A procurement strategy is a strategy which buys a given number of contracts spread over a given time. It will come with a benchmark and the strategy’s goal will be to buy for a lower price than the benchmark does.
This article will show you the general layout of a procurement strategy for German Power.
A Procurement Strategy Benchmark
For this article I will use the average price of the year as the benchmark. This benchmark indicator is commonly called a monkey as it hops around on the chart and you never know where it will end at the end of the year. See the code for this indicator at the end of the article.
The monkey benchmark indicator always starts with the first traded price at the beginning of the year, and then averages all prices until the end of the year. It represents the average price of the market for one calendar year. This average price is often guaranteed to the sales department. Therefore the procurement trader will have to beat this benchmark in order to generate profits.
Basic Procurement Strategy
If you needed to buy 250 MW within a year all would be easy. You would just buy one contract every day and at the end of the year your average entry price would perfectly mirror the monkey benchmark. You would not take any risk, but therefore you also would not be able to outperform the market. This would be the no-risk approach. You are always hedged perfectly as you bought the needed contracts every day. No headache but also no chance for any out performance.
To make this “risk-free” strategy a little more practical, just think about commissions. You could distribute the needed volume in chunks over a year and buy e.g. every first day of the month. This strategy would still resemble the original benchmark, but due to the introduced granularity of trading, it would also show some risk and compensate this by offering chances.
Have a look at the chart below to get a better grasp of the concept. It shows a procurement strategy which will buy 120MW of power, distributed in monthly chunks.
The magenta line shows the theoretical average price of the year. The blue line represents your average entry price, if you bought 1/12th of the needed quantity at the beginning of each month. If, at the end of the year, the magenta benchmark is above your blue average entry price, you have outperformed the benchmark. Any differences between the blue and magenta lines represent the risk.
In the example above the year did not start perfectly well. The “buy every month” approach was not able to generate a lower average entry price than the monkey benchmark. See the blue line (your entry price). Hovering above the magenta line (the monkey, average market price for the year). The procurement strategy is losing against the index.
This has been caused by the fact that the market continued to fall after each of our first entries, thus the average price of the market (monkey) averaged lower prices than our entries.
But there is an easy strategy to beat the benchmark in falling markets: do nothing.
If you just delay your entries until the market starts to rise again, and then buy all the needed quantity, your entry price will always be lower than the average market price up to this event.
The original strategy bought 10 MW at the beginning of every month.
The trailing stop strategy waits for a breach of the trailing stop, and then buys all the needed contracts. For this example, I used a 5% trailing stop. Replace the 5% by the volatility of the market and you get an even more flexible approach.
As it can be seen on the chart the strategy delays the buys in January and February and buys 40MW in mid-March and another 10MW in mid-April. Both trades buy 10MW more than it would have been needed in the specific month (we only need 30MW in March). This is another way to enhance the chances of the strategy beating the index. If you expect a rising market, then buy a few contracts in advance. In a falling market stay under hedged, until the market turns up again.
On the chart above you see how the strategy performed over the last years in the German power market. At the end of the year it consistently generated a lower entry price compared to the average market price of the specific years (blue entry average below magenta market average)
Adding an RSI Edge
As promising as this simple strategy on the chart above looks, at the end of the year it has always been a winner, there is one thing I do not like at all. In 2017 and the current year you will see that when the market is going sideways. The in-between downtrends have not been strong enough to exploit the edge the trailing stop entry should have shown. Thus, the strategy has been buying at a higher price than the average market price.
To overcome the downside of the delayed trailing entry, one can introduce a fast oscillator to make use of the small in between dips.
The strategy on the chart above uses a 5-bar RSI oscillator to detect short term dips. If it crosses above 30 the strategy hedges the needed quantity. If there is no RSI signal, the strategy uses a trailing stop on the market price as described above.
When you compare this chart with the previous one, you will see that the realised entry price (blue) is way closer to the average market price (magenta). This is the proof that the additional RSI entry was able to reduce the risk of the strategy, but still enables it to outperform the monkey indicator (=average market price).
When designing any procurement strategy, you will have to think about some key design decisions:
- How closely will the strategy follow the monkey benchmark. Is under- and over- hedging allowed? (e.g. monthly buy)
- When under- or over- hedging: how much risk are you willing to take (e.g. 5% trailing stop, buy one month in advance)
- How will the strategy make use of favourable events like sell offs and market dips? (e.g. RSI entry)
Contact me if you would like to implement a custom procurement strategy in your department. As shown above even some simple rule can give consistently positive results with limited risk.
Monkey Indicator Code
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