Excell with Options: Are Base Metals Positioned for a Rise?

The next step is to get a sense of what the driver for this upward economic momentum could be. Since the Great Financial Crisis, it has increasingly been the liquidity provided by global central banks driving the economy whether we are in crisis or not. I created an index that looks at the combined balance sheets of the FOMC, ECB, PBOC and BOJ, all in dollars, and plots them over time. As indicated by the white line, these balance sheets climbed steadily from 2015 to 2018 before peaking. This is also when the economy started to show signs of a struggle. Then, when Covid-19 hit in 2020, the combined balance sheets shot higher, leading to a sharp recovering of the global economy, which can be seen in the Leading Indicators. Over 2022 and 2023, these balance sheets have been declining, however, as seen in late 2022, even when they perked up a little bit, the base metals responded. On this chart I am comparing the generic front month aluminum and copper prices. While these balance sheets have perked up a bit in late 2023, I haven’t seen much of a move in aluminum or copper. While the size of the balance sheet remains well above pre-Covid-19 levels, I see aluminum in particular moving back toward these pre-Covid-19 levels.

Using that same OECD Leading Indicator graph, I can see the sharp bounce higher from easier financial conditions, primarily in the U.S., is not leading to higher base metal prices. In the past, the Leading Indicator, while noisy, has done a good job of anticipating these turns. Is the economy telling us metals could be poised for a rise?

Next, I want to look at the charts for aluminum and copper to get a sense of what traders are looking at. In the top chart, I look at the generic front month Aluminum contract on the daily Ichi Moku chart. I can see a large cloud has developed, which shows the level where bulls and bears are into their positions. I can see there is an area of resistance overhead, even if it’s shrinking in size. The middle panel on the chart shows the Moving Average Convergence Divergence (MACD), which is flat and not giving any indication of direction. Similarly, the RSI in the bottom panel of the top chart is also quite directionless. The overall tone from this chart suggests there is no particularly strong signal. 

That isn’t necessarily the case in the bottom chart. This is the generic front month Copper futures in the same daily Ichi Moku chart. I can see futures broke above resistance and are now throwing back to the support zone. The MACD in the middle is crossing and turning higher suggesting another bullish tilt from this support level. The RSI has no strong signal here, but the first two panels have a much more bullish sense to them in copper than what I saw in aluminum. 

Looking at the technical analysis, I can get a sense of how the market is positioned. However, I can also go to the Commitment of Traders report from CME Group to see how Managed Money in particular is set up. The top panel shows the COT for aluminum and I see is that positioning was a little short at the end of 2023 but appears to be moving back toward neutral at this time. The only extreme I see in this chart are the very large, long positions in August 2023 through October 2023 that built up but have now been liquidated. While these large positions built up, there didn’t seem to be any impact in the futures as the front month flat-lined during this period. 

The positioning in copper is quite different. If I look at the COT report for the last two years, I can see that positioning is at the maximum short position over this two-year period. Each time I have seen the market this short it has been reduced over the coming two- or three-month period. Going back to the Ichi Moku chart, I can see this period of reduction (June 2022, May 2023, October 2023) has also correlated with a rise in Copper futures. This appears to me to be a more bullish set up in copper vis a vis aluminum. 

New to the CME CVOL suite of products is aluminum. This is a great opportunity for traders to get more transparency into what is priced into the volatility markets in their product. As a reminder, CVOL uses a proprietary simple variance methodology that assigns equal weighting to strikes across the entire implied volatility curve. The CVOL Index produces a more representative measure of the market’s expectation of 30-day forward risk. 

In this graph, I show two measures relative to the underlying price. The first is the CVOL itself in the dark blue line (the underlying is in the blue dashed line). I can see over the history of the aluminum CVOL that implied volatility tracks closely with the direction of the underlying. This may come as no surprise to many, however, it is interesting and useful to see the magnitude, and any deviation, from this relationship. 

The red line on this chart is the skew ratio. The skew ratio is calculated as the Up Variance divided by the Down Variance. From this I can see where the market demand for out-of-the-money options is relative to the price of the underlying. Again, perhaps not surprising given the correlation between CVOL and underlying, but I see that skew tends to rise when the underlying rises and fall when the underlying falls. Traders demand the options in the direction of the underlying. What is interesting to me is that at the end of 2023 there was a sharp spike in the skew ratio, which was not corroborated by a move in the futures. While this spike has subsided somewhat, it has not pulled back all the way. This suggests to me that traders are still positioned in the options market for a higher underlying at a time when the futures may be running into resistance.