These option settlements are cash-settled and differ from many of the CME commodity options on futures that provide the right but not the obligation to purchase a futures contract.

Several strategies can be employed by producers and end-users who engage in commodity hedging, which take advantage of the flexibility offered by option contracts. Before we dive into some of the hedging strategies that can be used, we will touch on some option contract basics.

What is an option on futures contract?

There are a few different types of options offered by the CME. An option on a futures contract is a financial derivative that combines options and futures trading. It allows traders to have the right, but not the obligation, to buy or sell a futures contract at a specific price (known as the strike price) on or before a predetermined date (known as the expiration or exercise date). To purchase an option, the buyer pays the seller a premium.

Unlike futures contracts, options on futures provide flexibility and can have limited risk for traders and procurement managers. A call option gives the holder the right, but not the obligation, to buy the underlying futures contract at a specific price. In contrast, a put option gives the holder the right to sell the underlying futures contract at a predefined price.

Traders and procurement managers can use these options to hedge against potential losses, limit their exposure to market volatility, or speculate on lithium price movements. The most money the option buyer can lose is the premium that is paid to purchase the call or put option. Unlike the buyer, the seller can have unlimited risk.

What is an average-priced option contract on lithium hydroxide and cobalt metal?

The new lithium and cobalt option contracts that are listed are average-priced. An averaged-priced option is a type of financial security that derives its value based on the average price of an underlying asset over a specific period. The CME contracts use the average price calculated by Fastmarkets for a calendar month. These lithium and cobalt option contracts are cash-settled.

Instead of the option buyer having the right to buy or sell lithium futures or cobalt futures contracts, the buyer receives a cash payment for the difference between the strike and settlement price. An option strike price refers to the predetermined price at which an option can be exercised. No cash payment is made if the option settles out-of-the-money.

“Out of the money” for a call option means the option’s strike price is higher than the current market price of the underlying asset. Similarly, for a put option, it means the strike price is lower than the current market price. When an average-priced option settles out-of-the-money, the option seller keeps the premium, and the buyer does not receive a payout.

With an averaged-priced option, the payoff is determined by the average price of the underlying asset over the specified period. This averaging mechanism helps reduce the impact of short-term price fluctuations and can be helpful in situations where the underlying asset’s price is volatile.

The averaging can be suitable for hedging regular cash flows. The average-priced lithium options contracts settle like the lithium futures contracts. The difference is the option contract buyer’s loss is limited to the premium paid for the option.

Since the payoff of the options equals the under-average price, the effective historical volatility is lower. Daily spikes or drops in a commodity price generally occur more often than spikes or drops in a monthly calendar average. Therefore, average-priced options usually cost less than European or American-style options that expire simultaneously and have similar lengths of time remaining before a financial contract expires.

What option strategies can be used to hedge lithium or cobalt?

Asian option contracts on lithium hydroxide and cobalt offer traders and corporate hedgers several ways to mitigate their exposure to changing lithium prices and cobalt prices.

For example, a producer might consider purchasing a put option. The producer attains the right to sell lithium hydroxide at a specific strike price. The most the producer can lose on the hedge is the premium of the options.

The payout profile of a $20 strike put option shows that the producer will receive a payout for any price below $20 minus the premium paid for the put option. The producer will lose the premium paid for the options at expiration if the price of lithium hydroxide remains above $20.

Another example could be that an electric vehicle OEM exposed to lithium hydroxide might consider buying a call option. In this scenario, the OEM will pay an option’s premium, and the most they could lose is the premium paid for the option. The payout profile of a $30 strike call option shows that the OEM will receive a payout for any price above $30 plus the premium paid for the call option. A loss will occur at expiration, which is limited to the premium, if the price of LIOH remains below $30.

What if you don’t want to pay a premium?

If volatility rises, the premiums on lithium options could also increase, making call options and put option contracts more expensive. An alternative to purchasing a call or put option might be to combine one with another, where the producer or consumer sells one type of option and simultaneously buys another.

A costless collar is a hedging strategy that can be used to hedge lithium exposure where the producer or consumer does not have to pay a premium. For example, an OEM might purchase a $28 call option and sell a $20 put option where the premium from the sold put option offsets the premium from the call option purchase.

The payout profile of a purchase of a $28 strike call option combined with the sale of a $20 put option shows that a loss will occur at expiration if the price of LIOH remains below $30. The OEM will receive a payout for any price above $30. If the average price of lithium hydroxide is below $28 and above $20, there will be no exchange of cash. If the average price is below $20, the OEM will pay the difference between the average settlement price and $20. 

For example, if the average price of lithium for a calendar month settles at $30, the OEM will receive $2 = $30 – $28. No cash will be exchanged if the average price settles at $25. If the average price settles at $18, the OEM must pay $2 = $20 – $18.

The bottom line

The upshot is that there are several different option strategy combinations that a producer or consumer can use to hedge their lithium hydroxide or cobalt metal exposure. The benefit of using options is that they provide more flexibility than a futures contract. What is essential to understand is several components are used to generate the premium of an averaged-price option.

In addition to the price of lithium hydroxide and cobalt metal, the implied volatility, the strike price, current interest rates, and the time to maturity play a critical role in determining the premium of an option contract.

Additionally, when financial option contracts initially launch, success can sometimes be attributed to finding options sellers. 

For example, a producer might want to sell a call option since they already own the physical underlying commodity. An OEM might want to sell embedded options, which are listed in their physical offtake contracts. These are sometimes called ceilings or caps, look-back pricing, or escalators. These types of options can be monetized by potentially selling them to a financial institution.

Don’t hesitate to contact our risk solutions team if you would like some insight into how to hedge your lithium hydroxide/carbonate or cobalt metal risk using option contracts.

The post How lithium and cobalt option contracts can help producers and consumers with hedging strategies appeared first on Fastmarkets.

Broader use of futures contracts drives liquidity

As more traders accept a futures contract as a benchmark for the industry, open interest begins to grow. Open interest is the number of outstanding futures and options on futures transactions that have not been settled or closed.

For example, if you open a new position by purchasing a cobalt futures contract and do not sell it, your futures contract is counted as part of open interest. When there are more than 25 sizeable open interest holders, the Commodity Futures Trading Commission begins to report volume and open interest information.

The Commodities Futures Trading Commission (CFTC), a US government independent agency, reports the Commitment of Traders (COT) report weekly.

Why would you want to know who is trading what?

The COT report allows you to derive some sentiment information and evaluate whether producers are hedging or managed funds are active. The report can also tell you whether swap dealers or financial institutions are involved in providing liquidity.

What information is in the Commitment of Traders report?

The report is usually released by the CFTC every Friday and generally reports information as of the prior Tuesday. The data from the CFTC comes in a report format with few bells and whistles.

Before we dig into the report, let’s review a few basics.

The COT sorts the transaction that occurred during the week and adds or subtracts weekly volume from open interest by trader category.

When a trader opens a position by purchasing a futures contract, their position is “long.” When a trader opens a position by selling a cobalt futures contract, their position is “short.” If a trader opens a position with a futures contract purchase and simultaneously opens a position by selling another futures contract with a different maturity date, their position is referred to as “spreading.”

What can the COT report tell you?

There are several pieces of information that you can derive from the COT report.

For example, the COT report released for the reportable position date November 29, 2022, shows that producers/merchants are short. That likely means that producers are hedging their inventory.

The report also shows that swap dealers, generally financial institutions, are long cobalt futures contracts trading on the CME. Banks typically do not take an outright directional risk, which likely means they are short over-the-counter swaps and have used the futures market to hedge their short swap position exposure.

Another piece of valuable information is that managed money, generally viewed as hedge funds or commodity trading advisors, are long cobalt futures. Hedge funds typically take directional views, meaning they might speculate that cobalt futures will rise.

One last piece of open-interest information is positions held by “other reportables.” This category is left ambiguous, as it does not fall into commercials, managed money, or swaps dealers.

For example, a parent organization might not set up separately reportable trading entities to handle their different businesses or locations. In such cases, there will not be a separate Form 40 to allow the CFTC to determine that entity’s proper disaggregated commitment of traders classification.

What do changes in volume mean?

The COT report focuses on open interest, but futures contract volume information is also available. For example, on the November 29, 2022 report, you can see that nearly all of the long “swaps dealers” purchases of cobalt futures were offset by sales of cobalt futures contracts by “other reportables.”

Significant changes in volume, especially by swap dealers, indicate that liquidity is likely rising or falling.

How can open interest help you hedge?

While the information that is provided is objective, the analysis of what the data means is subjective.

Here are some tips.

The COT report can be used as a contrarian sentiment indicator.

The positions initiated by “managed money” are generally speculative. They will eventually exit their futures positions if the change in the futures contract prices generates a significant unrealized loss.

If the open interest is skewed (meaning the long position held by “managed money” is much greater than the short position), there is a chance of a rush to the door to exit quickly. The market might be poised for a short squeeze if the “managed money” short position is much larger than the long position.

Producers/merchant processors are more likely to hold on to their positions as they are usually a hedge to their underlying production.

Swap dealers are usually liquidity providers and generally exit futures contract positions when Over Counter (OTC) swaps roll off their books.

The bottom line

It’s not easy to find valuable commodity risk management information. Taking the market’s pulse is an essential piece of the puzzle in attempting to gauge future price movements. Certain information from the Commitment of Traders report (COT) can help you gauge sentiment.

The Commitment of Traders report is released weekly. The information categorizes volume and open interest on futures contracts by trader type. While the information is objective, the analysis can be used as a sentiment index to help traders make commodity hedging and trading decisions. If you want more information about cobalt futures contracts or hedging your battery raw material risk, contact our risk solutions team.

The post Cobalt futures hedging: Deriving sentiment from the Commitment of Traders report appeared first on Fastmarkets.

Short squeezes do not discriminate and can happen in many commodity markets.

The pulp short squeeze

A short squeeze episode occurred in the Chinese pulp market in 2022. It started as China’s imported pulp market experienced supply restraints, with prices hitting a record high at $1010 per tonne for Northern Bleached Softwood Kraft in July.

The lack of pulp supplies had buoyed futures prices and escalated trading volumes beginning in August on The Shanghai Futures Exchange. The pulp futures contract offered by the SHFE is a physically delivered contract with specifications that allow twelve softwood pulp brands from Canada, Finland, Russia, Chile, and Sweden. The cheapest-to-deliver brands from Chile and Russia likely constitute most of the physical delivery.

According to statistics from China Customs, the country imported 4,796,017 tonnes of softwood pulp during the first eight months of 2022, down 17.08% year on year. The decline in softwood imports, which constitutes the physical delivery brands, started the ball rolling, leading to a short squeeze!

In hindsight, the short squeeze was not a surprise. Pulp market participants started to raise the issue with physical delivery, especially after the SHFE futures contract closed at 8174 yuan per tonne on September 9, 2022.

What is a short squeeze?

The term Short-Squeeze reflects rapidly rising prices in a tradeable asset. The short squeeze happens to the short sellers. A short seller is a person or company that places trades that increase in value if the price of the underlying assets declines. To short-sell an investment, you need to borrow the asset from another party and then sell the asset.

If you short-sell an asset and do not own the assets to deliver it back to the lender, you need to go into the open market and cover.

Physically delivered products such as pulp face the same issue. If a company or individual sells-short pulp futures, they will eventually have to either repurchase the futures contract or purchase physical pulp and comply with the sale that the futures contract requires.

What creates a short squeeze?

A confluence of events usually generates a short squeeze. The pulp short-squeeze was likely painful to those who did not have physical products to deliver and potentially caused realized losses.

The lack of delivery brands of softwood on the spot market exacerbated the upward pressure on total pulp prices.

How can you mitigate the impact of a short-squeeze in physically delivered contracts?

If a trader is contractually obligated to deliver an unavailable pulp brand, their concern can elevate quickly. The impact of fear can create a snowball effect, boosting prices and generating an unlimited theoretical cost to finding the appropriate delivery brands.

Why you might use financial settled futures contracts

One solution to avoiding a physical short-squeeze is to trade a financially settled futures contract. There are several benefits to financially settled futures contracts for your commodity risk management.

One advantage is that the settlement is against a financial benchmark. While the underlying asset price might surge more than you expected, you will only be responsible for the realized loss you experience by selling and covering (purchasing) the financial futures contract. You will never be put in a position where you have to deliver a physical product that might not be available.

Another advantage is that many financial futures contracts settle against the average price through a specific period.

For example, the NBSK Pulp Futures Contract (Fastmarkets) settles against the monthly average trading price of the Fastmarkets RISI NBSK CIF China price.

An average settlement price can significantly reduce the volatility of any individual price point. For example, during a month with 20 trading days, if the price of XYZ is $800 for 18 days of a month and then shoots to $1,000 for two days of the month, the average settlement price will be $820.

Instead of stopping out of the trade when the price jumped from $800 to $1,000, you might instead take the contract to the settlement, where the average caps your loss for the month.

Commercial pulp participants have additional risks if they hold physically delivered contracts beyond the 13^th calendar month. There is an obligation that you will provide or receive the underlying asset.

The bottom line

One way to avoid the short squeeze created by a physically delivered futures contract is to hedge using financially delivered futures contracts. Contracts settle against several periods, including days, weeks, and months. More extended settlement periods, such as monthly settlements, tend to reduce the volatility of the returns of a futures contract.

If you what to learn more about hedging using financially settled futures contract or how hedging impacts your bottom line? Contact our Risk Solutions team.

The post Avoiding the short squeeze: Hedge using financially settled futures contracts appeared first on Fastmarkets.

The decision is an investor preference

Whether or not to hedge your risk is an investment question. Do you want 100% exposure to commodity volatility or the most efficient exposure with maximum risk reward?

If you choose the latter, some hedging techniques can maximize your risk-adjusted reward and simultaneously reduce the volatility of your returns.

On the other hand, if you desire 100% lithium price volatility reflected in your company’s value, hedging can be less impactful.

If you want to hedge some of your exposure to lithium prices, you might consider looking at some history of forward annual swap prices relative to the past 12 months’ swap price settlements. The forward curve will provide an estimate of where your 1-year future sales could be if you sold lithium futures contracts today. Instead of trying to forecast the price, you can gauge your forecast relative to the forward curve.

The Lithium futures price curve provides market participants with a tradeable market. The CME futures contract that tracks Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price cif China, Japan & Korea, $/kg, shows that prices are backward (another way of saying spot prices are higher than deferred prices).

The settlement of the annual lithium swap surged for the first ten months of 2022, but future prices show that lithium prices are likely to moderate.

Despite a backward futures curve, the average for the next 12 months, including November, reflects the 12-month average that is higher than the average in the prior twelve months by more than 13%.

How is the swap calculated?

The swap prices from each futures contract month equal the arithmetic average of all available price assessments published lithium hydroxide monohydrate LiOH.H2O 56.5% LiOH min, battery grade, spot price cif China, Japan & Korea, $/kg by Fastmarkets during the contract month.

A graph of historical 1-year swaps, beginning in November, shows that the futures curve is pricing in a one-year forward swap price about 13% higher than the prior year’s 1-year swap price ending in October 2022.

The upshot is that the market believes prices will decline slowly, but the average price for the coming year will be higher than last year, based on where lithium futures prices are trading now.

If you wanted to mitigate some of your lithium price volatility, the forward prices would allow you to tell your investors or banking partners that you will experience a 13% year-over-year gain in price value if you hedge now.

Your focus would then change to executing your production levels. Your hedging would create price-collateralized cash flows that can be discounted back using current interest rates to give investors a present value of your business.

The market is pricing elevated volatility

The current lithium futures swap price, at nearly $84 per pound, is well above October 2023, with futures settlements near $68 per pound. The difference between spot and one-year deferred prices is significant. The decline reflects implied volatility in the market at 84%, using a Black-Scholes model.

A historical chart of the spot swap minus the 12-month deferred swap shows that the current backwardation (deferred prices lower than spot prices) is the largest during the last five years.

The graph of the prices represents historical Fastmarkets lithium hydroxide monohydrate 56.5%.

While there is no extended record of a forward curve before the CME Fastmarkets Lithium hydroxide monohydrate 56.5%, the historical settlements show the change in the swap price settlements.

The bottom line

Whether you hedge your exposure to lithium, given investor preference, or ride the wave of lithium volatility, you should have an idea of what you could experience. Fastmarkets NewGen Long-Term and Short-Term Forecasts can provide you with a gauge of where prices might be headed.

The shape of the lithium futures curve reflects a price likely to be volatile. If you are considering hedging your lithium exposure and would like some insight on how to approach this endeavor, reach out to our risk solutions team. You can read more insights on our dedicated page for lithium analysis.

The post Should lithium producers consider hedging? appeared first on Fastmarkets.

While forecasting price movements can be challenging, some tools can make it easier. Evaluating the seasonality of historical volatility, current volatility and liquidity is less arduous.

These tools can help you determine when it’s practical to deploy your risk management plan.

What is the definition of historical volatility?

The term historical or actual volatility describes the variance (how different) of a price change from the average price changes. The term standard deviation equals the variance of price changes from the average price change squared, eliminating all negative variances from the mean.

The standard deviation is then multiplied by the square root of time to create a number in percent terms called historical volatility.

Why should you look at the seasonality of historical volatility?

To evaluate the seasonality of historical volatility, you can average the 30-day rolling volatility numbers and create an average for each month. The chart estimates seasonal volatility of cobalt standard grade, in-whs Rotterdam, $/lb.

You can see from the seasonal chart that November is the least volatile month of the year. Q4 is generally the least volatile quarter of the year during the past decade, leading into the most volatile period of the year, usually Q1.

November is a crucial month for the cobalt market, as annual supply contracts are usually agreed upon between traders, producers, and consumers within this timeframe.

The chart might help you answer the question of when you should commodity hedge using cobalt futures. One such answer might be before a period when cobalt prices are most volatile.

Using Bollinger Band Width to analyze current volatility

Another tool that can be used to evaluate historical volatility and periods when volatility is high and low is a technical indicator called the Bollinger Band Width. The Bollinger Band Width indicator uses the high and the low Bollinger Bands created by John Bollinger.

Bollinger Bands are a technical analysis indicator used to determine how far the proverbial rubberband can stretch. It measures as the default, a two-standard deviation range above and below the 20-period moving average.

The Bollinger Band Width subtracts the Bollinger Band High from the Bollinger Band Low, providing a measure of historical volatility.

You can see from the chart of Cobalt Metal (Fastmarkets) Futures on the CME the Bollinger Bands on the continuous contract are equal to the lowest levels since the inception of the CME futures contract. This information highlights historical volatility is near the lowest levels since inception.

In early August of 2022, the Bollinger Bands were near the year’s highest levels, meaning the recent 20-day historical volatility was also near its most elevated.

During this period, rumors circulated that China’s State Reserve Bureau was planning to add to its cobalt metal stockpile. China’s cobalt metal nearby dated futures contract increased by 12-percentage-points in intra-day trading on August 8.

Look for times when volume and open interest are rising

Another important time to begin to evaluate hedging your exposure is when volume and open interest are rising. If you plan to hedge your cobalt futures risk, you want increasing liquidity, as it’ll help keep trade costs low and shorten trade execution timings. Volume and open interest help provide insight into liquidity.

The volume describes how many contracts trade each day. The open interest notifies how many open futures contracts have yet to be closed out.

A recent chart of Cobalt Metals (Fastmarkets) Futures contracts on the CME have rising open interest and steady and rising volume.

During this period, market participants have utilized the CME to combat ongoing volatility in the cobalt metal market amidst a tumultuous macroeconomic environment.

“Increased volume and open interest is a direct result of increased adoption of hedging strategies from those across the cobalt space. The ability to efficiently hedge long-term contracts all the way through to December 2025 has brought new volume to the market,” said Jack Nathan, Head of Battery Metals at Freight Investor Services.

Hedging can be an effective tool during periods of uncertainty because it can ‘protect’ its user by enabling money to be made if the market moves in an opposite direction to their personal view of market sentiment.

“We want to use the CME to complement our business activities. We use the CME will help to reduce that risk,” commented one consumer.

Cobalt metal can be categorized into two categories; trading physical tonnage and trading futures contracts. The latter is known as ‘paper trading’ because the CME contracts are financially settled rather than with physical volume.

“Cobalt is a difficult commodity to short unless you go on the CME.” You can hedge on the CME if cobalt prices are decreasing. As a trader, you can use the CME to get out of a long position,” said one trader.

Longer-dated futures contracts have recently been added to the CME catalog for cobalt metal, with settlement dates reaching December 2025. Since their addition, the contracts have been subject to heightened liquidity, with electric vehicle manufacturers, cobalt producers, and traders reportedly hedging their exposure further out.

“The liquidity seen on the deferred contracts makes it an attractive option for any business wanting exposure to the cobalt market; this liquidity defines the success of the contract offered, and that is crucial for cobalt,” commented one producer.

The bottom line

The upshot is that there are tools that can be used to help you determine some of the best times to hedge your cobalt exposure. You might consider hedging when volatility is seasonally low or when a technical analysis tool shows that volatility is muted.

Additionally, it’s helpful to hedge using cobalt futures during a period when volume and open interest is rising. Increasing volume and open interest on a futures contract reflect growing liquidity and point to periods that are helpful to hedging your cobalt risk. Contact our risk solutions group to learn more about hedging your cobalt risk.

The post New generation energy hedging: When should you mitigate your cobalt exposure? appeared first on Fastmarkets.

An effective hedging tool you should have at your disposal is a graph showing the probability that a price will hit a target based on implied volatility from option prices.

That’s right; options traders price the likelihood that an asset will be in the money by a specific time, allowing you to gauge the probability that a commodity price will reach a target.

Probability graphs based on commodity option implied volatility are a sentiment gauge of market participants based on actual trades that have taken place.

What is a Call and a Put Option?

Recall that a financial option is a right but not the obligation to purchase or sell a commodity at a specific price on or before a certain date. A call option gives the buyer the right to buy a commodity, while the right to sell is called a put option.

If you buy an option, you pay a premium to the seller, who is compensated to provide you with the right to buy or sell a commodity. The premium is determined by market participants who decide how volatile a commodity will be in the future.

Based on market-derived implied volatility, you can determine whether the option will likely settle in the money on or before the expiration date. Implied volatility is the critical variable that drives option pricing.

Determining a distribution

A statistical way you can evaluate where the price might be in the next few days is to look at the history of the returns of a commodity price. This information will provide you with a mean return and the standard deviations of the returns, which you can use to generate a historical return distribution.

But what about the future?

Looking at enough stock and ETF pitch books, we all know that past returns do not guarantee future performance. It is only a guide. Another method you have at your disposal to create a future projection of probabilities is an option price. An option price uses the current price, interest rates, strike price, and implied volatility to create a premium.

The implied volatility is the market’s forecast of a likely change in a commodity price. It can be used to derive an option price, allowing you to create a probability graph.

Recall that one standard deviation covers about 68% of all returns, while two standard deviations cover approximately 95% of all the returns in a distribution.

An example

Using the current price of CME Copper and an implied volatility level, you can determine if future prices will be above or below a specific price level and the probability of each strike price being “in the money” by a particular date. You can then chart the distribution based on what is priced in the options market and create a probability calculation by a specific date.

Why future bets matter

The benefit of understanding the probability of where implied volatility places a distribution is pertinent. While a probability graph does not guarantee where the price will end up in the future, it gives you a gauge of where options traders think it will go. It can be used as a stand-alone guide or in conjunction with a probability range created by historical price changes.

The bottom line

The upshot is that by using implied volatility, you can create a probability graph that will provide the market’s interpretation of the probability of where a commodity price could be at a specific point in the future.

Creating a probability graph that will gauge what others think is another excellent risk management tool you can add to your hedging arsenal. One of the best ways to do this is to use the probability mechanism embedded in option prices.

If your business engages in commodity hedging, you might consider deploying a probability graph that can provide you with pertinent information to help you decide if it’s the right time to hedge. Contact our risk solutions team if you are interested in more details about creating a probability graph or learning more about hedging.

The post How to use probability to make commodity hedging decisions appeared first on Fastmarkets.

The current market dynamics could remain in place, as inflation can remain stubbornly high for an extended period.

High levels of inflation tend to generate uncertainty and volatility. When volatility impacts a company’s profits, it can reduce investor confidence and create a dynamic where risk aversion gains traction.

One of the best ways a company can determine if the volatility of its returns is beyond what investors want to accept is to use a Sharpe Ratio to measure its profitability.

What is a Sharpe Ratio?

The Sharpe Ratio is a risk management statistic used to measure the consistency of returns. The ratio compares the average return on an investment relative to the standard deviation of the returns on investment.

The Sharpe Ratio represents the gains you generate per each unit of volatility. The standard deviation is a statistical measure of the variance from the average and is used to calculate volatility.

The numerator of the Sharpe Ratio also removes the risk-free rate of return, such as a benchmark like a treasury bill. The average return is the profit you generate above what can be generated without taking risks.

Sharpe Ratio = Average Return (minus risk free rate) / Standard Deviation of Returns

Why is the Sharpe Ratio important?

Understanding the returns you produce is essential. Volatile returns might be alarming and can reduce confidence.

Here is an example of how understanding the Sharpe Ratio can impact investment decisions.

Let’s say you can choose to invest in company ABC or XYZ. Both companies have an average return over a year of 18%.

Company A has steady returns, all steady gains. The standard deviation of those returns is about 1.25%.

Company XZY also has an average return of 18%, but the profitability was erratic and lumpy. In several months there were vast gains of more than 25%, and in some months, there were losses of more than 20%. The standard deviation of company XYZ’s returns was 21%.

The Sharpe Ratio for company ABC using a risk-free rate of return of 3% is 12 = (18% average minus 3% risk-free rate)/ 1.25% standard deviation of returns.

The Sharpe Ratio for company XYZ using a risk-free rate of return of 3% is 0.70 = (18% average minus 3% risk-free rate)/ 21% standard deviation of returns.

Company ABC has a Sharpe Ratio of more than 17-times better than the Sharpe Ratio of company XYZ.

ABC provides you with a much better return for the same level of volatility.

Hedging can help you increase your Sharpe Ratio

The returns you generate for your business should be determined by owner/investor appetite.

Calculating these metrics allows you to decide the type of returns your investor desires. If your goal is to risk a lot on the direction of your feedstock variable cost, or your production, then hedging is likely less helpful than a company looking to lock in growing stable margins.

By commodity hedging a portion of your portfolio, you can manage your Value at Risk to enhance your Sharpe Ratio to its optimal level.

How can you optimize your Sharpe Ratio?

You can start optimizing your Sharpe Ratio by analyzing the volatility of your returns relative to your average return.

To determine the volatility of your profits, you would start by evaluating whether a significant change in your input costs would impact your earnings. If the answer is yes, you want to calculate how much the variation in your feedstock costs alters your profits.

For example, if your commodity input costs determine 90% of your profits, then the volatility of your returns will be generated mainly by commodity price changes. By fixing your input costs using a commodity hedging technique, you can reduce your company’s earnings volatility and increase your Sharpe Ratio.

If you are looking to optimize your Sharpe Ratio and want to know how you can reduce the risks associated with your commodity price risk, feel free to contact our Risk Solutions Team.

The post What kind of investment returns is your company producing? appeared first on Fastmarkets.

The short answer is yes. There are several ways to assess the movements of a commodity price. While the fundamentals drive the price of a commodity over the long run, the sentiment of market participants will usually be a factor over the short term.

Different types of analysis that can assist in your view of cobalt prices are technical analysis and seasonal analysis.

Seasonality

The seasonality of a time series reflects regular and predictable patterns that recur every calendar year. Any change or movement that repeats over one year is seasonal. Seasonality is present in many commodities. For example, heating oil and natural gas prices seem to rally during the winter most years.

Cobalt prices have tumbled, dropping more than 39% since hitting a high in May. While this has been driven by fundamental factors, including Chinese Covid lockdowns and ongoing weakness in demand from consumer electronics and NCM battery makers, it is noteworthy that August and September have historically been seasonal low points for cobalt prices over the past decade.

You can see that there is some seasonal nature to cobalt prices. Prices appear to peak in March and then slide and bottom in September. During Q4, prices seem to rise and then rally in Q1, peaking in March.

Technical analysis

Technical analysis is the study of past price movements. Some technicians believe that all the currently available information is incorporated into the price of a commodity. If this concept has truth, then past price movements may be able to describe the future activities of cobalt prices.

One of the most common ways to evaluate prices is to determine if they have moved too far too fast. A study that can help you determine if prices are stretched too far is the Relative Strength Index.
The purple line is the RSI, with the purple shaded band marking the threshold of overbought/oversold levels. The bottom part of the chart shows the MACD indicator; the blue line is the MACD line, the orange line is the signal line, and the red/green histogram shows the difference between the two.

J. Welles Wilder developed the relative strength index (RSI) in 1978. The RSI is a momentum indicator that monitors how quickly prices have moved over a specific period. Wilder’s default when testing the RSI is a 14-day/week/month. The index oscillates between zero and 100. According to Wilder, levels above 70 are considered overbought, while a reading below 30 is considered oversold.

The chart of Fastmarkets standard-grade cobalt metal prices – the settlement basis for cobalt futures – shows that the RSI has dropped to where weekly prices are oversold. The relative strength index (RSI) has a weekly reading of 24.33. This reading is below the oversold trigger level of 30 and could foreshadow a correction.

Another technical indicator we can use is the Moving Average Convergence Divergence (MACD). The MACD, invented by Gerald Appel in 1979, measures the relationship of exponential moving averages (EMA).

The defaults used to create the MACD are the 12-period moving average minus the 26-period moving average (The MACD line). These EMAs are compared to the 9-period moving average of the MACD, which is the signal line. The MACD displays a MACD line (blue), a signal line (orange), and a histogram (red/green) – showing the difference between the MACD line and the signal line.

The MACD histogram oscillates around the zero level, helping to signal uptrends (MACD line above zero) and downtrends (MACD line below zero). In addition, the MACD can indicate a buy or sell signal when the MACD line and signal line cross. When the MACD line crosses above the signal line, traders may use this as a buy indication. Conversely, traders view this as a sell indication when the MACD line crosses below the signal line.

As we can see, the crossing of MACD lines around May this year was a clear sell signal, with prices dropping sharply over subsequent weeks. The oscillation began to reverse in late August, and we see the two lines starting to converge.

Fastmarkets research cobalt forecast

The latest commentary from Fastmarkets Research’s weekly Battery Raw Materials Tracker states that: “Seaborne cobalt metal prices have fallen, reflecting the weakness in China, where prices have been trading at a significant discount for an extended period.”

One interesting issue with the RSI is that prices can remain oversold for a long time…

Fastmarkets analysts also note that: “Cobalt prices have shown signs of stabilizing in Q3 2022. With the lifting of the majority of lockdown restrictions in China boosting market sentiment and China’s State Reserves Bureau’s plans to stockpile around 2,500t of cobalt over the coming months, prices are not expected to fall further this quarter.”

Fastmarkets do, however, “see headwinds for the cobalt market later in the year and heading into 2023. The ongoing energy crisis and inflationary pressure continue to damage the global economic outlook.”

How to take advantage of seasonal and oversold conditions

While the market is in contango, with deferred prices above spot prices, there seems to be an opportunity if you believe there is a seasonal tendency to cobalt prices. Traders looking to hedge an oversold condition based on the relative strength index can purchase the Fastmarkets cobalt futures contract, looking for prices to rebound and rally to their seasonal norm.

The bottom line

The upshot is that there are several ways to analyze a commodity market. While fundamental analysis is the cornerstone, understanding seasonal and technical analysis can help determine the best time to hedge your commodity exposure. Two of the most useful technical analysis tools are the relative strength index and the MACD. These popular indicators allow you to determine if cobalt prices are overbought or oversold and whether they are in an uptrend or downtrend.

Technical analysis may help reinforce conviction and optimize timing if you have identified a fundamental trend you wish to trade.

If you would like help in determining if your business would benefit from commodity hedging, please reach out to our risk solutions team.

The post Commodity hedging: Trading cobalt using seasonal and technical analysis appeared first on Fastmarkets.

To combat volatile market conditions, Norexeco, a paper and pulp exchange based in Norway, launched two China-inbound pulp futures contracts in June 2021. These new futures contracts are a great supplement to its existing portfolio of Europe pulp futures contracts, European recycled paper OCC, and a Shanghai pulp contract.

The two China import pulp futures contracts are cash-settled against NBSK (Northern Bleached Softwood Kraft) ) CIF China and BHKP (Bleached Hardwood Kraft Pulp) China Net prices published by a commodity price-reporting agency Fastmarkets.

Fastmarkets’ NBSK CIF China market assessment captures the physical seaborne price for products exported from Canada and Northern European to China. The price was first published in 2001 and updated every Friday. China’s Shanghai Futures Exchange (SHFE) also lists a softwood pulp futures contract that started trading in 2018.

Why trade NBSK Fastmarkets futures contracts

Futures provide financial tools to hedge risk exposures. If pulp producers are worried that the price is likely to fall, they can sell in the futures contracts to lock in their sales price and fix profit margins at pre-determined levels.

The hedging principle also applies to the pulp buyer. If the pulp is expected to rise, buyers might buy in the futures market to lock in purchase costs.

Cross futures hedging

Opportunities might exist to arbitrage these futures contracts and lock in the logistics costs or mispricing.

The following graph shows SHFE pulp futures settlement price and Fastmarket’s NBSK CIF China price over four years. A conversion was applied to the SHFE settlement price by deducting 120 yuan transportation cost, 13% value-added tax, and then converting to US dollar for comparison. A daily estimate of the Fastmarkets price assessment was created for this analysis.

After the adjustment, we found that SHFE futures and NBSK CIF China were highly correlated at 95% since 2019. Of these three variables (mispricing, transportation, and VAT), transportation and mispricing are the most likely to deviate.

The spread between SHFE and NBSK CIF China prices constantly changes but converges to a mean.

A tool to measure spread convergence

One efficient way to capture the mean reverting tendency of the adjusted SHFE-NBSK spread is to use Bollinger bands.

Bollinger bands are two standard deviations of the price series around a defined mean. When the adjusted SHFE-NBSK declines to the Bollinger low (2 standard deviations below the 20-day moving average), the SHFE is undervalued relative to the NBSK, likely due to higher transportation costs or mispricing.

When the adjusted SHFE-NBSK rises above the Bolinger band high (2 standard deviations above the 20-day moving average), the spread has contracted and probably expresses limited demand for the seaborne product.

During the past 12 months, there have been four occurrences when the spread dropped below the Bollinger band-low. There are several situations where the declines in the adjusted SHFE-NBSK spread continued below the Bollinger band low before hitting a short-term bottom.

During the past 3.5-years, there were 52 occurrences when the adjusted SHFE-NBSK spread was either above or below the Bollinger Band Range. Using this technique, commercials and traders can determine if there is an arbitrage opportunity to trade the SHFE-NBSK spread.

The bottom line

We can identify scenarios when a market anomaly exists by creating an adjusted SHFE-NBSK spread from an underlying two-price series with a 95% correlation coefficient.

Using Bollinger bands to find situations when the adjusted SHFE-NBSK spread declines below or rises above the specified range, we can identify conditions when the price series is likely to revert to the mean. Traders and commercials can use the techniques to trade the Fastmarkets NBSK futures contract in conjunction with the SHFE futures contract to capture arbitrage opportunities in the pulp market.

If you are interested in more information, please get in touch with our Risk Solutions Team.

The post Commodity risk management: Evaluating the Spread between SHFE and NBSK pulp futures appeared first on Fastmarkets.

Besides creating a different living environment, the rules associated with feeding these animals are stringent. The majority of the ingredients in organic animal feed are organic soybean meal and organic corn.

Organic soybean meal sets the standard for the protein used in feed rations for organic livestock in the United States and Europe. Organic soybean meal has some of the highest crude protein levels as a percent of feed product.

For example, most of the organic soybean meals used by feed mills have between 40-48% crude protein. For comparison, organic canola meal contains between 38% and 40% crude protein.

A case study: Organic soybean meal volatility surges

Organic soybean meal has been the benchmark for protein in organic animal feed for a least the past decade. As consumer tastes for organic poultry, eggs, and dairy rose, the demand for organic animal feed increased.

Unfortunately, the United States imports more than 50% of the organic soybean meal used in animal feed. Most soybean meal crushed in the United States comes from genetically modified soybeans which do not meet organic feed standards.

The reliance on imported organic soybean meal has created challenges for livestock consumers in the last couple of years. Recently, a duty was placed on imported organic soybean meal from India, eliminating the largest supplier to the United States. The lead-up to the import duty generated a sharp rally and a surge in organic soybean meal volatility to 60%.

How can you mitigate your organic soybean meal risk

It would be nice if feed mill procurement management or livestock producers could reduce their exposure to organic soybean meal with a futures contract. Agribusiness has a long history of using futures contracts, and many farmers, traders, and feed mills are familiar with these instruments.

Unfortunately, the movements of CME soybean meal futures contracts and organic soybean meals are uncorrelated. There is no observable connection between the returns of organic soybean meal and CME soybean meal. The 5-year correlation is zero.

Market makers who have licensed Fastmarkets data are now offering financial products that allow you to hedge your organic soybean meal exposure. The products are similar to insurance policies that pay off if organic soybean prices rise or fall. The financial products, referred to as vertical call or put spreads, are financially settled versus the daily average price of Fastmarkets Organic Soybean Meal mid-West assessment.

A call spread combines call options where you purchase a lower strike call and simultaneously sell a higher strike call option. A put spread combines a put option where you buy a higher strike put option and simultaneously sell a lower strike put option.

How are organic soybean meal options traded?

You can buy or sell organic soybean meal option products in the over-the-counter (OTC) market. If the product you want to hedge is not on a futures exchange, like organic soybean meal, you can ask a market maker for a price for a premium that you pay upfront for protection in the future. Only cash will change hands, and you will never receive or deliver organic soybean meals.

What does the payout of a call spread look like?

A simple way to visualize a call spread is to look at a payout profile. In this example, a feed mill ingredient purchaser could buy insurance where the company is protected if the price of organic soybean meal rose above $1,700 per short ton, up to $1,900 per short ton.

It’s important to understand that the most you can lose from purchasing a call spread or a put spread are the premium you pay.

For a call spread, your break-even price is the lower strike price plus the premium you paid for this insurance.

You can see from the diagram that you have an unrealized loss until the price of organic soybean meal rises above your breakeven level. You would then experience unrealized gains on your call spread until $1,900, where your insurance would cap out.

The most you can earn on this commodity hedge is the difference between the two strike prices ($1,900 – $1,700) minus the premium you pay for the insurance.

Summary

The bottom line is that using a financial product to protect yourself from rising organic soybean meal prices is to trade a financial derivative such as a call spread or put spread. If you cannot transact the product you want on an exchange, you can work with an OTC market maker to transact an over-the-counter call or put a spread to protect yourself from volatile organic soybean meal prices.

You can also use techniques to determine how much commodity risk exposure is inherent in your business and the prudent amount to protect.

If you are interested in learning more about how you can protect yourself from volatile price changes, please reach out to our risk solutions team.

The post A feed mill’s guide to hedging organic soybean meal appeared first on Fastmarkets.