It has been a wild ride in the metals markets in the past few weeks. It began with the news of 50% tariffs on foreign copper, which led to a price surge in U.S. Copper futures. However, once it became clear that raw copper was excluded from the tariffs, prices decreased. Then the U.S. Customs and Border Protection issued a ruling that 1 kilogram and 100 ounce gold bars from Switzerland would face a 39% tariff. Futures surged. Later, the Administration attempted to clarify, and the President even issued a message on social media saying gold would not be tariffed. What are traders to do? One thing I have always attempted to do within the metals market is to track the ratio of copper to gold and compare it to economic data. After all, copper is a highly economically sensitive metal while gold is a store of value. If the economy is corroborating moves, perhaps falling prices are a sign of slowing economic activity. If not, perhaps there is a trade to make.

The top chart looks at the ratio of the generic front month Copper futures to generic front month Gold futures. I overlay the ISM survey and the change in GDP. GDP is lagging data, and I only include to try and corroborate. ISM is more real-time and tends to move in tandem with risky assets like stocks, as illustrated by the chart above. In spite of the volatility over the last few weeks, the ratio of copper to gold has been falling for some time, in conjunction with falling ISM. This suggests that it may be slowing economic activity that is bringing down this ratio.

However, if one looks at the bottom graph, which shows a 35 year history of the ratio, they would see that it is at the lowest level since this data was made available. Is economic data that weak? The ratio is at levels that are lower than Covid-19 and lower than the Great Financial Crisis. Even if the economy is slowing, is it in that bad a shape?

Looking at the spread of copper to gold, instead of the ratio, there are also extreme readings. The recent spread, as shown on the right side of this chart, is almost three standard deviations above the five-year mean. While the spread has been trending in this direction for over a year, recent moves, particularly this year, have the level at potentially unsustainable levels. There is nothing saying that the spread cannot widen. There is nothing that forces mean reversion. However, when I see this, it suggests to me that there is potentially a better margin of safety for contrarian trades, because I am entering at levels rarely seen in the last several years.

Turning to the CVOL Index to get a gauge of what the options market is pricing in for future moves, I can see that volatility levels have come down considerably from previously elevated levels. At the current level of CVOL just below 24, it is closer to the mean, if not lower, over the last five years. This suggests that longer volatility ideas may have some merit particularly if the trader believes uncertainty and volatility could continue. The bottom chart looks at the ratio of upside variance to downside variance to determine the skew ratio. It shows where there is relative demand for options. While it is off the highest levels seen in Q1 of this year, the skew ratio is about 1.2, which suggests there is more demand for upside options than downside options. This tells me that if I want to look to get long upside, positioning for a contrarian trade, I may need to consider spreads because the relative cost of upside calls is higher than downside puts. In addition, I see that the skew ratio is sensitive to futures prices. As futures move higher, it moves higher and vice versa. This is good information to know if I want to trade out of the spread at some point.

I look at the term structure of implied volatility to see if there is a particular expiration that is more appealing. My eyes are drawn to the H4WQ5 and H4RQ5 area as these have lower implied volatility than the dates around them. Comparing these expirations to the economic data, I see that the H4RQ5 expiration would capture the next round of GDP data that will come out in August, after which traders will firm up their view of the future economic direction. Could this be the catalyst I need for a contrarian bet going long copper?

Putting all of this together, I decided to do a call butterfly for the H4RQ5 expiration. However, I want to use asymmetric strikes because we have had large moves in the futures so if there is a large move higher, I don’t want to assume it will stop. It could continue on and I don’t want to lose money by being “too right (i.e., calling for a rally and getting too big of a rally). I do this by structuring the trade long 4.60 calls, short two of the 4.80 calls and then long one of the 4.90 calls. The symmetric fly would have covered the last wing with 5.0 calls, but by choosing the 4.90 calls, I can ensure that on a large move higher, I could still have the potential to make money as shown in the expected return chart. The trade-off is that by choosing asymmetric strikes I am paying more premium: 0.0266 ticks or $665 per spread traded. If futures do end at the midpoint of 4.80, my return would be 6.5x the premium risked (0.175/0.0266). If futures trade above the 4.90 strike, my return would still be about 3x (0.075/0.0266). Any continuation of futures prices lower and I would lose all premium invested.

The bottom chart shows the daily technical chart for the Copper futures that these options settle into. I have drawn the Fibonacci retracement levels on here as well as a shaded area that identifies the profitability zone from 4.60 to 4.90. Of course, above 4.90 the trader makes money, but this zone highlighted is the one traders will most care about. It only requires a move back to the mean seen this year for this trade to be profitable.

I also consider the possibility that traders do not want to be spending a premium, particularly after they have already seen big moves and considering August is a big vacation month. Maybe this idea sounds interesting, but you don’t want to risk $665 per spread. Is there any way to defray this cost?

Instead of looking at other Copper options to sell to defray the cost of the spread, I decided to think outside the box and look to the Gold options market for places to collect premium. After all, the spread between Copper and Gold futures is near three standard deviations above the mean and the ratio between the two is at all-time lows. That said, selling gold calls outright does not feel like the right trade given the macro news and the risk of tariff headlines.

The CVOL chart on the top above shows that gold volatility is really near the mean of the last 10 years in spite of Gold futures being at all-time highs. Thus, Gold options are not necessarily too expensive. I dig in and look at the term structure of implied volatility. I look at the area of the curve where I have chosen Copper options and see these dates are a bit of an outlier. However, I want to consider this as a package even though trading precious metals versus base metals may not be a regular spread for many people. I decide to stick with the same expiration. Drilling into the OG5Q5 expiration, I see that upside gold calls trade at a premium to the at-the-money options, which should not be surprising. On the downside, though, the puts trade at a discount. Thus, doing a spread where I buy a strangle versus selling a straddle, I will be roughly selling the same volatility as I am buying, which gives me some comfort since I know that Gold options on their own are not too expensive.

Putting this together, I decide on an OG5Q5 iron butterfly, selling a 3380 straddle and buying the 3280-3480 strangle. By doing this, I take in 66.5 ticks and my maximum risk is that the spread is worth 100 ticks. Thus, my reward to risk is 66.5/33.5 or about two to one. In addition, the 66.5 ticks I take in is $665 dollars, which coincidentally is exactly what I am spending per spread in copper. Thus, I can use this gold iron butterfly to neutralize the premium from the copper asymmetric call butterfly. In addition, a two to one reward to risk is not bad for an iron butterfly. The bottom chart shows the generic second month Gold futures price, which this spread would settle into. I have drawn green lines that highlight the area that futures need to stay in order for me to make money. That range encompasses almost the entirety of the move in the futures since Liberation Day, which gives me a bit more comfort that this trade on its own could be profitable.

Sure, I prefer to look for three to one or better when entering trades, but I am getting three to one or better on the copper side of the trade. Since I have positive reward-to-risk in this trade too, I have the possibility of attractive gains if Gold futures sit and do nothing for the next two weeks while copper reverts to the year-to-date mean.  Of course, I can also lose on both sides of the trade if copper trades lower and gold has a large move (over 100 ticks) in either direction. As I said before, with the ratio and spread of copper to gold at all-time widest, I have some comfort that a big move in gold, particularly to the upside, may be matched by an even bigger move in copper. News that would cause both prices to collapse is my largest risk and one I would need to be attuned to in order to risk manage this position.

It has been a wild ride in the metals markets the last few weeks. This can create opportunity as well as risk. With the right tools that CME Group provides, traders can analyze and enter into trades that allow them to take advantage of the moves in futures. It even gives them the opportunity to consider trades like copper versus gold that they otherwise would not have considered.

Good luck trading!

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