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JUNE 14, 2021 // THIS WEEK'S TOPIC: FINANCIAL SWAPS – PART 8
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In this Trader’s Corner, we continue with part eight of our series on financial swaps. Since these segments build upon each other, we highly suggest you review the previous segments if you missed them (parts one, two, three, four, five, six and seven). Also, our Trader's Corner of April 5, “The logic behind managing propane price risk,” is very pertinent to our segment this week.
In earlier segments, we covered using financial swaps as a hedging tool. Hedging occurs when the retailer has locked down the price he will pay for propane in the future and made a sale against that supply to lock in a margin.
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Then, two weeks ago, we moved on to using financial swaps as mechanisms for speculating. Speculating happens when a retailer locks down only one half of the equation. If retailers buy propane without a corresponding sell or sell propane without a corresponding buy, they have speculated.
Last week, we used current conditions to show how a retailer was up on a position bought in April and how the retailer could have captured gains of nearly 10 cents per gallon on that position in June. The gains were captured by selling swaps during the same months and at equal volume to what the retailer had originally bought. All of the swaps remained active from June through October, when the first settled. Then, each pair of swaps settled each month through March.
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In April, the retailer was correct on his assumptions about the price of propane, making management of his position relatively easy. Being able to capture a gain is a nice position to be in. But sometimes our assumptions about the market are not correct. What if propane prices started going down immediately after the swap position was bought in April?
The decision to close a position at a loss is very difficult. There is always the tendency to not want to accept a loss. We see this with our friends who trade stocks or equities. They will sell a stock that's up to capture gains, but they tend to hold stocks that are performing poorly, hoping they will come back. That behavior is actually counter to good investment practices. Stocks that are performing poorly should be sold, the loss taken, and the money reinvested in more promising stocks that could recoup the loss more quickly.
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The first thing retailers must accept if they are going to speculate is that they are not going to be right 100 percent of the time. Sometimes our assumptions are wrong. If you can’t accept that reality, you simply can’t speculate. That means you shouldn’t do traditional prebuys or buy financial swap positions. If that is you, it means you will never take advantage of opportunities the market presents. Retailers that use the tools at their disposal, take advantage of opportunities the market presents and then manage the risk around the position will come out ahead in the long run.
In today’s scenario, we are going to assume the retailer took a position that was wrong from the outset. The retailer bought swaps only to see the market fall and continue to fall. Because this is a possibility, it is essential that a retailer set a "stop loss" on any position taken. A stop loss is a threshold that will trigger the position to be closed, thus limiting the loss on that position.
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Setting a stop loss before a position is ever taken removes the emotion from the decision. Any loss is unfortunate, but what must be avoided is holding a position until it becomes catastrophic.
The tolerance for loss is different for everyone, but we have a guideline that we think can help. There is a price that every retailer can set above his competition and not experience much, if any, pushback from customers. We have asked retailers what that number is for them, and it ranges widely. Some retailers say they can’t price above their competition at all. If that is the case, don’t speculate. We have had some retailers tell us 50 cents. By and large, the number is somewhere in the 10- to 15-cent range. We would use whatever number you decide will not hurt customer retention as the stop loss.
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If you believe you can be 10 cents above your competition from time to time and not lose customers, then put a 10-cent stop loss on all of your speculative positions. In our swap buy examples, the retailer had a price of $0.7908 on his swap position. He knows his stop loss is 10 cents, so he should resolve to close his swap position if the value dropped to $0.6908.
The process for closing a losing position is the same one we used last week to close a position that was up. The only difference is that we are locking in a 10-cent loss instead of a 10-cent gain. That 10-cent loss is not going away, and the retailer needs to figure it into his overall cost of supply. Otherwise, he is going to lose margin. That is where knowing you can price 10 cents above your competitor without losing customers comes into play.
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Our speculative loss means we will be pricing higher than competitors. Now, remember we should never speculate on our entire sales volume or anywhere close to it. Therefore, any loss on a speculative position will be divided among all of the retailer’s sales volume, so our actual retail price to cover the speculative loss should be well within the 10-cent range.
However, if a retailer can’t accept a loss and holds on to a position too long, a manageable loss can soon become a loss that can do real damage to the company. That is what we want to avoid. By setting a stop loss in advance on a speculative position and sticking with it, a catastrophic situation can be avoided.
Over time, taking advantage of opportunities in the market by using financial swaps will provide a more profitable, healthier retail propane company that is in a better position to serve its customers. It is a way to significantly add to our bottom line, but the risks must be managed. Retailers must accept that they will be wrong occasionally. They must be very disciplined in making sure those times do not go from being unfortunate to catastrophic. One way of doing that is setting stop losses on any speculative positions and being disciplined in sticking to those parameters.
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About Cost Management Solutions
Cost Management Solutions LLC (CMS) is a firm dedicated to the analysis of the energy markets for the propane marketplace. Since we are not a supplier of propane, you can be assured our focus is to provide an unbiased analysis.
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