Realizing the option
Traders should keep in mind W.C. Fields’ response to a sucker card-player’s inquiry in My Little Chickadee: “Is this a game of chance?” To which Fields responded, “No, not the way I play it.”
Let’s illustrate using data from Nov. 15, 2013 and March 24, 2014. The Metals Bulletin Midwest spot and premium prices are converted from dollars per pound to dollars per metric ton. A long position in the Midwest spot can be matched against a short April futures contract.
Four months later, after paying the LME warehouse and capital charges, the trade would be approximately $109 per metric ton underwater ($117.25-64.15-162.10). The call could be realized by first repurchasing the futures contract and then selling the spot aluminum at a Midwest premium $190 greater than it was in November. Now the gross and indicative gain would be $81 per metric ton (see “Embedded option,” below).
The trick to realizing this call is not delivering the aluminum in a timely fashion. Otherwise, the premium could not materialize. Moreover, just as the mid-continent discount in crude oil led to expansion of inventories held at Cushing, Okla., a form of insurance against supply disruption, the Midwest premium led to the growth in aluminum inventories seen here. The U.S. automobile manufacturing industry can rest easy at night knowing this, and aluminum smelters did not have to cut production runs in the face of growing supply overhangs; instead of selling to fabricators, they could sell to warehouses. Social utility is such an abstract concept, is it not?
The introduction of a new aluminum futures contract by the CME Group based on the all-in delivered price of aluminum should end the odd cycle of rising spot market premiums in a market with excess supplies. The repurchase price of the short futures contract in the illustration above will incorporate the increase in the Midwest premium and thus will negate the gains on the spot market side of the trade.
Howard Simons is president of Rosewood Trading Inc. Reach him at email@example.com.