Sep 29, 2014

    Trading strategies for base-metal futures

    ESSENTIAL for many industrial applications, copper, nickel, aluminium, lead and zinc are some of the base metals traded in the global futures and options market.

    The London Metal Exchange (LME) is the focal point for global trading, with provision for up to 11 types of base metals, some of which are not as active as the five highlighted.

    The list of base metals includes tin, aluminium alloy and Nasaac, steel billet, cobalt and molybdenum. Copper is also traded in Comex, which is the United States exchange for metal futures and options trading.

    As it attracts many different users, from base-metal industry players to banks, investment funds and speculators, the LME has a system of regulation and settlement in place, with compliance measures to ensure observance of its trading rules.

    A feature of futures trading is that the capital required is a fraction of the total contract value of the base metal.

    Known as margin trading, the practice requires traders to place a minimum sum with their brokers, a typical contract value being 12.8 times higher.

    The highly leveraged trades may be attractive but price fluctuations, hence profits and losses, are similarly magnified by that number of times. This means traders have to adopt a stop-loss strategy in their overall trading plan.

    Contracts are mainly on a three-month window based on standard lot sizes and metal grades. A contract must be settled or delivered when its prompt date falls due.

    Most LME transactions involve cash settlement, with the remainder being physical delivery.

    Taking copper as an example, when its market price is US$7,000 (S$8,880) a ton, the total value involved for such a contract will amount to US$175,000, as each transaction done is in a standard lot size of 25 tons. A trader will need to put up a margin of US$13,650.

    The wisdom of "not putting all your eggs in one basket" applies with base-metals trading, as does the need to have a risk appetite and being comfortable with trading in a market with higher risks.

    Apart from knowing the workings of the futures market and appreciation of the risks of highly leveraged transactions, one needs to have a system to trade.

    Trading decisions are generally grounded in two schools of thought: one stresses an understanding of market fundamentals, while technical trading based on charts is favoured by the other.

    After analysing price charts, a technical trader may discern a trend in market fluctuations to formulate a trading plan for exit or to take a position when prices are at the right levels, based on an acceptable risk-reward ratio.

    Meanwhile, market fundamentals can also form a basis for trading decisions. Keeping up to date on supply and demand is important, as is having a macro view of the various economic indicators and measures which have an impact on base metals.

    For example, the base metal market reacted favourably to a decision by China on Sept 17 to pump 500 billion yuan (S$103 billion) into five state-owned banks to boost a sluggish economy.

    Another example is the move this year by Indonesia to stop the export of intermediary products, such as nickel pig iron.

    It is regarded as a resource nationalism initiative by the country's leaders, who want local mining companies to step up value-added processing of raw materials.

    It will take time for such an initiative to bear fruit as legislation has to be complemented by investments by industry players to process higher-end finished products in the value chain.

    Following Indonesia's lead, the Philippines just set 2021 as a target to ban the export of ores and gave notice to the relevant authorities to improve the infrastructure, including power, required as base metal companies upgrade production resources.

    Both industry fundamentals and charts are open to savvy traders who can derive benefits from analysing data from different perspectives to help with decision-making in their transactions.

    Traders take positions, buying long or selling short, to capitalise on market fluctuations. Since reaching a peak around 2010-2011, price charts covering a six-year cycle show that base metals have declined and are trading sideways.

    The soft market is attributable to oversupply, but two of the base metals, namely nickel and zinc, are already showing strong signs of recovery as seen in the two price charts.

    Zinc has since edged up this year to US$2,416 per ton (intraday price) against the previous high of US$2,539, while nickel has climbed to US$21,625 per ton against the previous high of US$29,425.

    Both base metals are transiting from a surplus in the past to deficit next year, while resource nationalism is another reason for the increase in prices.