International and Domestic Opportunities
Over the last 7 years the copper market has generally assumed the role of long term macroeconomic indicator. Going into the Sub-Prime Crisis, copper prices registered some surprising gains, and they appeared to have forged a major top above the $4.25 level. Considering that prior to 2005 copper had never traded above $1.60, see copper climb above the $4.00 level came as a surprise to copper miners, scrap dealers and industrial buyers. Not surprisingly, the post sub-prime slowdown and subsequent global uncertainty fostered a washout of $3.00 per pound in 2008.
But copper's subsequent rebound of $3.38 per pound to fresh historical highs in the wake of lingering sub-prime carnage allowed it to gain credibility as a leading economic indicator. To this day it is sometimes referred to as "Dr. Copper" and is thought to be a solid indicator of big picture macro-economic and industrial demand conditions. Several analysts now use the COT large and small spec reading in copper as a broad-based sentiment indicator. A net-short position points to negative economic expectations, while a move to a net-long position suggests a shift towards economic optimism.
China a Dominating Influence on Copper Prices
Surprisingly, exchange copper stocks saw a pattern of declines throughout the aftermath of the sub-prime crash. Even more surprising is the apparent pattern of stocks migrating from exchanges outside of China to what is thought to be significant copper stock storage inside China. From mid-2013 until the middle of 2014, formal exchange stocks held outside of China declined by roughly 75%.
The mass movement of physical supply to China was thought to be the result of special financing capacity for Chinese firms through the Chinese government. These "inventory loan schemes" were thought to have pulled excess supply into China. When it appeared that the Chinese government was going to halt these special incentives, nearby copper prices encountered another compacted historical washout of almost 11% in just 9 trading sessions!
However, even after the reported unwinding of loan schemes and the sharp decline in flat prices, copper exchange stocks of copper fell outside and inside. Indeed, after the sharp spring 2014 washout and the exposing of the copper loan scheme situation, official Chinese buffer stock managers reportedly labeled nearby copper prices below $3.00 to be a "solid value."
China is in the midst of a 5-year electrification project that is expected to include a new grid that of the size of the current US electrical grid. Global, above-ground supplies of copper appear to be tightening significantly. Even if China has its needs filled with domestic inventories, one has to wonder where the rest of the world will get their supply once the developed world gets back on a positive economic track.
Classic Copper Fundamentals
World copper consumption is expected to rise above 22 million metric tons in the coming years , and with recent world production reaching a new peak around 23 million metric tons, it is clear that copper does have the potential to see a surplus condition ahead. However, since 2007 the world copper market has seen 4 annual surplus years and 4 annual deficit years, and the net change in stocks from the annual matching of supply and demand results in a only a small net surplus of 50,000 tons! Through one of the most disastrous economic slowdowns in modern history, world copper supplies increased by only 50,000 tons.
As can be seen from the enclosed chart, producers Chile, China, Peru and the US are the main sources of supply, so production issues in those countries should be given added importance. While copper can take periodic direction from significant changes in the US currency (usually an inverse relationship), the equity markets and the precious metals markets, recent action has shown copper to be developing a tighter relationship with nickel, zinc, lead and aluminum, and that might suggest that copper is attempting to embrace a more classic, physical commodity market focus again. If copper does begin to track its physical fundamentals, it could result in a tighter daily correlation with US equities and energy prices.
Upcoming Copper Market Dynamics
Like many other commodity markets, copper's daily focus is expected to continue to shift toward all things Chinese, but the trade is also likely to begin to reacquaint itself with the ebb and flow of trends in global auto production and construction. It is also likely to begin to monitor environmental issues for several Asian producers. For instance, Indonesian copper production has come into the radar of government officials as a potential source of export taxes. Production in Mongolia has come under environmental monitoring for both ground and air pollution.
Another issue that is likely to surface soon is the subject of wages. Miners of all metals continue to have very low standards of living. Like other commodity markets, the subject of higher wages and better working conditions are usually exacerbated by high prices. Copper might have to return to the vicinity of $4.00 to begin to foment wage disputes.
Practical Strategies using Copper Options and Futures
Relatively speaking, copper tends to settle into more consistent trend patterns than are seen in interest rates and equities. Perhaps copper's heavy industrial foundation lends the market to uptrends in periods of global economic growth and downtrends in periods of economic easing. Therefore an effective strategy for trading copper might be to be long copper in the early phase of a global recovery and protecting that position by buying a slightly out-of-the-money put option. With liquidity in copper futures and options solid 6 or 9 months into the future, using a long put as protection can allow "traders" to become "investors."
Traders can also consider selling calls against the long futures position as a tool to bank some windfalls. This could be a temporary play against a sudden macroeconomic deterioration, or it could be a tool to reduce the cost of the put. Some traders describe a long futures position with long put protection and a short call a "fence" because the outcome normally has a specific definition of risk and reward. The fence can also be a short-side trading tool, with the trader implementing a short futures position and protecting that position by buying a call and a selling an out-of-the-money put.
Volatility Event Strategies
From time to time markets will become pent-up ahead of a major event that can result in a sudden expansion of volatility. There can also be major a trend change following certain events. Examples of such events are US Fed rate statements, strike deadlines, geopolitical unrest, elections and severe weather. In the past the copper market has been affect by flooding, earthquakes, electrical grid problems and other one-off events.
While every event presents a different set of circumstances, it is possible that monthly Chinese copper import readings, US unemployment results and global auto sales figures could become the catalysts that spark an end to the downtrend pattern in copper that started in early 2011. Typically, Chinese import/export data is released in the 3rd week of the month. With copper prices throughout most of early 2014 registering a spec and fund net short, exchange stocks of copper on the decline and the markets in general disappointed with the pace of the global recovery, some traders might decide to make a play off the next Chinese import/export release or off an upcoming US payroll result.
With the long term trend pointing down for 3.5 years and nearby prices sitting 30 cents above a recent low, playing for a volatility event and a long term change in trend could prove effective. Traders could consider buy 2 just out of the money puts and entering a long futures position, both with an expiration of 5 or 6 months into the future.
For instance, consider buying 2 September Copper $3.00 puts and buying the September Copper futures around the $3.14 level. On a break below $3.00, the long puts would serve to cushion against the loss in the futures. On a significant, trend-changing washout in prices, the gains in the puts position should outpace the net loss in the futures (depending on time decay). In the event that an uptrend begins in earnest, and the futures contract manages to rise sharply, it should more than offset the cost of the 2 puts, and the trader should be well-positioned in the newly-formed uptrend. The biggest profits will occur the further the market moves away from the initial entry point.
The information herein has been compiled by CME Group for general informational and educational purposes only and does not constitute trading advice or the solicitation of purchases or sale of any futures, options or swaps. All examples discussed are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. The opinions expressed herein are the opinions of the individual authors and may not reflect the opinion of CME Group or its affiliates. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, CBOT and NYMEX rules. Current rules should be consulted in all cases concerning contract specifications.
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