The Effect of Rising Prices and Volatility on Computer-Assisted Trading
energy-trading
7 Mar 2023
Mario Nakhle, Product Management
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Over recent years, European energy markets have experienced an unprecedented surge in power prices and their volatility levels.
Since daily power prices are set on the basis of the merit order effect, recent extreme price movements in power spot markets are predominantly driven by commodity prices (natural gas in particular) that skyrocketed following the war between Russia and Ukraine.
What’s Behind the Rise in Power Prices and Their Volatility Levels
To zoom in on how power spot prices and their volatility levels have been changing since 2019, let’s refer to the historical Day-Ahead market data in Germany:
Daily power prices were growing from 2020 and soared in the second half of 2021 and the first half of 2022 (reaching a daily average of 705 €/MWh in August 2022). Daily volatility was rising accordingly (with the highest daily standard deviation of 204.8 €/MWh in August 2022) and behavior-driven extreme events only exacerbated these dynamics (e.g. power prices exceeded 1000 €/MWh in August 2022 that was extremely expensive even taking into account soaring gas prices).
While power spot prices and their volatility levels stalled since the beginning of 2023, those extraordinary price developments had a strong and lasting effect on trading operations.
Let’s elaborate.
The Effect of Rising Prices and Volatility on Computer-Assisted Trading
In theory, absolute price levels might seem irrelevant given that asset-less and a number of asset-backed traders speculate on price movements. However, practice shows that rising prices and volatility have a detrimental effect on trading operations and risk management.
A surge in power prices increases the requirements for collateral — i.e. the amount of money that market participants have to provide to an exchange in order to trade a certain volume of power. Collateral can be either deposited in cash or provided by third-party institutions in the form of securities (e.g. bank guarantees). Collateral requirements vary among European exchanges and market access providers.
For example, if a trading company is required to have twice its exposure as collateral to open a position on a given energy exchange, a deposit of 1000 € enables traders to buy 500 € worth of power. If the power price during a given trading day is 100 €/MWh, 5 MW can be bought. If the price goes up to 500 €/MWh, power traders will be able to purchase only 1 MW.
On top of that, the rising volatility has a direct impact on value-at-risk (VaR) modeling which is applied to predict and estimate potential portfolio losses. Since VaR is calculated based on absolute price spreads, any increase in spread size may trigger VaR breaches. Therefore, market participants have to adjust traded volumes taking into account the likelihood of higher losses.
Historical VaR data for Day-Ahead to Intraday volume-weighted average price (VWAP) spreads in Germany illustrate this dynamic:
VaR1 of Day-Ahead vs. Intraday VWAP spread in Germany. VaR1 is defined by the 1st percentile of the absolute spread. With 99% confidence, it indicates that losses per MW will not exceed this value
As power prices and their volatility levels surged, VaR1 exceeded 1000 €/MWh and started to increase exponentially (peaking at 4244 €/MWh between September and November 2022).
To minimize value-at-risk breaches, market participants tend to reduce their computer-assisted trading activities preventatively.
Once critical risk-limiting automations have been employed, the rising volatility can be seen as an opportunity for speculation.
Let’s take a look at the size of spreads between the Day-Ahead and Intraday markets in Germany:
Average Day-Ahead vs. Intraday VWAP spread in Germany
Bigger spreads of the years 2021–2023 as compared to 2020 allow market participants to make more profit from the same volumes of power.
However, trading at high levels of volatility requires the application of automated trading engines that quickly react to market changes and therefore reduce risks and increase trading performance.
Verdict
The rising power prices and volatility substantially increase the cost of power spot trading and magnify portfolio risks that should be accounted for given the new market conditions.
Even though power spot markets have now stabilized — as natural gas prices have reduced due to mild winter temperatures and full gas storages in most European countries — the overall power prices and their volatility levels still remain high if compared to the 2019–2021 period.
Whatever the future holds, the energy crisis emphasizes the role of solid risk management and trading automation in navigating market shocks.
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