't.
 
if the first method sounds odd, think about buying and selling a house, once you've bought a house you're very interested in how much you paid for it, and how much it's currently worth. Once you sell it however, you're only really interested in the price you paid and the price you sold it. You have little real interest in the current price
 
P&L that may result in a cash flow in the future is often discounted back to present day value
 
We may refer to undiscounted, and discounted P&L

 

nick

Position

by Nick Henfrey - Thursday, 16 January 2014, 5:42 PM
 

All physically settled derivatives imply either an obligation to deliver, or take delivery of, a commodity at a location at some time in the future

The obligation to deliver a commodity is called a short position of that commodity at that location and time in the future

The obligation to take delivery of a commodity is called a long position of that commodity at that location and time in the future

Detail

Traders sum the position of a set of trades to know their net position across that group of trades - usually called a portfolio, a book or a strategy. This is known as the traded, or trader, position

Traders take a long position if they believe the value of the commodity at the time of delivery will be greater than the contract, or strike, price

Traders take a short position if they believe the value of the commodity at the time of delivery will be less than the contract, or strike, price. Taking a short position is sometimes known as shorting

Each time a trade is executed the trader's net position changes. Most traders update their net position as each trade is executed 

nick

Realization

by Nick Henfrey - Thursday, 27 February 2014, 7:24 AM
 

The p&l of trades (and cash flows) is described as:

Detail

Most trades involve delivery at some point in the future

Because the value of the commodity to be delivered is not known before the delivery, the value needs to be estimated or calculated from market data.

For forwards and futures and other linear trade types the value may be estimated by a simple mark to market calculation

For options and other non-linear trades the value may be calculated using the Black 76 method (derived from the earlier Black-Scholes method)

We say the trade's value (its p&l) is unrealized because it is not yet known for certain, and is therefore a cause of market risk

Once delivery has taken place, we know (or don't care about) the delivered value, the value of he trade is known and no longer varies. In effect the p&l is locked in, there is no more market risk associated with this trade and the p&l is said to be realized

The p&l of a trade (or cash flow) moves from unrealized to realized when one or more of the following conditions has been met

  • Delivery has taken place
  • Payment has taken place
  • Some time after one of the previous conditions

Realization is the set of business rules that defines when p&l moves from unrealized to realized based on:

Realization is subjective: different organizations may have different business rules to determine realization

nick

Theta

by Nick Henfrey - Thursday, 27 February 2014, 7:31 AM
 

The value of options varies with time, in general the uncertainty in the price of the underlier reduces as the moment of exercise approaches. Theta is the measure of how much the value of a trade, or set of trades, varies with time

Detail

Theta is one of the Greeks that measure sensitivity of the value of a trade or portfolio to the passage of time

Like most Greeks, except Delta, it is zero for linear trades (trades with no optionality)

 

nick

Underlier

by Nick Henfrey - Monday, 8 June 2015, 7:37 AM
 

Something physical or tangible that may be referenced by a contract or trade

Detail

Financial derivatives are completely cash-based and usually have no physical underliers

Energy derivatives usually have at least one physical underlier, which may be a commodity,

e.g. coal

or a something related to a commodity

e.g. storage

The underlier acts as a bridge to the physical world - and usually as a set of reference prices for price-setting and valuation

We need to emphasize that nearly all energy trades have at least one physical underlier - few of them actually involve the delivery of energy commodities

 


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