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14. August 2007

Aluminium a market sleeper

THE London Metal Exchange is a heady place for speculators. Nickel, tin and lead have all touched all-time highs, copper was recently at its highest level for 11 months, and zinc saw prices rise by 11 per cent in the first week of May.

Only aluminium -- the "pariah" of the LME according to the analysts at Goldman Sachs JBWere -- is languishing, 40 per cent below its 1988 high.

This is easily explained by the fact that stocks of aluminium have risen by 136,300 tonnes -- almost 20 per cent -- since the start of the year, to reach 835,600 tonnes.

Not surprisingly, aluminium is one of the most common of the base metals to trade, with its production and consumption dwarfing that of the others.

"Investors are hooking on to the copper and nickel story at the moment, but they're ignoring aluminium because there's so much of it," says Jonathan Barratt, managing director of Sydney-based Commodity Broking Services. "Aluminium is in such a large surplus, it simply doesn't have the volatility that some speculators want to see. However, the flip side to this is that your positions are controllable. The attraction to trade aluminium is that it's a very liquid market, and if you're looking for a rise, it's more of a gradual process compared to other metals. On this current market, if you're looking for it to trade to $US2900 a tonne -- maybe even $3000 -- you may be waiting a while, because the demand/supply situation is not going to turn in your favour soon."

Investors can trade aluminium futures on the LME itself: the normal contract size is 25 tonnes, with a minimum tick (price move) of 50 cents a tonne. But recently the LME introduced an LMEmini contract, a cash-settled, electronically traded contract of five tones and a minimum tick of $1 a tonne.

Barratt says LMEminis are designed to appeal to market participants who like to trade on the LME with smaller, non-physically deliverable contracts, which are settled in a similar fashion to non-deliverable futures contracts. "The minis are cash-settled contracts, so you're not going to end up having to deliver or take delivery of aluminium. It's a good way to participate in the market and not wind up with aluminium ingots being dropped off in your driveway."

With the three-month aluminium price at $US2828 a tonne, a mini-contract over aluminium represents a position worth $14,140. The deposit requirement is approximately 10 per cent of that, or $1414: this margin must be maintained at all times. For every $1 that the aluminium price rises, the investor makes $5.

"It's an innovative approach by the LME, as trading in the traditional contract can become cumbersome if it is not fully understood. The traditional LME three-month contracts trade each day out until the delivery date: you buy the LMEmini for expiry in three months, a date that becomes your 'prompt' date for delivery. The next day has a new prompt date. It's not a traditional futures contract as such, although it has a futures scenario in terms of the leverage," says Barratt.

Where a traditional futures contract is settled on a known date and everyone trades to that date, each LMEmini contract has its own prompt date. Barratt says the mini is a far simpler approach to trading and gaining exposure to the base metals markets.

"In a traditional LME contract, if the market is in contango (where the price for future delivery is higher than the spot price) the investor receives some of that contango back, on a per-day basis for as long as you held the contract, plus your profit on the contract. But if the market is in backwardation (where the price for future delivery is lower than the spot price) the backwardation per day will come out of the profit on the investor's contract. In an LMEmini the contango/backwardation is implicit in the contract price, making it easier to understand for the trader."

"It's very liquid, because you have market-makers who specialise in buying and selling the prompt dates, and it's a good, steady hedge market that's used by a lot of aluminium producers to hedge," says Barratt.

For speculative-minded investors who want a simple leveraged investment in aluminium, contracts for difference (CFDs) and spread betting are easily accessible. An aluminium contract for difference (CFD) is a financial derivative that represents a theoretical order to buy or sell the equivalent of 25 tonnes of primary aluminium on the LME. The tick is US25 cents, while a "point' move is $1.

With three-month aluminium quoted at US$2828-$2838 a tonne, a trader bullish on aluminium "buys' a CFD for 25 tonnes at the offer price of $2838, for a total position of $70,950. (If you think aluminium will fall in price, you would sell at $2828.) The margin for aluminium CFDs is 200 points -- you're covering a 200-point move in the market -- which means $25 times 200, or $5000, that you need to cover when you establish your position, and maintain.

For every $1 that aluminium rises, the trader makes $25: but for every $1 that aluminium falls, the loss is $25. To take a profit in the future, the trader closes the trade by "selling' the CFD at the new bid price.

Say it is a month on, and IG now quotes three-month aluminium at $2860-$2870. To close the trade, you "sell' your lot of 25 tonnes at $2860.

For the interesting profit calculation please the "Australian Business"

A bearish investor would "sell' aluminium at $2828, and close the trade by "buying' at the upper end of the new quote, which would have to be lower than $2828 for the trade to be profitable.

"It's effectively a futures contract, all the financing is taken into account and you're only charged the spread (the difference between the buy and sell price)," says Martin Batur, senior dealer at IG Markets. "There is a spot price, but all LME quotes are a three-month quote. Even though you've bought a three-month contract, you can always get out at any time. We'll work out whether it's trading contango or backwardation, which is given by the market, and then we'll make our quote.

"So the price for your expiry date might be our three-month quote minus 20 points, if the market is in contango, but if there was a short-term supply shock and the market moved into backwardation briefly, your price can actually become 30-40 points above the three-month quote." Batur says the move from contango to backwardation -- from a discount to the three-month price to a premium -- can cut into your profit if you're not careful.

"But on the flip side, you can take advantage of it, too. If you want to speculate in LME metals, which trade on a three-month basis, this variable is something you've got to be aware of. Say the underlying spot price has risen by 10 per cent: if you're long, a move from contango to backwardation can reduce your profit on this move. If you're short, it can reduce your loss from this rise in the underlying."

An even simpler mode of speculation is simply spread betting on aluminium, offered by IG Index. Here, the investor can deal in as little as $5 a point. Again, an investor bullish on aluminium would "buy' at the sell quote: if the three-month aluminium price rises by $10, the investor makes $50. If it drops 10 cents, he loses $50.

"CFDs and spread betting are the cheapest leverage available in metals," says Batur.

The attraction of spread betting is that profits are free of capital gains and income tax, unless you are deemed by the Australian Taxation Office to be a professional gambler. But the corollary of no tax on the profits is that any losses are not tax-deductible. The Australian Taxation Office says that the issue of the tax status of spread betting is "still being looked at", and IG Index recommends that investors seek their own tax advice.

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