I have two charts up on my computer that I routinely go through. I learned early in my career that the best traders, even outside of the commodity complex, like to look at these industrial metals (ALE1 and HG1) priced in terms of gold (GC1) in order to take the FX effects out of the price. Thus, a trader might be able to ascertain a solid view of the commodities market’s sense for supply and demand. Since May, as both of these measures have shown extreme weakness, it has led to a number of commentators wondering if the global economy is entering into a period of meaningful economic slowdown.

Ideally, a trader would like to compare these two futures markets’ measures to a global GDP to see how closely they match the actual economic output. After all, the latest GDP reading in the U.S. was 5.2% in nominal terms, while it was 4.7% in China. That might sound like reasonable economic growth to many. Interestingly, those measures do not correlate well with the futures market. Instead, I have found that the U.S. ISM (orange) and the Chinese Li Keqiang Index (yellow) do a much better job. The ISM is a survey of business conditions in the U.S. and it coincides with asset markets while GDP lags. There have also been criticisms of the Chinese GDP, which is why I use the Li Keqiang Index on Bloomberg. When he was Premier of China from 2013-2023, a reporter asked Li about GDP. Li said he did not like the man-made data but preferred real measures like rail traffic, electricity consumption and bank lending. Bloomberg put that index together. A trader can see that both the ISM and Li Keqiang do a good job of tracking the futures markets, if not leading them. To me, both suggest there could be downside here even though the narrative is about a soft landing and rate cuts now in the U.S.

Now I turn to each of the futures markets individually and look to the futures themselves and not those priced in gold. I can see a similar shape where each has been under tremendous pressure suggesting those earlier moves had little to do with gold and more to do with the supply/demand of the futures themselves. In the top chart of aluminum, we can see a chart that has broken solidly through the Ichimoku cloud, which attempts to find the zone of where buyers and sellers are. In fact, this cloud is starting to turn lower suggesting a trend change may be afoot. On the positive side I see the MACD in the middle panel is starting to turn higher, though it has not crossed yet. Importantly, in the bottom panel, the RSI appears to be solidly oversold and has not been this oversold this year.

The Copper market is very similar to this. Price has moved below the cloud and the cloud is turning lower. The MACD is showing signs of turning higher but may not yet be as far along as aluminum. The same is true for RSI, which is only marginally oversold and has touched this level of oversold in the past year.

While neither chart looks particularly healthy, it may be easier to make a call for a trading bounce in aluminum than in copper. 

Now I want to get a sense for how the volatility markets are reacting to these moves. I move to the CVOL page at CME Group to first get a look at where each product is trading relative to its last year of trading, but then to also compare each to the other Metals products to see if anything stands out. At the top of the page, I see that aluminum CVOL is at 18, on the lower end of its one-year range of 16.25-29.75. Copper, on the other hand, is higher in both absolute terms (27.43), but also relative to its one-year trading range of 14.46-40.70. Traders in copper appear to be expecting a bit more volatility in copper than in aluminum, at least according to CVOL.

Not only do I want to look at the overall CVOL levels, which uses all strikes to calculate the level of volatility, but I want to look at the skew ratios for both. The skew ratios give me a sense if the supply or demand of options in these markets is being driven by upside or downside options. When this ratio is rising, there is more relative demand for upside options. When it is falling, there is more relative demand for downside options. In the top chart, one can see that the trend in Aluminum options has been for the downside until a very recent spike higher. The opposite is true in copper where the trend had been for upside options until a recent spike lower in the last set of data. Do I trust the trend or the spike? I tend to trust the trend and not the spike, but I want to investigate further.

Turning to the Commitment of Traders data, in particular focusing on Managed Money, I can see that positioning in copper stands out as leaning much lower than in aluminum. Even though both have fallen of late (not surprising given the move), copper positioning is still higher and still shows that there is more room to move lower relative to its own history as well. Copper appears to be a more active market and used as more of a proxy for traders than aluminum, where the positioning is quite light in general. Thus, from a continued unwind perspective, there appears to be more of a risk in copper than aluminum.

I said before that I wanted to investigate more because of the recent spikes in the skew measure within CVOL. To do that, I used QuikStrike and looked at the implied volatility surface by delta. Here I can see not only how the implied volatility curve for the at-the-money options look in each product, but I can also look at the calls and puts by delta. Therefore, I can compare it to the relevant at-the-money as well as to similar deltas in other expirations, and ultimately across product. I can see a few things from the two charts above: 1) Implied volatility for aluminum is consistently lower than in copper, not just in the front month, but even going out for a year. 2) I can see the effects of the skew spike in later months in aluminum, but upside implied volatility is flat in September; in copper, despite the drop in skew, upside options are the same if not higher than the at-the-money. 3) The further out-of-the-money one goes on the call side for both products, the implied volatility is fairly similar, thus any difference in pricing is nearer to the at-the-money options. As I mentioned, there is a consistent discount for aluminum. Has this always been the case?

In order to see if aluminum always trades at a discount to copper, I bring up my CVOL. In the upper right, a trader can choose more than one product. This plots the CVOL for both aluminum and copper over time. This very simple exercise shows me that any difference in CVOL or implied volatility levels has begun to happen only in the last couple of months. In fact, historically, these products trade at remarkably similar volatilities. Does this spread then present an opportunity?

I want to lean into the fact that aluminum is oversold and has the potential for a trading bounce. It is at the low end of its CVOL range over the past year and trading at a discount to copper. In addition, if I look at the nearer upside options, I can find implied vols that are lower than the at-the-money. This is most pronounced in September options, but since I am looking for a trading bounce, I do not want to go out too far. The chart above shows that expected return for buying two of the September 2275 calls is about 2% out-of-the-money. One can see that for every two options I buy, I spend 22.829 in ticks, which translates to $570.725 for every two options I buy. This is important because in buying these options even though I think the volatility may be better value and I have defined risk. I have taken on economic risk in that if the U.S. or Chinese economies do not show signs of improvement, I could still miss the mark.

To neutralize that economic risk exposure, I choose to sell one September Copper 4.19 call. This option is slightly more out-of-the-money than the 2275 Aluminum calls at 2.4%. One can also see that this option trades at a higher implied volatility of 19.28 vs. 16.59 for aluminum. Because of this difference in implied volatility, I take in more premium to sell this option, 0.0474 in ticks, which multiplying by $25,000 means I take in $1,185. Even though I am selling only one option, and it is slightly more out-the-money, because of the implied volatility difference, I can net take in premium. What does this mean? It means if I am completely wrong and neither product has a bounce yet both stay where they are or go even lower, I will still take in some money.  It means if both rally because of an oversold bounce in each, better economic data or re-positioning by traders, I own more upside options than I am short. I also have a premium head start so even if copper moves up faster than aluminum, I have a buffer to work with. It also means that if I am right and aluminum moves up sooner or faster, given it is more oversold and has less positioning to work through, I can really benefit from being long in the right place and having more leverage to that move. This is the best case scenario for my trade. The biggest risk is that copper moves higher and aluminum does not, meaning I am short an upside call and the cross-asset deltas that I am using to hedge do not do a good job of hedging. In this case, I will need to decide whether I need to close the short side of the trade. 

Given the set-up in each futures as well as the given the correlation of the products and given the relative pricing of the options, I feel comfortable that there are more ways that I can win than I can lose in this relative value trade.

Good luck trading!

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