Executive summary

Image 1: OECD Leading Indicators vs. the relative performance of aluminum and copper vs. gold

It has been awhile since I last sat down to write an Excell with Options about base metals. Before I dug into any sort of idea, I wanted to get my bearings. We know that these metals are relatively common in the Earth’s crust. However, these metals are also extremely important for the global economy, especially as we move vehicle production to aluminum and continue to electrify the economy, which drives a higher need for copper. My first stop when I wanted to get a sense for the underlying dynamics was to look at these metals compared to the OECD Leading Economic Indicators. I normalize both copper and aluminum by dividing them by the price of gold to take out any FX impacts, since there has been a bit of volatility in FX in the latter half of 2023. When I look at this chart over the past 10 years, I can see that the Leading Economic Indicators do a good job of forecasting the direction of the base metals relative to the price of gold. In fact, these indicators are pointing higher at a time when the base metals are still relatively languishing.

Image 2: The combined balance sheet of FOMC, ECB, PBOC and BOJ relative to aluminum and copper prices

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.

Image 3: OECD Leading Economic Indicators vs. generic front month aluminum and copper

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?

Image 4: Daily Ichi Moku charts for generic front month aluminum and copper

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. 

Image 5: Commitment of Traders report for aluminum and copper

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. 

Image 6: CVOL for 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. 

Image 7: CVOL for copper

Turning to the copper CVOL there is a bit more history to work with. I see the same pattern where the CVOL Index and the underlying tend to move in the same direction. As a result, the skew ratio also moves in the same direction of the underlying, with upside demand leading moves higher in the futures and downside demand leading to lower futures. I want to draw your attention to the late 2021 and early 2022 period as well as the late 2022 and early 2023 period. In each of these we saw a series of higher lows and higher highs in the skew ratio in copper. This led to higher underlying prices, which also meant higher CVOL levels. As we end 2023 and head into 2024, we see that seasonal move higher in the skew ratio. While it may pull back some from here, this could again be the beginning of a series of higher highs and higher lows that would suggest higher futures prices. Given the short positioning from the COT report, and futures prices looking to bounce off near-term technical support driven by higher Leading Indicators, this may be the bullish set-up I am looking for.

Image 8: Term structure of implied volatility for aluminum and copper

The next step for me is to go to QuikStrike and look at the term structure of implied volatility to see if there are any points that stand out as a better place to express my views. Given the set-up I discussed before, I am focused more on the copper market than the aluminum market, but I want to show you both.  In aluminum, I can see implied volatility trending higher across the different maturities along with the futures curve. Other than the front two periods standing out as a little higher than the others, there doesn’t seem to be many interesting points. 

Copper looks a little different. The front periods out to March are the lowest on the curve. Then prices move higher with futures. If I am looking for a near-term bullish idea, focusing my long options in the front of the curve makes sense. 

Image 9: Implied volatility by delta surface for aluminum and copper

Now I turn to the entire volatility surface to look at the out-of-the-money and at-the-money options. From here I can sense where I want to look more specifically for my opportunities. The Weekly Copper options (H1WH4) stand out because they afford a little more time to expiration than the standard March expiration, but where I don’t have to pay too much of a premium. I am also focused on the upside options because I want to have a bullish strategy in place. Not only do I want to be bullish the underlying, but I want to be bullish implied volatility given the correlation. Thus, I want to see where I can get long upside options, preparing for the series of higher highs and higher lows in volatility, without having to pay too much extra. This is another reason I prefer the March weekly to standard March. As I look at the difference between the deltas on the upside, I’m not paying as much of a premium as I go higher as is the case in other expirations. This view tells me to focus on the Weekly Copper options.

Image 10: Expected return for short 1-unit H1WH4 3.80 call vs. long 2 units of H1WH4 3.95 calls

I have decided to use a ratio call spread but one in which I buy two upside options and sell the at-the-money. I can do this at zero cost. This gives me upside exposure, which we can see from the dashed lines of profitability all moving higher with underlying price. If futures move in the short-term, I am simply long options to the upside and I will enjoy the benefits of that. However, there is a risk to this ratio call spread and that is I sit for several days or weeks before the move. The closer I get to expiration, the more difficult it is for me to make money on the upside moves. I can see that at expiration a move to the 3.95 strike is the highest pain in the strategy. Therefore, it is important to note that this is not just directionally dependent but also time dependent. The longer it takes for a move to happen, the more inclined I would be to trade out of the position. I don’t want to let this get too close to expiration if there is no move. 

We can see from the table on the right, that I am not paying much of a volatility premium (1 vol point) to get long these out-of-the-money options. Given the correlation of CVOL and skew to a move higher, I’m comfortable paying some premium, but I want to be careful the move is not already priced in. I don’t believe it is. 

Image 11: Expected change of vega for short 1-unit H1WH4 3.80 call vs. long 2 units of H1WH4 3.95 calls

A key reason I wanted to express my view in this way is to get long vega if there is a move higher. Looking at CVOL and skew I can see that the volatility markets react positively for moves higher in the underlying. As I want to have a bullish view, I also want to make sure that if futures move higher, I am getting longer volatility. This gives me more opportunity to trade out of my position on moves in my favor. If futures break down and move lower, I’m not disadvantaged in either profits or vega because I paid no net premium to get into the idea, and I lose my long vega quickly on a move lower. Thus, I believe the structure is more favorable than simply getting long futures. On a move higher that also sees volatility move higher, I could potentially benefit in two ways. That is why I like this idea. Of course, there is still the risk that I sit for weeks and then move higher, and I could end up at my long strike at expiration. I need to beware of this risk and trade out if I don’t get the move in the near-term. 

The combination of the information that can be gleaned from the CVOL tool, now available for aluminum, with the flexibility of weekly options, give traders many ways to determine what they want to trade and find the exact spot to put on the idea. I see more choices and more flexibility as an opportunity for more profits. 

Good luck trading!

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The opinions and statements contained in the commentary on this page do not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs. This content has been produced by [Data Resource Technology]. CME Group has not had any input into the content and neither CME Group nor its affiliates shall be responsible or liable for the same.


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