Using energy and weather derivatives effectively is crucial for effective risk management. You may need to protect your business against adverse changes in the price of fuel or from disruptions due to hurricanes. Energy and weather derivatives provide the means for managing such risks. Energy and weather derivatives can be difficult to use, so proper training is critical prior to using these risk management tools.

When seeking energy and weather derivatives education and training, you should first think about how you want to use them. The following three steps will get you started:

1. Decide the level of energy and weather derivatives education and training you require.

2. Understand the agencies that regulate weather and energy derivatives trading.

3. Consider getting a license if you want to work as an energy or weather derivatives broker.

Action Steps
The best contacts and resources to help you get it done

Further your understanding of energy derivative valuations

When you want to develop weather derivative strategy or learn energy derivatives pricing, you will want a strong understanding of how weather and energy derivative traders operate. This requires significantly more coursework than if you simply are interested in using derivatives to collect information. You should also develop a solid understanding of derivative markets in general by taking a variety of finance courses either online or in the classroom.

I recommend: The New York Mercantile Exchange offers courses in using weather and energy derivative strategy for different purposes. The Chicago Board Options Exchange also has many high-quality courses.

Get to know the rules that govern energy and weather derivatives trading

If you are going to trade energy and weather derivatives then it is critical to know the rules of trading. Knowing the rules before beginning trading is critical to understanding energy and weather derivatives pricing, and it is crucial to stay within the bounds of the law.

I recommend: A good start is with the National Futures Association, a self-regulatory association of futures traders, including energy and weather derivative traders. The Commodity Futures Trading Commission is the governmental body that regulates trade in energy and weather derivatives.

Consider getting a license to trade energy and weather derivatives

If you want to become a professional trader or broker for energy and weather derivatives you will need to obtain a license. There is also added benefit to becoming a member of an exchange as this allows greater trading flexibility.

I recommend: American Investment Training has an excellent self-study package for the Series 3 exam, which is required to obtain a futures trading license You will need this to act as an energy and weather derivatives broker. As the leading energy and weather derivative exchange, the Chicago Mercantile Exchange offers memberships that are very useful for active traders.

Energy and weather derivatives are financial instruments that fluctuate in price because of underlying variables. When purchasing an energy or weather derivative, you are only purchasing the paper contract. Rarely in the case of energy derivatives does a person actually take delivery of the product. Energy derivatives as an instrument have a much longer track record than weather derivatives. Energy derivatives markets began in 1949; weather derivatives markets began in 1997. Because of the potential risk involved in each, you should only invest in energy and weather derivatives if you have a thorough understanding of the specific market.

Energy derivatives and weather derivatives are similar in that both offer protection against potential business risk. With energy derivatives, this risk is rising energy prices. Weather derivatives provide a type of insurance against adverse weather conditions. Most every business feels the economic effect of energy- and weather-related costs. However, you need to determine if either cost necessitates the investment in energy and weather investments. To assist this assessment, you should consider these issues before making a decision:

1. Understand the basics of energy and weather derivatives markets.

2. Analyze the potential problems and obstacles in energy and weather derivatives trading.

3. Decide if you want to hire energy or weather hedging consultants to assist your business in energy and weather derivatives pricing.

Action Steps
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Evaluate the workings of the weather and energy derivative market

The energy derivatives market offers a robust list of trading options such as swaps, futures and forwards. Each of these offers a different energy derivative strategy for your business. Understanding how each works is vital before making any investment. Conversely, weather derivatives offer fewer investment options with weather futures and options on those futures. Weather derivatives can effectively insure your business against high probability and lower cost weather-related risks if you understand the market.

I recommend: CME.com offers a history of weather derivatives. The Weather Risk Management Association website has an introduction to weather derivatives. To understand the basics of energy derivatives and energy derivatives pricing, read The Barnyard Basics Of Derivatives.

Evaluate the potential pitfalls of energy derivatives trading

Minimizing risk can sound like a good idea at first, but these derivatives are risky instruments. Therefore, learning as much as you can about this process is vital before investing any assets in the endeavor.

I recommend: Realize that derivatives are essentially a bet on the price movement of the underlying assets and that this venture can be detrimental to your business. Two historical examples are the Indian derivative debacle and the Orange County bankruptcy.

Contact energy hedging consultants

After you understand the basics and pitfalls of derivatives, it is a good idea to contact a consultant to discuss a weather and energy derivative strategy.

I recommend: Speak to a weather or energy hedging consultant to determine the best course of action. There are several consultants available on the Internet, but you can also contact a local derivative broker.

Tips & Tactics

Helpful advice for making the most of this Guide

• •  Because of the complexity of these financial instruments, it is not prudent to use derivatives of any kind without proper training or assistance. At the very least, you or someone in your business should take a financial derivatives course of study at the local business university.

Improve your investing strategies by defining and understanding energy and weather derivatives key terms. This is a unique investment area, and terms have different definitions from similar terms in market trade. Understand key terms in energy and weather derivatives to keep current with trends and to show your professionalism. By understanding these terms, you keep an edge in market investment and show your clients that you understand the inner workings and history of weather derivative investment strategies.

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Burn

This term refers to an analysis of the historic payout for a product in the investment industry. Using weather trends for this analysis, the burn corresponds with the payout historically on a given contract.

I recommend: AllBusiness.com offers some information on pricing derivatives for weather. The selection includes a variety of different approaches including the burn-rate method.

Cap

Many weather derivative structures implement a cap, or a maximum level, for payout, ensuring that the payout does not go over it. Sometimes the cap corresponds with all-time highs in an index.

I recommend: Carbon Finance offers information on cap and trade programs in the U.S.

Detrending

Detrending is a process where one assesses a probable outcome for an index in the future according to research from past historical data. Detrending figures out the trend and proceeds in adjusting for it.

I recommend: Social Science Electronic Publishing provides information on the different angles of weather derivative investing. It covers many topics including detrending and three representations that are alternatives to damped linear formats, a type of detrending.

Recalibrated data

The term recalibrated data refers to information on the adjustment for changes historically, ensuring a match-up with current conditions at a particular site of reference.

I recommend: Speedwell Weather Derivatives offers tools like recalibrated data sets that re-base data (historical) and sets them in current reference conditions, fixing discontinuities from changes in instruments and site moving.

Strangle

A strangle is a trading term referring to the purchase of a call and put combination, each having their own strike. A strangle purchase client expects the index to finish either below or above the level at purchase.

I recommend: Investopedia offers a detailed explanation of terms used for weather derivative investments. It introduces trading terms like strangle among others.

Volatility

Unlike other financial derivatives that refer to a volatile market as one with the standard deviation in an asset price log return, volatility in the weather market refers to an index standard deviation.

I recommend: Risk Limited discusses weather derivative instruments and market pricing. It details volatility among other terms.

Some investors may not be very familiar with energy and weather derivatives, but others know that these options provide alternatives for getting involved in various markets like oil, crops, or other areas of the financial world where the environment plays a role. Energy and weather derivatives are basically options for abstract investing in conditions, such as unusual weather patterns or a change in demand for fuels. Diversified investors use these financial tools to help manage a changing portfolio.

When a business wants to find out just what's involved in weather or energy derivative strategy, how these options are trading, or anything else that might affect either a business investment portfolio or current operations, the web can help. Business readers can find energy and weather derivatives news and trends:

1. To help with energy derivatives pricing and trading info when leaders are thinking about branching out in a new direction with investments tied to a business asset.

2. For help in determining whether changes in energy or weather derivatives have any relation to a business's current role in markets or industries.

3. For looking at how the competition may use energy derivatives within a given field or market.

Action Steps
The best contacts and resources to help you get it done

Look to online magazines for some info on energy derivatives

One place on the web to find authoritative, well written articles on energy derivatives is in financial magazines. Online magazines frequently have relevant, studious pieces on what energy derivatives are doing within the greater context of the financial sphere.

I recommend: Get news on energy derivative valuations and more at Environmental Finance, an online magazine exploring the fascinating link between our environment and the financial world. Find more from leading online pubs like BusinessWeek.

Get info on how and where energy derivatives are traded

Other news sites on the web give details on the operational aspects of energy or weather derivatives pricing or trading, and what may currently be involved in building weather or energy derivatives into an investment plan.

I recommend: Find out about energy derivatives traded on the Chicago Mercantile Index at this CME Group site.

Locate more news on weather and energy derivatives

There is an abundance of other websites that also may include content on what energy derivatives are doing and what their role is in the financial markets. Take a look and find relevant and specific details that guide knowledge of the process of dealing in weather or energy derivatives.

I recommend: Learn more about the financials of weather at Climetrix. Read more on weather hedging consultants and similar options at sites like this one from Risk Control.