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How to Trade Weather Derivatives and Options

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by Gavin in Blog
October 18, 2021 0 comments

Do you want to hedge against weather-related losses for your company? Read on to find everything you need to know about weather derivatives trading.

Contents

Introduction

Our day-to-day life is not the only thing that the weather influences.

Favourable weather conditions also play a critical role in the success of our business ventures.

But, on the other hand, no matter how big or small the business, unprecedented weather conditions can result in a significant loss of profit.

These conditions can lead to a disparity between supply and demand, for example, in the energy market.

Or perhaps, they can cause significant delays, which allow competitors to get ahead.

One of the best ways to hedge against such losses incurred due to specific changes in the weather is weather derivatives trading.

Over the past two decades, weather options and derivatives have gained immense popularity among all sorts of businesses.

Let’s take a closer look at what weather derivatives are, how they function, and how you can trade them.

What Are Weather Derivatives?

A weather option or a weather derivative is a hedging product for maximum risk management.

A company can hedge against any losses it might face using weather derivatives trading. Consequently, this company will receive a payout based on a predetermined weather index.

Let’s try to understand this with the help of an example.

A company specialising in gas distribution runs the risk of losing profits in a mild winter season.

Understandably, the demand for gas will go down if the temperatures remain tolerable.

This company can use weather derivatives trading to ensure that it will be compensated for its loss in these circumstances.

First, the trader and the company will agree on an index that needs to be set.

Usually, an HDD index will be used to set the limit for the temperature change at which the company will receive the payout.

Moreover, the company need not show its losses to get the payment.

Indeed, all it needs is a record of the winter temperatures to back its claim.

Therefore, looking into various weather options trading strategies can be a pragmatic way to protect from weather-induced damages.

The first weather derivatives were traded in the late 1990s.

These contracts are usually of the OTC (Over the Counter) type and fit the specific needs of a particular business.

What Is Their Function?

Weather derivatives save you from profit and loss fluctuations owing to the weather.

Changing weather can pose a series of problems for companies, no matter what the business.

For example:

  • Transport delays due to blockades
  • Low gas consumption due to reduced needs in milder weather
  • Poor crop yield due to unprecedented rain
  • Disastrous harvests due to unfavourable weather
  • Event delays due to excessive rainfall, winds, thunderstorms, etc.

Protection against these hurdles is possible via different weather options trading strategies.

The payout if the index is achieved will make up for any losses.

How Do You Trade the Weather?

We have seen how helpful weather derivatives trading can be in the long run.

Now, let’s see all the parameters you must cover to trade the weather.

Step 1: Knowing the Difference

Weather derivatives are different from weather insurance.

Similarly, commodity derivatives don’t quite work as weather derivatives do.

Therefore, you must know what you are signing up for.

The Difference Between Weather Derivatives and Insurance

Apart from trading weather derivatives, you can ensure protection against damages incurred due to weather via weather insurance.

However, the difference between weather derivatives and weather insurance lies in the payout structure.

For insurance, you will only receive the payment after showing proof of loss.

This proof is because insurance works on the principle of indemnification.

As per this policy, your insurance company compensates you for the apparent harm you have suffered.

When it comes to weather derivatives, you receive the payout regardless of whether you have suffered a loss or not.

Once the weather conditions match with those specified in the index, you are entitled to your claim.

The Difference Between Weather and Commodity Derivatives

A commodity derivative is an investment option where traders can profit from a commodity without getting complete ownership of it.

However, the trader has the right to buy or sell the commodity according to the need of the time.

Weather does not quite work that way, but this hedging method against loss follows the basic principle of derivatives and options.

Step 2: Knowing the Market

We know what you must be thinking and the questions you may have.

How do I know if my company qualifies for trading in weather derivatives?

Do I need it?

Am I better off not investing in some weather options trading strategies and keeping the profits to myself?

To answer these questions, you need to have a thorough understanding of what companies benefit from these derivatives and how so.

What Companies Rely On Weather Derivatives?

As discussed a couple of sections ago, weather can influence just about any kind of business.

Even if not directly, weather can result in transmission and communication delays for anyone.

However, let’s look at some companies that need to rely heavily on weather derivatives trading.

● Insurance Companies

Interestingly enough, insurance companies themselves often rely on weather derivatives.

For example, when constructing weather insurance policies, insurance companies need to ensure they will not incur a loss paying for heavy damages that the premium cannot cover.

Therefore, they often set an index for weather derivatives trading according to which they must be compensated.

Or, they can be used to manage risk for large scale mutual funds.

● Energy Companies

As we saw before, energy companies that supply fuel for consumption rely heavily on favourable weather to keep their profits up throughout the season.

As a result, gas distributors incur a loss if the winters are not cold enough to warrant regular fuel consumption.

Similarly, if hilly areas are blocked off by excessive snow cutting off vehicular access, gas stations run at a loss.

In these cases, the index is set to describe a specific temperature limit or level of snow, after which the energy company receives the payout for losses it might or might not have suffered.

Then, if you invest in wind energy you can also speculate with weather derivatives.

weather derivatives

● Farming Businesses

Crop production and yield are also strictly governed by the weather.

Moreover, farming businesses are also vulnerable at the time of harvest.

Even if the process goes smoothly all year round, extreme weather at this time can lead to huge losses.

Therefore, farming businesses make sure to cover all extremes of weather in their weather derivatives.

● Event Management Companies

A perfectly planned event can get cancelled in the blink of an eye once the weather is against you. This scenario is especially true for events conducted outdoors.

The company may have to undergo the same preparations twice for the same amount of money.

In addition, the company may face damages to their props and equipment.

Unprecedented harsh weather ruining an event season is another scenario in which an event management company might need to hedge against weather-related loss.

● Shipping Companies

Transportation faces a significant hurdle in severe weather conditions.

For example, roads may be blocked by snow or landslides.

In addition, heavy rainfall may lead to congestion, due to which deliveries are delayed.

All these possibilities can lead to heavy loss of revenue, and weather derivatives can provide adequate compensation for recovery.

Are These Derivatives Only Suitable for Large-Scale Ventures?

Although large-scale businesses tend to take the different weather options trading strategies a lot more seriously, they are not the only ones needing them.

Contrary to popular belief, small companies have a much larger need for these weather derivatives.

The reason is that the smaller the company, the harder it becomes to recover from a huge loss.

The payout from the weather derivative can go a long way in making up for previously irreparable losses.

Step 3: Knowing What You Can Trade

Now we know what companies most require weather derivatives trading. But how do you know what to trade or how to set an index?

Well, worry not; we’ve got you.

What Are the Different Types of Weather Options Trading Strategies?

Let’s look at some of the typical weather derivatives used by the majority of these businesses.

● Heating Degree Days (HDD)

Energy companies often use the Heating Degree Days index to trade weather derivatives against risky winter temperatures.

In the USA, the average daily temperature is subtracted from 65 degrees Fahrenheit to find the temperature at which heaters are usually switched on.

A long-term trend of these values helps determine the index for the weather derivative.

Moreover, the HDD value can serve as a good mirror for gas demand.

● Cooling Degree Days (CDD)

Like the HDD index, a Cooling Degree Days index can hedge against risky summer temperatures.

Therefore, air conditioning companies can use these values to keep their power demands insured.

In the USA, CDD is calculated by subtracting 65 degrees Fahrenheit from the average daily temperature.

The values derived after long-term calculation form the index.

● Cumulative Precipitation

Farming businesses or shipping companies are often profoundly affected by rainfall.

For weather derivatives trading in these sectors, the index is set at a specific volume of cumulative precipitation over some time.

Hydro companies also use this index.

● Others

Levels of snowfall, thunderstorm predictions, and heatwaves are some of the other weather parameters companies can hedge against.

Each has its particular index, which serves as the centre point of the weather derivative.

Step 4: Knowing the Money Side of Things

Let’s now answer the question of setting prices. Moreover, if you are on the other side of the trade, we’ll tell you what the scope for earning is.

How Do Companies Price Weather Derivatives?

Three major factors govern the pricing:

  • The payoff values over the past two to three decades
  • Recent weather conditions and predictions
  • A buffer amount to make up for damages

These parameters will help you set an ideal payout amount.

Finally, the two parties decide on an initial settlement, usually within a week of the index expiry.

What Is the Average Salary of a Weather Commodities Trader?

A weather commodities trader has an average salary ranging from $60,000 to $90,000 per annum in the US.

However, this value is dependent on the following factors:

  • The state you are working in
  • Clientage
  • Weather patterns
  • The weather options trading strategies you offer

Step 5: Knowing the Risks

No trade is successful unless you enter with full knowledge of the risks involved and a plan to deal with them.

What Losses Can You Incur When Trading Weather Derivatives?

Generally, weather derivatives trading is a relatively risk-free trade.

Of course, if the weather patterns do not meet the index, you will not receive your payout.

However, if they do, you will receive the payout whether you have suffered a loss or not.

In case of severe damages, this payout can be life-saving for you and your company.

Compared to weather insurance, you stand a better chance to earn back the premium you invested.

The Bottom Line

Before weather derivatives were introduced, companies relied on luck to get through the losses incurred due to non-catastrophic weather conditions.

However, in today’s economically tense and climatically volatile world, weather derivatives are life-savers for most businesses. We hope you found this article informative and helpful.

Author Bio: Kyle is the founder of The Impact Investor, a website focused on helping others invest sustainably without sacrificing financial returns. We all want products sourced by sustainable and ethical means, why should investing be any different? Follow my investing journey on my Facebook, YouTube or Twitter accounts.

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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