WHAT IS A HEDGING STRATEGY? WHAT ARE ITS OBJECTIVES?

What is a hedging strategy? It is a set of actions relating to energy supply contracts that allow you to switch from a floating price to a fixed price, in whole or in part. A hedging strategy only makes sense in relation to the objective you set yourself.

And the objective assigned to a strategy is generally a compromise between performance (buying at the best price) and the risks incurred (i.e. the risks to which you are exposed in order to achieve the desired performance).

Let’s take a simple example. Let’s imagine that I set myself the objective, when the price of gas is 40 €/MWh, of only hedging my position if the market price falls below 35 €/MWh. The expected performance is not to pay more than 35 €/MWh for my gas. The risk incurred is that I am not sure that the market price will fall from €40 to €35/MWh and that if, unfortunately, the market rises, I am likely to lose a lot of money.

Companies, depending on their sector of activity, the weight of energy in their P&L and their financial culture, opt for different strategies.

Some companies are seeking to defend a budget, while others are seeking to remain in the market, i.e. to buy at a price that is not too far removed from market prices. This is what we have tried to illustrate in the diagram on the right of the screen.

At the top left are companies that set their prices well in advance and base their budgets on the fixed price. These companies accept that their purchase price may be significantly different from market prices at the time of delivery.

At the bottom right are companies that remain 100% exposed to the spot market. These companies take the risk of not knowing the purchase price of energy in advance and therefore of not meeting their agreed budget.

In the middle are companies that adopt mixed strategies, hedging in several stages based on market opportunities or a predefined purchase schedule.

TREND INDICATORS, MOMENTUM INDICATORS, VOLATILITY INDICATORS

Let’s take a quick look at technical analysis indicators, focusing on three categories.

1. The first category is trend indicators. These indicators characterise market trends. There are two possible trends: upward and downward. Moving averages are a trend indicator. The problem with this type of indicator is that they are not able to indicate whether the current trend will reverse.
2. The second category of indicators are momentum indicators. These indicators measure the strength of the trend. They allow us to see whether a trend is strengthening or weakening. The problem with momentum indicators is that they do not allow you to judge the absolute level of prices.
3. The third category of indicators are volatility indicators. Volatility is measured by calculating the variance in prices over a past period. Volatility measures market nervousness. It is also an indicator of the risk to which you are exposed in the market.

In the following section, we will associate a particular indicator with a particular strategy. In reality, a set of indicators is used to execute a strategy as effectively as possible. The challenge lies in synthesising all the information provided by these indicators in order to make the best possible decisions.

A HEDGING STRATEGY FOR EACH OBJECTIVE

We will now consider three alternative hedging strategies that are commonly used in companies. The choice of one strategy or another depends fundamentally on the company’s degree of risk aversion. It is usually the finance departments that communicate to the purchasing departments the amount of risk they can take on in their strategy.

The first strategy is fairly simple and is known as opportunistic: the buyer, either alone or as part of an energy committee, looks for the best time(s) to set their price. To simplify matters, we will assume that buyers who adopt an opportunistic strategy set the price of their contract in one go. We will combine this strategy with a well-known technical analysis indicator called the Relative Strength Index (RSI), which is a momentum indicator.

The second strategy is a little more complicated and aims to stick as closely as possible to the average forward market price (e.g. the N+1 Calendar price). We combine this strategy with a volatility indicator called the volatility tunnel, which is a simplified indicator derived from another well-known indicator, Bollinger Bands.

The third strategy is a defensive strategy that aims to cap the purchase price of energy and is based on setting a price ceiling with the particularity that the ceiling evolves with market prices, as we will see later.

THE VOLATILITY TUNNEL, DYNAMIC STOP LOSS, RSI (RELATIVE STRENGTH INDEX)

We will now look at how these indicators are constructed.

The volatility tunnel that we will use below is a tunnel that is re-evaluated at the beginning of each month with an upper and lower limit. The tunnel is centred on the last price of the previous month. The upper limit is located two standard deviations (the standard deviation being calculated on the last ten prices of the previous month) above the centre of the tunnel and the lower limit is located two standard deviations below the centre of the tunnel.

The RSI is an indicator that varies between 0 and 100. To obtain the RSI, the average of the rises and falls over the last fourteen prices is calculated and the formula shown on the screen is applied. The indicator works as follows: if the average of the rises is very large compared to the average of the falls (in absolute terms), then the member preceded by the minus sign tends towards zero and the RSI tends towards 100. Conversely, if the absolute value of the average decrease is large compared to the value of the average increase, the member preceded by the minus sign tends towards 100 and the RSI tends towards zero.

The last indicator, the dynamic stop loss, is a price limit defined as follows. A starting price is set above the current market price, with the difference between the starting price and the market price left to the buyer’s discretion, bearing in mind that the smaller the difference, the more likely the stop loss is to be triggered quickly. The value of the stop loss will then change (hence the name dynamic stop loss) according to market price movements: if the market price falls, the stop loss falls, provided that the difference between the stop loss and the market price is at least equal to the initial difference. If the market price rises, the stop loss does not move.

PRICE LIMITS

In order to use indicators, they must be combined with management rules. For a given indicator, the management rule will associate a decision (buy or do not buy) based on the behaviour of the indicator. Let’s start with the volatility tunnel.

The management rule associated with the monthly volatility tunnel is as follows:

• If the price crosses the upper limit of the tunnel upwards, a certain fraction of the price is hedged (in practice, one sixth if the hedging strategy is a six-month strategy).
• If the price crosses the lower limit of the tunnel upwards, i.e. after leaving the tunnel, we hedge.
• At the end of the month, if the price has remained within the tunnel, we hedge.

When applied over a sufficiently long period (in practice, at least six months), this management rule allows you to hedge at the market average over the period in question.

Let’s now move on to the RSI. We will consider that the market is overbought, i.e. that prices are high and likely to fall, when the RSI exceeds 70. Conversely, we will consider that the market is oversold (i.e. prices are cheap and likely to rise) when the RSI is below 30.The associated management rule is to set the price in full when the RSI falls below 30. Two comments at this stage:

• Firstly, the RSI may well remain between 30 and 70, in which case the buyer receives no hedging signal.
• Secondly, we could modify the management rule and only set a fraction of the price when the RSI falls below 30.

Finally, let’s move on to dynamic stop loss. The management rule is simple: hedge in full if the market price crosses the stop loss upwards. The same comment applies here as before: if the market price crosses the stop loss, it is always possible to hedge only a fraction of the price.

THE VOLATILITY TUNNEL

We will now examine the behaviour of each of the three strategies. We have applied the strategies to an electricity supply contract in which the buyer must hedge the French base load calendar for 2026 during the first four months of 2025. The period from January to April is a period when prices fall, with a period of high price volatility in February.

As we will see, the relative performance of the three strategies is partly linked to how prices evolve, i.e. to the trend and volatility.

Applying the volatility tunnel and the associated management rule leads to four fixing operations:

• one at the end of January, with the price remaining within the tunnel throughout January;
• The second on 7 February when the price crossed the upper limit of the tunnel;
• The third at the end of March, with the price remaining within the tunnel during January;
• The fourth at the end of April, with the price returning to the tunnel on the last day of the month.

THE RSI

Let’s now move on to the RSI. There are two curves on the chart: the prices of the France base load 2026 calendar in green and the RSI in yellow with two scales: a scale on the left for prices and a scale on the right for the RSI.

As you can see, the RSI never crossed the 30 or 70 thresholds. Logically, we should not have hedged. However, we considered that on 5 March 2025, the index had come close enough to the lower threshold (the RSI was 31.34 on 5 March) to set the price at 61.65. But it is important to realise that, unlike the volatility tunnel, you can never be certain of your setting. Finally, as we can see from the curve, it is perfectly possible to have a high RSI level while prices are falling. This was particularly the case on 23 April, when we were in a downtrend that had started a month earlier on 20 March and the RSI was at 63.

DYNAMIC STOP LOSS

Let’s move on to the last strategy and stop loss.

The initial spread between the market price and the stop loss was set at €3.5/MWh. The stop loss decreases as the price falls. On 31 January, the price of the France base load 2026 calendar rose above the stop loss and we hedged at 69.93. The initial gap between the stop loss and the market price would have had to be set at a much higher level to successfully navigate the February price spike, bearing in mind that this strategy would have been very risky and would not necessarily have resulted in coverage over the period.

An alternative would have been to redefine the dynamic stop loss at the beginning of each month. The market price would have crossed the stop loss again at the beginning of February but would have allowed us to take advantage of the price decline in March and April.

COMPARING THE COMPETITIVENESS OF THREE STRATEGIES

If we now compare the three strategies, we see that the strategy that achieves the lowest price is the opportunistic strategy using the RSI as an indicator. The strategy of sticking to the market achieves a price of £66.91/MWh, £1.5/MWh below the market average. However, the coverage period (four months) is not long enough to get close to the market average (€65.5/MWh). The defensive strategy based on dynamic stop loss is the least effective, with a price of €69.93/MWh.

CONCLUSION

I would like to make three points in conclusion.

1. Firstly, the three strategies are ranked in the correct order in the sense that the riskiest strategy (the opportunistic strategy with the RSI as an indicator) is the one that gives the best result. Conversely, the least risky strategy (the defensive strategy with the stop loss) is the one that gives the worst result, with the market tracking strategy with the volatility tunnel giving an intermediate result.
2. Secondly, the relative performance of the strategies is linked to the way prices evolve. It could be shown that in a scenario where prices only rise, the defensive strategy (with dynamic stop loss) is the best performer. Strictly speaking, the strategies would need to be evaluated over a large number of scenarios (Monte Carlo simulation) and the average performance and performance variance calculated in order to be able to truly compare the three strategies.
3. Finally, the performance of the strategies depends on the management rule associated with them.

We have seen, for example, that the result obtained by the defensive strategy changes if we allow ourselves to redefine the stop loss each month and make four fixings instead of just one.