Building Blocks for Market Understanding
True Indices in Action
Reflections on building blocks to break down and understand complexity. As ever, let me know if you spot errors or mistakes or simply disagree. We’re just experimenting here.
How do you approach something very complex with simple building blocks?
Variance swaps are complex derivatives, but it is possible to approach them with simple hedging strategies. How close can you get to the complex thing by piecing together the simple things?
In this case, the ‘optimal’ combination of simple things leads to ‘robust’ bounds for the complex thing. If the market price for the variance swap is outside the bounds, there’s an arbitrage opportunity.
Similarly, optimising for maximum revenue in the energy markets is very complex. ‘Indices’ aim to measure the potential. But do these measures help us to understand what is going on behind the scenes?
The Index Strategy Builder invites the user to explore building blocks and build replicable energy market strategies in a simplified but realistic setting. The app is an extension of this newsletter, a different genre of writing that leads to a different kind of output.
Starting Simple
The Index Strategy Builder starts with basic, replicable blocks:
FCR (frequency containment)
aFRR+/- (balancing reserves)
Day-ahead trading.
The challenge is to define a 1MW/2MWh symmetric strategy from these blocks for the future.
You should aim to ‘beat’ naive strategies, like those shown above, e.g. FCR Pure, or FCR night/ DA Day.
To get started, you might look backwards and check to see the optimal strategy with these blocks with hindsight.
If you think the next 7 days will be similar to the last 3 days then you might like to build on the 3-Day optimal strategy. You are beginning to develop and express a market view that you can test.
As you go through the exercise, you might think about current market conditions and what influences them.
The app helps to pin down and express a hypothesis about what will happen next. In a similar way, fantasy sports apps ask us to ‘bet’ on the development of sport performance statistics and virtual portfolios get us to think about where the market will be going, and experiment with our views.
State of the market? Building a picture from the blocks.
