For many investors, the word “trading” is a scary one. It conjures up images of somebody hunched over a keyboard for hours on end, with a huge bank of screens displaying massive amounts of data and charts. They simply can’t or at least don’t want to put themselves in that situation. That is understandable, but the nature of the energy markets makes it essential that even those whose attention is more fleeting understand and utilize at least some basic trading concepts.
The reason for that can be summed up in one word…volatility. It is important to understand here that while that word is often used to imply big drops in price it really means rapid, somewhat unpredictable movement both up and down, and virtually all major energy markets and stocks have shown plenty of that in the last year or so. Even large, integrated oil companies such as BP (BP: Chart below) have had a year of ups and downs.
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That is easily explained. Everything energy related responds to some extent to fluctuations in the price of oil and natural gas, and those markets are themselves volatile. Consistent, one directional moves in commodity prices are rare because of the nature of the market and flexibility in production. Higher prices encourage increased supply which depresses the price until supply is reduced. At that point prices begin to climb again and the cycle is repeated.
That is economics 101, but it has implications for anybody involved in energy investing in that it makes a more traditional “buy and hold” approach to stocks in the sector a frustrating exercise. The answer is to take a few pages out of the trading playbook.
First and foremost, energy investing should be based on realistic targets. When you identify favorable conditions for a particular stock or sector of the industry and decide to buy a stock you must understand that as that scenario plays out it will inevitably contain the seeds of its own demise, and taking a profit at some point is necessary. Even those where the influence of the main commodity is less pronounced such as solar power display dramatic two-way movement. The three-year chart for First Solar (FSLR) below ably demonstrates that. If you had bought that stock in mid-2015 and watched as it climbed around seventy-five percent over the next nine months or so, you would have thought that you had made a good long-term investment. Five months later, however, you would have been stuck with a losing position.
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Just as taking profit is important, so the other side of that coin, protecting against losses, is a trading technique that is essential to energy investing. As we found out when the price of oil collapsed a few years ago, the volatility in the underlying commodity markets can result in rapid changes to the fortunes of companies in the business. Using stop loss orders goes against the grain for some investors, who hate the idea that you could be cut out of a position that would have proved profitable eventually, but a disciplined approach is a must when volatile oil prices can result in bankruptcy, and therefore a total loss for stockholders, for even what once looked like solid companies.
I am not saying here that we should all take very short-term positions and jump in and out, enriching our brokers in the process. What I am saying, though, is that even those with long-term views must understand that the energy markets are different. Investing in them involves understanding that every investment should have an end point, and that discipline is vital. These are traders’ techniques and attitudes, but in these markets even those who see the short-term nature of trading as part of the problem would do well to embrace them.